Tuesday, October 7, 2008

Time to Act!(?)

If you haven’t been stewing about the market, don’t bother to read this. If you have been losing sleep over the market’s ups and downs, we hope this will put it in perspective. We had a conversation this morning with over 75 members of the Alliance of Cambridge Advisors (ACA) across the country to discuss the situation and appropriate action clients could take.

As of this morning the Dow was down about 25% YTD, and the European Markets are down over 30% YTD. The impact of the bailout won’t be felt for at least a month, and we are likely to see significant market volatility at least until the end of the year.

To put this in historical perspective, the Dow dropped 25% in one day in 1987. In the last recession, from 2000-2002, the market was off 45% at the bottom in 2002. A number of clients jumped out of the market in 2002 because they couldn’t stand the thought of losing half of their portfolio.

Alas, once burned, twice shy = so they were hesitant to put money back in the market when it started to recover, worrying it would drop again. During 2003, the market soared over 30%, and by the time they got back in during 2004 they were never able to make up for the loss they experienced from jumping out.

This market presents both dangers and opportunities for investors. Below we review actions you might consider depending on your stage in the ACA Life Cycle, as well as specific advice if this market is now impacting your cash flow. We have included all of the stages, not just yours, because many clients like to share this information with their friends and family.

1) Foundation - ages 20-30: This is a great time to buy your starter home. You have to shop for foreclosures and short sales though, or you might buy a house you could buy for half the money next year. If more than 10% of the home sales in your area are foreclosures, they are driving the market price, so hold back, no matter how tempting it is to jump in. In the meantime, pay off your credit cards and accumulate cash. Keep contributing to your 401k, since you can borrow this money for a down payment if you have to.

2) Early Accumulation - ages 30-40: Since by now your net worth should be 1 to 3 times your annual income, and you have a home, save-save-save. Hold off on home upgrades and renovations until you have built up a cash reserve of at least 20% of your mortgage balance. Split your 401k contributions 50/50 between cash/stable value funds and equity mutual funds.

3) Rapid Accumulation - ages 40-55: Your net worth is now 3-10 times your annual income so invest aggressively in your equity mutual funds to bring them to at least 60% of your portfolio. This is a great time to buy stocks using Dollar-Cost-Averaging (i.e. buying some every month). Doing this now will guarantee you a great retirement, and you will look back in 10 years and be amazed at how low the prices were. However if you are in danger of losing your job, see the section below on “Cash Flow Problems.”

4) Financial Independence - ages 55-70: At this point you are still working but supplementing your income with investment earnings. This is a dangerous stage right now. You want to make sure you don’t deplete your investment portfolio!
Either work more to increase your income, or cut your living costs.

5) Conservation - ages 70-85: You are probably now retired and should have your ACA Bond Ladder complete. It is critical to make sure you continue to live within your means. Excess spending means your portfolio will be depleted to quickly. Keeping to your spending plan will assure we will be able to replace the rungs you are using from your ladder when the economy turns around.

6) Distribution - ages 85+: Many clients in this stage are distributing their largess. We suggest holding off on additional gifts to children or charities for 6-12 months. You want to gift your largess, but you don’t know what that will be until this financial crisis ends.

For a more complete discussion of these life stages, we would suggest re-reading chapter 7 of “Why Smart People Do Stupid Things With Money” by Bert Whitehead, MBA, JD, who founded ACA.

Cash Flow Problems? Special consideration should be given in situations where a client is laid off or their business is losing money. You should contact us before taking any action. However, here are the sources of cash we suggest in order:
a) Cash: conserve it, and if you have depleted your cash to below 4 months living expense, consider borrowing money on your home equity line of credit (banks only lend you money if you don’t need it, so don’t wait until then).
b) Bonds: sell bonds which are not in a qualified (i.e. pension) account.
c) Stocks/Mutual Funds: sell equities which are not in a qualified account. At this point it is likely you will have a very low taxable income this year. If the stocks are at a gain, you may not have to pay capital gains tax if you are in a 15% bracket. If there’s a loss, you can use $3000 each year after offsetting capital gains and carry forward the loss to future years.
d) If you are anticipating a negative taxable income, we may want to use the opportunity to convert IRA’s to Roths.
e) If things get this bad, you may have to consider cashing in Savings Bonds.
f) If you end up having to live on your credit cards, we should be doing bankruptcy planning with you.

The economic situation could worsen substantially, particularly if there are compounding exogenous events like terrorists setting off a Middle Eastern war which interrupts the world oil supply, or a severe California earthquake, or a global health plague. These however are very remote. There is nothing you can do about these possibilities.

It is more likely that your endogenous situation could change due to a disability, layoff, divorce, etc. In these cases we should rebalance your portfolio accordingly, so give us a call to set up an appointment.

Finally, if you find yourself often anxious about the world financial situation, do yourself a favor and stop watching TV news or listening to the radio. The media has been hyping this issue to increase ratings, and of could all the politicians are bellowing about it to get votes. Most of them don’t really know what to do about it and just rant. Stop listening!

Warren Buffet is a calm, collected buyer in this market; Jim Cramer is jumping up and telling people to sell now! Warren Buffet is one of the richest men in the world; Jim Cramer earns a living with his antics. Who do you want to emulate?

Bert Whitehead, MBA, JD

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