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In recent articles, I have tried to make the case that stocks are now more likely than not to either do relatively poorly over a year's time or perhaps longer, or short of that, have disappointingly flat returns. While no one can be certain that this will happen, the question becomes whether investors should prepare themselves for this possible eventuality, and if so, how.

While the typical investor usually doesn't create a step-by-step road map to guide their investing decisions, I believe that making such a plan to deal with such uncertainties can be highly beneficial.

Wait and See, or Take Precautions?

Most investments are made to achieve financial goals. How is this end result best accomplished? After choosing one's investments, does one simply wait to see progress toward reaching these goals, continuing on the same path so long as things are going reasonably well, and only switching course once trouble is clearly confirmed? Or, should one consider adjusting their plans before actually knowing how his or her investments will fare in the months or even years ahead?

Planning for possible future contingencies may not be for everyone. Due to time constraints, but more likely, fear of acting on a plan that may go against the current prevailing direction of the market, or perhaps, admonitions that merely holding on works best, it seems that such planning will only be considered by a minority of investors.

But failing to make such a plan, it is easy to lose sight of one of investing's most sage principles - "buy low, sell high." While many may be content with whatever the market "gives" them, especially in the midst of an extended bull market, will the same apply once the market either no longer provides stellar returns as in the case of a flat market, or once the market turns decidedly lower?

When markets turned down as they did between 2000 and 2002 and in late 2007 through early 2009, many investors were no longer content. As the extent of the drops became ever more severe, it was only then that in many cases quickly devised plans were enacted to either reduce holdings or exit the market altogether.

Likewise, more recently, more and more investors, upon seeing the magnitude of the past gains achieved since 2009, revised their prior thinking, "planning" if you will, to participate more, especially beginning in 2013 according to fund flow data. A similar phenomenon occurred in 2000 as the extended bull market continued, before it had morphed into a bear.

While no one can be certain of what will happen in the future, making a plan only after something happens, that is, becomes fully known, might be compared to beginning to plan for earthquake safety only after a big one hits. While most residents of earthquake country (myself included) tend to become complacent in the absence of damaging quake activity, the few who bother to develop and take necessary precautions will likely suffer less once the inevitable happens. But human nature, it seems, dictates that minimal interventions should be made, in spite of potentially harsh consequences, until such time that a near-crisis situation actually emerges.

Anyone who examines the history of stock prices is aware that stocks have both good years and bad. And such periods last, in many cases, for several years running, with mediocre, flat, or even opposite performing years sometimes interspersed.

For investors who have participated in most or all of this current exceptional bull market, returns have been so good that it makes sense to me to plan on actually realizing some of these gains in the belief that they will not last forever. For investors who more recently entered the market and whose gains are not nearly of the order of magnitude of these longer-term participants, the picture may be less clear. However, even these shorter-term participants might want to consider making sure that they aren't like some initially lucky casino patrons who hit a jackpot upon first arriving: Does it make more sense to leave the casino right away with profits in hand, or, keep playing with the house's money until it likely is frittered away, given that the odds always favor the house?

Note that while the remainder of this article focuses on the details of developing a plan for the eventual winding down of a bull market such as the one we have been experiencing since 2009, a similar kind of step-by-step plan likely would be in order once a bear market has actually occurred. In the latter case, however, the particulars would be reversed: the essence of such a plan would be to prepare for the eventual return to better days ahead.

With this rationale in mind, here are the steps you can take right now to prepare ahead of more potential trouble:

Step 1: Assess which investments in your portfolio are relatively risky.

Not all stock ETF/mutual fund investments are created equal. Some, even within the same fund category, are actually considerably more risky than others. While risky investments tend to do well in bull markets, by the same token, they will likely do more poorly in bear markets. And they will probably lose their advantage in flat markets, making them not worth the added risk of holding on to.

How can one determine which fund investments are more risky than others? There are many ways to do this so let's highlight just a few:

a. Use some commonly accepted notions of higher risk to estimate level of risk:

  • Small/Mid-Cap ETFs tend to be riskier (and more volatile) than Large Cap ETFs;
  • ETFs that consist of stocks only tend to be riskier than Balanced or Target Date ETFs that have some investments in bonds;
  • Foreign ETFs (and Emerging Market ETFs in particular) tend to be riskier than most US-only ETFs
  • sector ETFs tend to be riskier than non-sector ETFs;
  • many Growth ETFs are typically riskier than Value ETFs;
  • finally, High Yield "junk" bond ETFs as well as long-term bond ETFs are riskier than most other bond ETFs.

