Living in South Florida has its advantages. We have beautiful beaches, access to boating and fishing, year-round golf, and 70-degree weather in mid-January. But as we all know, one of the downsides of living here is the possibility that in any given year, a major hurricane could hit the area. When a storm is approaching, those of us who live here know the drill—we put up shutters, stock up on supplies, and if necessary, we leave the area and evacuate.
In the investing arena, we have economic storms—recessions, bear markets, and financial crises. These episodes can be rather frightening, as lower account balances are often accompanied by a general sense of panic and media speculation about the coming end of the world. But while leaving the area is the smart thing to do when a major hurricane is approaching, can the same be said when it comes to investing? In other words, is it also a good idea to get out of the way and wait until the “storm” has passed? (For related reading, see: Protecting Your Assets From Contingencies.)
The Downsides of Getting Out
While it is certainly true that you can always sell your investments and wait until the economic outlook improves, the question is, at what price? A better analogy is as follows: a Category 5 storm is headed toward your home, the storm is three days from landfall, and to play it safe, you decide to sell your home. To most people, this idea sounds ridiculous. It’s not as if you are going to be able to find a buyer who is completely unaware that a dangerous storm is approaching. And how likely is it that the borrower will be able to get financing on such short notice and find an insurance company that is willing to insure the property? It’s not likely at all. Selling would mean selling at a very deep discount.
And if you did sell, yes, it’s possible that it could turn out to be a brilliant move if the home is destroyed or sustains severe damage. On the other hand, what if the storm weakens, turns out to sea, or does only minor damage? Would you be able to re-purchase the home at the discounted price? Not likely. You would probably have to re-purchase the home at full price now. (For related reading, see: Why You Absolutely Need an Emergency Fund.)
The idea of selling your home ahead of an oncoming storm is much like the idea of selling an investment portfolio in the midst of a recession or in anticipation of a possible financial crisis. The idea that you can unload your risk onto someone else when the news is bad, and jump back in when the news gets better, is a faulty premise because everyone else has access to exactly the same information that you have.
But just because we can’t sell our homes in advance of an approaching storm doesn’t mean that no one ever buys a home in South Florida. Instead, we take measures to reduce the risk of a severe loss in the event of a storm. We install hurricane shutters and avoid building in areas that flood easily; we pay more for newer homes and we purchase homeowners insurance.
And similarly, just because a serious market downturn is possible doesn’t mean we should never invest. But it does mean that when we invest, we should look to reduce the risk of a severe loss by diversifying broadly, using the principles of asset allocation, and incorporating lower-risk fixed income investments to dampen volatility. And most importantly, we should only take on the amount of investment risk that we are comfortable taking. In other words, the preparations for the storm are done well before the storm arrives, in the form of a well thought out investment plan. (For related reading, see: 4 Ways to Weather an Economic Storm.)
Core Wealth Management is a Registered Investment Advisory Firm in the State of Florida and is located at 4600 Military Trail, Suite 215, Jupiter, FL 33458, (561)491-0231. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against a loss in periods of declining values. Investing in securities involves risk, including the potential loss of principal invested. Investors should be aware that investing based on strategies or models does not assure a profit or guarantee against a loss.