Today was another down day, a reversal in the stock market. For those who use the market to support long-term financial goals, this is a good time. It is a good time, if your plan is based on your balance sheet, to consider adding to your Upside holdings by buying or rebalancing. If you’re beginning to wonder if you should be selling off and getting out, you may find that a strange comment. Let me explain why this is a good time.
I start any financial plan with a close look at the household balance sheet. I look at the current value of savings (financial capital) plus the present value (“PV”) of future employment earnings (human capital) and Social Security, pension, and other income (social capital). I compare that with the present value of estimated future expenses.
The amount of savings needed to cover the PV of future expenses is the Floor. Anything left over is Upside. You can afford to expose Upside to market risk for future growth because losses to Upside will not jeopardize your lifestyle—your lifestyle is covered by the Floor.
Upside is a simple name for the risk capacity—the ability to withstand losses—on your balance sheet. It’s a mathematical measure, not an emotional one. When you understand your balance sheet and know your Upside, you take the emotions out of investing.
Instead of always worrying about the market, you build a safe, risk-free Floor so that your lifestyle is covered and you can sleep at night. And instead of thinking about running for the exits when the market tanks, you think about adding to Upside to bring it back into balance with the rest of your plan.
The Upside of Upside
Today the broad US market closed about 14% off its all-time high last June, and is down almost 9% for the year. The upside of Upside increases when risky assets—stocks—are cheaper, as they are now.
So it’s a good time to be buying or rebalancing if you have a long-term plan that includes covering your lifestyle goals with risk-free Floor and only investing Upside in risky assets. You’re being smart by investing within your means, the same way you protect your lifestyle by spending within your means.
The investment guys talk about trying to catch a falling knife, meaning that buying a market that is down can be dangerous, since it could go down further. Yes, it can. It can also go up and then you haven’t bought in, either, and what was cheaper is now pricier. In fact, no one knows what the market will do. Not your “money guy,” not Goldman Sachs or Merrill-Lynch, not the Fed, not Donald Trump, not your insurance agent or your brother-in-law. No one. The market goes up, and it goes down. Timers lose more often than they win.
We don’t try to time the market. We aren’t trying to beat the market. We don’t have to. We’re using the market to support our long-term goals for growth. To get the best use of the market, we buy the whole market and then buy more if it when it’s cheaper. We get market returns, which typically are better than 2/3 of the results of those who are trying to beat the market.
In fact, we get something better than market returns. We get a rising return on our Upside investment by value averaging down. Let’s say you have a global allocation to five low-cost index ETFs in your Upside portfolio. Your average share price (cost or basis) of the largest fund—the US total market—is $100/share.
The price per share drops to $90. Your allocation is 10% down, so you rebalance by purchasing 10% more at $90 with cash from your Reserves, if your balance sheet affords it (we haven’t talked about Reserves; we’ll save that for another discussion).
Your average share cost is now $99 [the Excel math for that is =(90%100)+(10%90)]. You’ve lowered your cost by 1%, which will increase your return accordingly if and when the market recovers.
A week later the market falls another 10% from $90, to $81. The price is now 19% lower than your original basis. So you buy another 10% at $81, lowering your cost to $97.50.
Value Averaging Adds to Market Returns
This is called value averaging—investing to target percentages rather than by dollar amounts (“dollar averaging”). In this example, when the fund rises back to your old average cost of $100 a share, you’ll have gained 2.5%. If it falls even further first, and you value average down even more, then your gain will be even higher when it recovers. Value averaging down increases market returns by lowering your basis. Dividends increase the total return further.
That’s how you catch a falling knife without bleeding. And that’s why this is a good time for those who have a strong balance sheet and a long-term plan to manage Upside, Floor, Longevity, and Reserves.
–Michael Lonier, RMA
I am teaching another section of the Retirement Management Analyst course starting this week to financial planners and advisors through the Salem State University (MA) distance learning program. Learn more at the Retirement Income Industry Association site.