Note that many investment company web sites will show a graphic under the fund's description or objective that estimates the riskiness of the fund. But, as shown below, simply using a fund's category to judge risk won't always match other more objective data.

b. Since determining how risky an ETF is by analyzing statistical data is a difficult task for the typical investor to accomplish on his/her own, I suggest using the ratings of ETF/fund risk provided free by Morningstar.com.

ETFs/funds are rated as either Low Risk (the lowest), Below Average, Average, Above Average, or High Risk as compared to other funds within its identical Morningstar category for funds in existence at least 3 years. Data are examined over several intervals when possible and on an overall basis. (To access these ratings, enter the fund symbol on the Morningstar site. Then click on the "Ratings & Risk" tab.)

As noted, these ratings are most useful in comparing a particular fund you own to other possible choices of funds within the same category you might choose instead. For example, one Small Growth fund might be shown to be High Risk while another Below Average.

c. Compare how a given fund performed under adverse conditions to performance for the S&P 500 index.

Once again, using freely accessed data from the "Performance" tab on Morningstar, you can see how any ETF which has been around since the beginning of 2008 did during that bear market year as compared to the S&P 500 index which itself dropped 37%. Any drop meaningfully greater than 37% shows the fund wasn't able to shield itself well during 2008. The assumption to be made is that it might also suffer a great deal in the next bear market. An ETF with a drop meaningfully less than 37% implies that it might fare somewhat better than the index in the next bear market. (Note: the usefulness of this data assumes the objectives of the fund remain essentially the same now as in 2008.)

Of course, while potentially "less" losses can still be serious losses, use of this data more or less assumes you are a long-term investor and will find less of a loss more tolerable, enabling you to stay the course rather than bailing out at low prices.

The ETF within my current Model Stock Portfolio which would have suffered the least during the 2008 bear market year turned out to be the Vanguard Consumer Staples ETF (NYSEARCA:VDC); it lost "only" about 17%, suggesting it might be a good choice for those who want to remain invested in stocks but with likely significantly less risk than most other funds.

By comparison, what might one find for funds/ETFs that invest in the smallest of companies, the so-called micro-cap stock funds? The best performing Small Cap Growth fund during 2013 according to the Wall Street Journal was Oberweis Micro-Cap (OBMCX). It returned 64.9% last year (through Dec. 31). Sound great? Not according to our three risk-assessing guidelines above. Not only is its Morningstar risk rating classified as High, but its long-time manager suffered a 52.98% loss during 2008, making it among the worst performers against its Small Growth peers that year.

Step 2: Decide whether your current percent allocation of your portfolio to stocks is still appropriate given the apparent mounting risks to stocks.

Suppose that your current allocation to stocks is 60%. While such an allocation is often considered an "ideal" one for many Moderate Risk investors, it may not turn out to be ideal over the next several years if the market undergoes a serious drop or merely underperforms somewhat as a result of overvaluation. Put otherwise, while a 60% (or more) allocation may have served investors well over the last five years, such an allocation would have drastically hurt most investors during the last two bear markets. While no one can be sure when the next bear market might emerge, research has shown that bear markets occur about once every 4 1/2 to 5 years with an average drop of 38% according to the Leuthold Group.

My Model Portfolios, updated every 3 months, present my opinions as to what might be considered an "ideal" risk-adjusted allocation to stocks taking into consideration a variety of factors. Among others, these range from economic data such as interest rates, growth forecasts, historical cycles, Fed policy, and my own measures of under/over-valuation.

Currently, my recommended allocation to stocks for Moderate Risk investors is 52.5%, having dropped from as high as 67.5% for an entire year beginning in Apr. 2013, along with an even higher allocation for Aggressive Risk investors. While I can't pretend to provide an allocation percentage that's suitable for everyone, due to differences in age, risk tolerance, and even such factors as one's prior personal investing experiences, my Model Portfolio allocations are meant to help investors decide whether it makes sense to maintain the perhaps typical allocation they have maintained in the past, or whether it might be more profitable to either raise or lower the percentage.

