When stock markets crash and the news headlines are full of doom and gloom, most of Wall Street talks about dollar cost averaging. i.e. if you continue to buy, you will buy at a cheaper and cheaper price, improving your long term returns. The whole time they are generally trying to pull as much of their own funds from the market as the possibly can and need someone to sell to. That person being the one who believes you can’t time the markets and dollar cost averaging is a good thing. The picture below shows how volatile the stock market has been for the last few years. Because of the high levels of debt in the markets the system is unstable and drops of 50% or more can easily happen. The figure below is a monthly chart of the S&P 500 from 1995.
The figure below shows a median return of 10% over 9 years (the short term debt cycle) resulting in a -$2565 loss on a $100K invested.
How can you reduce downside risk from the financial system?
In troubled times there are a few types of risk you need to worry about.
- Large drops in the value of your investment
- The company that holds your investment going bankrupt
- The value of the currency getting destroyed
- Risk of Bank Collapse and you can’t get your funds. (If to many banks go bankrupt the FDIC will become insolvent, just look at Greece right now)
The easiest way to protect the value of your investment is to invest in things that don’t lose money. That may sound like a glib comment but there are several ways to achieve this, the reason most people don’t look for them is that get seduced by the promise of high returns.
Here are a few examples.
- Whole Life Policies – guarantees you not to lose the cash value of your investment however you need to be careful about the fees you pay. i.e. you want the maximum cash value for the minimum life insurance coverage which is not typically how they are sold. The risk in these policies is the company going bankrupt so you need to choose a company that has been around for a long time, and be careful about the fees you pay.
- Indexed Universal life Policy – has the same benefits and risks of a whole life policy with a different fee structure and is linked to the stock market performance but if the market drops the investment value doesn’t the max gain is also often capped.
- Annuity Policies – provide a guaranteed return for the length of the policy. For these you don’t need to work about the fees, but they still have the company risk & Currency risk and your money is still tied up just like 1&2 above and if the finical markets go haywire in bad way strange things can happen.
- Collar trading with ETF’s such as the SPY (S&P 500) or the QQQ (Nasdaq) This is where you use options to protect the value of your investments. If the value of the stock falls the value of the options rises minimizing the loss. Your investment is more liquid however this requires a lot of knowledge and skill to be able to execute and our returns are also capped. There is also the 200 day moving average that can help you judge if the market direction has changed. When price drops below and stays below the market is probably heading down.
- Unleveraged real-estate. This is my favorite because it’s like buying an annuity. If you have the real-estate in a relatively stable market then the income it generates will be relatively stable and even if the price drops the income generated won’t usually drop, and if inflation happens then the income generated will rise and keep up. After the volatility you can also apply for loans on the asset that will increase the returns and allow you to buy more assets at a cheaper price. The other benefit of unleveraged real-estate is that it is outside of the financial system with very little risk from bank issues.
- Gold – Many people talk about gold being the best security; however I am not sure I agree due the extent of major financial manipulation by large institutions. The only form of gold worth having is physical metal that you hold because it is outside of the financial system and can easily be exchanged for currency. It can be a good thing to put some of your rainy day funds into in case of emergency, and acts like an independent currency outside of the bank risk; it also preserves value fairly well. The reason it’s not a fantastic investment is it doesn’t generate any income and isn’t easily leveraged. Also if the dollar gains in strength more gold will continue to drop. Here is a strange fact though, despite the fact gold has dropped vs the dollar, it has gone through periods where it has risen vs the Euro. i.e. it behaves like an independent currency.
Great article Paul. If and when there is a market correction, these strategies will help hedge against further devaluation.
Great article Paul. I like the example of how a seemingly 10% return over the 9-year period is actually a loss. I think it’s a good example of how we must pay attention to the details. Good tips!