Being wealthy doesn't mean having all the money in the world, just not having to worry about it.

Lesson 19 – Panic Insurance

The great investor, Warren Buffett, has said, “Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” Buffett’s Berkshire Hathaway holding company has endured such declines multiple times during its climb from $15 per share in 1965 when he took over the company to its current $130,000 or so per share (which is actually still down 10% from its $150,000 peak in 2007). (Buffett doesn’t believe in stock splits or dividends, probably so that his genius will be evident to all in its current stock price.)

One of my favorite stories about Buffett is about an interview he gave in late 2008 with Berkshire stock down 44% at $84,000 per share. The interviewer asked, “How did it feel to see your stock go down over 40%?” “It felt pretty much the same as it did the half-dozen other times it’s happened.”

But how do you deal with the panic and real temporary loss of a major bear market in stocks? I have several possible solutions to offer:

    1. Don’t panic. Well, I thought it was worth a try.
    2. Pay someone else to panic for you. Obviously, that’s one of the services I provide my clients. I had virtually no discussions with clients about the market performance between Oct 2007 and March 2009. We talked plenty about their personal finances and did consider the current value of their investments in each discussion of goals and plans. But nobody panicked out of the market, and virtually nobody even commented to me about a change in strategy as a result of the decline, except for a couple of clients who wondered if they should do some extra buying to take advantage. Later on, I asked a few clients how they managed to handle the decline so calmly, since even I was amazed. A few clients mentioned that I had warned them such declines occurred periodically, but the answer most of them gave was that they didn’t open their statements, figuring it was my job to worry and that I’d let them know if something needed to be done.
    3. Eliminate all your debts. Much of the concern over major declines in assets is the result of the fixed payments people owe. Obviously, you have more reason to be concerned about a major decline in your assets if you have a large mortgage, credit-card debt, car loans, and student loans. Being debt-free makes it a lot easier to patiently wait out bear markets.
    4. Keep money you’ll be needing within years in cash equivalents. The average bear market lasts around one-and-a-half years. If you’re retired and drawing regularly from your investments, one reasonable approach is to stop selling your stocks for spending purposes once an official bear market (defined as a 20% decline) has started and to draw on your cash reserves until the market has recovered to that level or higher. While it is certainly possible that it will take more than two years, you will at least have avoided liquidating large amounts of stock during that time period.
    5. Buy gold-bond insurance. You knew I’d get here eventually. As you’ll recall, I spent an entire lesson trashing bonds and another trashing gold. As investments intended to produce meaningful returns after taxes and inflation, they stink. But when people are panicking OUT of the stock market, they have to be panicking INTO something else. Usually, they panic into U.S. Treasury securities. But when the crisis includes a fear of government collapse, they typically panic into gold. So gold-bond insurance refers to a mixture of gold and Treasuries likely to hold up and even increase significantly in value during lousy stock markets. I reviewed every calendar year with U.S. stock-market declines in excess of 10%. (This is in nominal rather than inflation-adjusted amounts since people don’t seem to be bothered by a 5% increase during 10% inflation as much as they dislike a 5% decrease during 10% deflation, even though the latter is a far better result for them.) There were 27 such years between 1802 and 2011. Short-term Treasury bills went up in every one of those 27 years, with an average gain of 4.4%. Long-term Treasury bonds rose in 23 of those years, and fell in four. But the average result was actually slightly better than bills, at 4.7%. The price of gold was fixed during most of U.S. history, but in the 10 years when its price was allowed to change during a double-digit stock-market decline, it rose five times and fell five times. The increases, however, were so enormous that the average result in those 10 years was a gain of 14.9%. Even averaging in the other 17 periods in which the price was not allowed to change, the average performance of gold in the 27 bad stock years was a gain of 5.5%. Thus, there is a good argument for including all three — bills, bonds, and gold — in a portfolio intended to reduce overall volatility.
    6. Buy a smorgasbord of hedges. Treasury bonds and gold have the advantage of long histories and ease of acquisition and ownership during crises, but there are other investment categories that tend to do well during stock-market declines and could play a part in a complete portfolio as long as their limitations are understood. Thus, at various times I have used corporate bonds, commodity futures, managed futures, real-estate investment trusts, Treasury Inflation-Protected Securities (TIPS), timberland, and foreign bonds. Many of these, however, become difficult to trade during extreme crises, and I don’t recommend their use by do-it-yourself investors.

Most of these techniques are reasonably obvious except for number 6, which I’m not going to discuss in detail because a do-it-yourself investor is likely to botch the implementation or at least not fully understand the special dangers. Number 5, however, leaves open the question of how much of your portfolio you might choose to allocate to T-bills, T-bonds, and gold — which we will discuss in our next lesson.