Conversation with Jane...

Here's an email I received today from my dear client Jane (btw, all my female clients, when I write about them, are named Jane):

Hi Marty,

I am getting more and more disgusted every day about how this country is being run. Our domestic and foreign politics stinks and nobody stands up for anything. The news people talk about a coming crash. Since my anxiety level is high (my doc says), I am worried about a big loss at my age. Now you have to be my money doctor and give me some medicine. You probably have a waiting list....

Jane

Here's my reply:

Hi Jane,

I completely understand. Here are my thoughts:

For starters, and most importantly, we have to figure out a way to make sure your portfolio is not the source of your anxiety.

For the moment, we're attempting to do that by keeping your exposure to stocks relatively moderate. All things being equal (meaning if your portfolio moved in lockstep with the major averages), your portfolio would suffer roughly 1/3rd of the magnitude of a "coming crash". If that thought causes you anxiety, then we have a few options:

1. Reduce your target allocation to stocks to something less anxiety-provoking for you. Maybe 25%. Maybe less.

And/or

2. Decide on a percentage loss and put in stop-loss orders. For example: if we were to re-position your stock exposure entirely to exchange-traded securities (meaning we'd sell your mutual funds and buy all ETFs [you have both now]), we could put in stop-loss sell orders that would trigger the minute the share price of a given security declined by a certain percentage. If we chose, say, 10%, and the market subsequently declines by more than 10%---and all of those orders filled right at their stop price---you'd mitigate your losses (dramatically in the case of a "crash"). There are, however, some risks inherent in this strategy:

For one, a stop-loss order is, again, a sell order. Meaning the position is for sale (not necessarily sold) when it hits the stop price---it could fall further before someone buys it, resulting in a loss greater than we intended. That's why, when we do this sort of thing, we try to use the most heavily traded securities (they're the most liquid). Also, if bad news happens overnight, a position could open the next trading day at a price lower than the stop price: which would trigger the sell order somewhere below the price we intended. Lastly, and, in my opinion, most dangerously, the market might drop by the percentage we chose then rally back from there, leaving you "stopped out" (everything sold), while the market moves higher. You'd then have no option---if you're to buy back in---but to buy back at a higher point than where you sold (I've, alas, seen it happen).

Or

3. We can re-position your portfolio into "optionable" securities. We would then buy "put options" that would guarantee you a set price for each position regardless of what the market does. I.e., if it tanks, you're entirely protected. Although you would pay a premium for each option, and it can get expensive over time.

I would be very happy to further explore any or all of these options with you...

As for the things that worry you (other than the way this country is run): the part about people talking about a crash is actually a good thing. Seems strange, but the time to fret over the stock market is when nobody's fretting over the stock market: When optimism peaks, everybody (well, maybe not everybody) is fully invested, and a bit of bad news can send everybody to the exits at once. Which, for lack of buyers, can exacerbate, and accelerate, the decline. When, on the other hand, pessimism/skepticism is high, there are plenty of potential buyers to prop prices up when the market takes its hits. Which is what's been going on lately. Doesn't mean there's not a crash coming. In fact there's always a crash coming---just don't know when or how deep. That's why having the right allocation for your stage in life, and your temperament, is essential to your longer-term investment success, and sanity.

Should we get together soon to discuss further?

Marty

P.s. Jane, would you mind if I recreate our communication in a blog post, while of course changing the name to protect the innocent?

My purpose for sharing my conversation with Jane is, in addition to making you aware of a few methods of potentially reducing downside risk, to remind you that when it comes to investor sentiment, fear is a beautiful thing. And, as always, to stress the importance of maintaining an asset allocation strategy that fits with your time horizon and, most importantly, your temperament...