The market is dropping faster than the ball at 11:59pm on New Years Eve.
is it time to panic?
Your answer most likely depends on a few factors…
- Whether you’re an investor or a trader.
- How close you are to retirement.
- Your investment style.
Most investors aren’t totally freaking out because investors – true investors – take a long term view of the market.
As Warren Buffett says, you just need 3 things to be a successful investor: time, patience, and compound interest.
And according to that philosophy, income investing with its inherent compounding is exactly the right investment style for long-term investors.
So, what about the folks who are close to or already retired?
I’ll share a deeper dive into my “bucket” system of portfolio management a little later in this article to help with that.
But first, let’s figure out exactly what the heck’s going on.
The good news is, historically, the stock market always comes roaring back after significant corrections.
By definition, corrections are declines of 10% or more, while minor ones are 5%-10%. Bear markets are declines of 20% or more.
Where Are We?
Let’s take a look at some recent numbers.
- S&P 500 closed down -2.71% Monday, December 24th for its seventh negative day in 8 and its worst day since Dec. 4, when the S&P lost -3.24%
- Until Monday, the Dow & S&P 500's worst Christmas Eve ever was back in 1985, when they fell 0.63% and 0.69%, respectively
Month to Date
- S&P is down -14.82% on pace for its worst December ever back to back-tested inception in 1928, with the next worst December in 1931 when the S&P lost -14.53%, and its worst month since October 2008 when the S&P lost -16.94%
- Small caps are down -17.37% on pace for their worst month since October 2008, when small caps lost -20.90%
- Dow is down -14.67% on pace for its worst month since Oct. 10, 2008, when the Dow lost -18.15% and on pace for its worst December performance since 1931, when the Dow lost -17.01%
- NASDAQ is down -15.52% on pace for its worst month since October 2008, when the NASDAQ lost -17.73%
Year to Date
- S&P is down -12.06% in 2018 on pace for its worst year since 2008 when the S&P lost -38.49%
- Small caps are down -17.49% on pace for their worst year since 2008, when small caps lost -34.8%
- Dow is down -11.84% in 2018, on pace for its worst year since 2008 when the Dow lost -33.84%
- NASDAQ is down -10.29% on pace for its worst year since 2008, when the NASDAQ lost -40.54%
So, it’s ugly.
Since 1920, the S&P 500 has on average experienced a 5% pullback 3 times a year, a 10% correction once a year, and a 20% bear market decline every 3 years.
So, while it may be unsettling, it’s not unusual to experience a sell-off of this magnitude.
Long Term Investors: What to Do?
Stick to the Plan.
As I mentioned, I’m an investor and that means I invest in companies and hold them long-term.
Specifically, I’m an INCOME investor and that means I primarily invest for income and as long as I keep getting that sweet income yield, the capital gains (or losses) just represent the daily fluctuations of the market.
And that attitude freaks a lot of people out.
I was at a cocktail party a few nights ago and several of the guests nervously asked what my plan is for this market.
I replied, “I’m watching and waiting and preparing to buy, buy, buy.”
And that set off a big debate between the patient and the panicked.
The patient realize that this is the norm…
The panicked are just very scared to lose even one penny of capital.
I’ve received several emails and texts from friends and subscribers complaining about recent “losses” and market volatility.
I’ve noticed, most of the fear from the panicked is around two main issues…
- Being in or very close to retirement.
- Having no idea what the hell they are doing.
Now, there’s never an excuse for being clueless with no plan. Especially when it comes to your money. So, if that's you, immediately join the Income Investors Academy and let's get you a plan (and a clue).
If you're in or close to retirement, I have a strategy for you and it comes back to a familiar theme… buckets.
Retirees: What to Do?
Manage Your Buckets.
Look, I understand being close to retirement and wanting big gains but being unwilling to accept any risk or decline in your invested capital.
I also understand it’s a totally unrealistic expectation.
It’s like saying you love the beach but hate sand.
You really can’t have one without the other.
I manage my portfolio according to the 80/20 rule.
Or more specifically, the 80/15/5 rule.
Meaning that 80% of my investments are in income, 15% in value, and 5% in growth.
The Investment ‘Style' Buckets
Generally, 100% of the income comes from 80% of the portfolio. Natch.
And 80% of the big capital gains come from 20% of the portfolio. This is because growth and value stocks are way more volatile than income.
Now, here's the biggie…
In a market correction, the market value of my holdings may decrease but my income stays the same.
This is why I don’t panic too much.
Here’s an example using the absolute worst performing stock I own right now.
I own 200 shares of Government Properties Income Trust (GOV), a real estate investment trust (REIT).
A few months ago, GOV announced it was merging with another REIT and the share price tanked hard. (You can see the straight shot down on the chart above.)
At the same time, the company announced that their $1.72 per share dividend was unsustainable and that after the merger, the surviving company would pay a dividend between $0.50 – $0.60 a share.
One guy flipped out after the announcement and emailed demanding a full update on what I planned to do about this.
My answer was simple: “Wait and see.”
He didn't like that answer but here’s why it's my answer:
- At the time, the merger was just proposed – the shareholders hadn’t even voted on it yet. I don’t make decisions based on what “might” happen.
- My cost basis for the stock is $12.63 and the shares are trading at $6.91 representing an unrealized loss of 45% but I didn’t buy the stock for capital gains, I bought it for income.
- The stock is currently yielding about 25% and my yield on cost (the income I locked in at my buy price) is 13.6%. My target yield is 9% so this still fits my model.
- The companies have yet to complete the merger or announce the new dividend rate so even though the market value of my invested capital has been reduced by 45% my plan is to wait and see.
Do I like seeing my capital reduced by 45% even if it's just on paper?
Of course not.
Am I still collecting my 13.6% income?
Will I still collect 13.6% if the surviving company from the merger cuts the dividend rate to say $0.55?
No. My yield on cost at that point will be 4.4% well below my 9% target.
Will I sell the shares then for a capital loss?
I’m not sure yet since it hasn’t actually happened and I don’t make decisions based on what “might” happen.
If I do sell will my loss actually be 45%?
Because that doesn’t factor in the income I’ve been collecting. My 200 shares pay me $344 a year in dividend income so if I sell now after owning them for two years, my capital loss is 18% not 45%.
A little better.
But what if I don’t sell?
I have a couple of options.
- I can buy 200 more shares at $6.91 to average down my cost basis to $9.77 and increase my dividend yield to 5.6%.
- I can make sure I have an offset to the high side so that 4.4% income doesn’t drag down my 9% portfolio yield. (I’ll need something that yields 13.5% to offset).
What if I just decide to sell? Is there anything I can do to offset the capital loss?
- If I am investing in a cash account (not a retirement account) I can use the loss as a tax harvest and reduce the taxes paid on other gains.
- I can also look to see if I can profit cycle another holding to cover the loss.
In this case, I have another REIT that has an unrealized capital gain of 140%. (Yes, even after the correction.)
I can sell enough shares to lock in that gain and cover my loss so the portfolio is “whole” again.
Or, I could just hold it for a few more years, collect my income (with an offset to the high side), and watch the stock climb back up reducing or eliminating my capital loss.
The bottom line here is that we have options.
And these options are based on math, not emotion.
Ok, retirees or soon to be's, here's the part that's important to you…
We’re Going to Need More Buckets
The investment “style” buckets are great but if you’re facing a bear market at or near retirement, you may need investment “term” buckets as well.
Basically, you divide your money among different kinds of investments based on when you'll need it.
Jason L. Smith, a financial adviser and author of The Bucket Plan, uses the system with clients, splitting their assets among three buckets:
The Now bucket holds what you'll need in the short term.
Smith recommends setting aside enough cash so that, when added to Social Security or a pension, it will cover your basic expenses for up to a year.
It should also have enough for major expenses that are likely to crop up over the next couple of years, such as a new roof or a tricked out golf cart, plus cash for unexpected emergencies.
Money in the Soon bucket will be your source of income for the next 10 years.
Smith recommends investing in a fixed annuity.
I recommend short-term bonds or exchange-traded debt securities aka baby bonds. (We provide research and ideas on these in Academy.)
As the Now bucket is depleted, you withdraw money from the annuity or sell some of the bonds in this bucket to fill it back up.
The assets in the Later bucket aren't meant to be tapped for more than a decade into your retirement, so it’s cool to be invested more aggressively in stocks, REITs, and private investments that are typically less liquid than public market holdings.
Consider selling off your Later bucket holdings to replenish the Soon bucket starting about five years before it runs out of money.
If the market is in a downward spiral like it is now, you can wait, knowing you still have a few years before the Soon bucket will be empty.
So, there you have it.
An expanded bucket system for the folks close to (or in) retirement.
The market correction is nothing to fear when you have a plan and follow it.
Here are a few parting thoughts for you to tape to your bathroom mirror or stick on the fridge…
Selling low and buying high never works so no panic selling!
Never make important financial decisions based on emotion. Do the math!
And assuming you have an investment plan and are managing your buckets, my advice is turn off the TV, log off Fidelity, and start thinking about all of the amazing experiences you will have in 2019.
Money is just fuel for your ideal life. Start living it.