The jury may remain out on the wisdom of making such changes since a lot depends on how long one is willing and able to hold on to their investments: Over periods of 20 or more years, holding on to appropriate stock fund investments will nearly always beat returns from non-stock investments. But guess what? Holding a low cost S&P 500 index fund over the last 15 years still trails holding a statistically middle-of-the-road performing bond fund such as Vanguard Total Bond Market Index by about 1% annualized - about 5.1% vs. 4.1% - data through 1/31/14).

However, if you conclude as I have that the risks to stock investors are now greater than they have been for at least several years, you should probably reduce (and certainly not increase) your stock holdings from the levels you might have recently had.

Step 1 above should help you choose which stock funds are the most likely candidates for making these reductions. If, however, you decide not to reduce your allocations to stocks at this time, you should at least consider switching from your higher risk investments into stock funds that have lower risk characteristics. This will allow you to maintain your current allocation percentage to stocks while hopefully putting your portfolio's risk profile at a lower level. At the same time, you may want to consider doing the same for your higher risk bond positions, such as high yield bonds or any long-term bond ETFs that you own.

Step 3: If changes are decided upon as a result of Steps 1 and 2, implement those decisions.

Once you have determined if any of the investments you own are considerably riskier than others, or have risk characteristics that suggest you might be better off lightening up on them in the event of poor stock market performance ahead, you could either a) sell some of these funds outright or b) exchange some or all of your shares into a fund that seems less risky and more likely to hold up in the event of a negative change in the market's direction.

Depending on the size of your portfolio as well your confidence that your more risky funds will indeed be likely to suffer for a long enough period to make taking action worthwhile, you may want to make your overall percent allocation and particular fund allocation changes gradually rather than in one fell swoop. This will give you more time to assess whether risky investments are indeed going to suffer more than less risky ones as the year progresses.

Here is a concrete example. Suppose you do decide to reduce your current allocation to stocks from 60% to 50%. Also suppose that you now have $60,000 in total in your stock funds. This would mean selling $10,000 worth. But rather than assuming that a market correction, or even worse a bear market, is just around the corner, you might decide to proceed gradually and cautiously. Thus, your plan might be to sell $2500 or 2.5% immediately, with the remaining amount possibly over three intervals of say a month or two each.

Using this gradual strategy will permit the possibility of considering a more lengthy pause in completing the sales, or even canceling the plan completely if the market does not wind up being in a further corrective mode at this time. You might apply the same gradual strategy if you decide to transfer funds from a relatively risky, but currently quite profitable fund, to a less risky fund.

If, on the other hand, there start to be more concrete signs that the market is indeed faltering, you might want to stop using such a gradual approach and accelerate, or even complete the entire 10% sale as you initially decided upon. Many a regrettable investment decision is based on an appraisal of the market's apparent potential at one moment in time. By permitting yourself to start with a gradual reduction of risky investments, you are spreading your appraisal over a longer period allowing for the possibility that the appraisal might have been wrong, or perhaps, too early.

Step 4: Decide what, if anything, may cause you reverse this defensive stance.

As implied by the quote at the end of the companion article, by adopting this plan, you are essentially giving up on the idea of making as much money as possible by retreating on the notion that being as fully invested in high power stocks as you can, especially during a bull market, is almost a no-brainer.

But stepping down one's risk level isn't likely to be a foolish move. Rather, it is an effort to adopt a defensive stance in order to protect yourself from what might in hindsight appear as greediness and over-assurance that all will continue to go well. It further helps to assure that you won't be faced with making potentially unwise sell decisions when accumulated returns have already turned considerably less favorable.

As you assess where you are on the continuum to reaching your financial goals mentioned at the start of this article, if you are among the fortunate, you may possibly decide to cut back on your portfolio's risk level permanently. If, though, you are more like the great majority of investors who still have a ways to go to their financial nirvana, you should regard yourself as merely pausing a bit at this lofty juncture.

If this is the case, therefore, you will want to consider planning in advance what conditions will likely cause you to reverse this posture. If, for example, you agree with me that the overall market is pretty much overvalued at this point, you would want to see that overvaluation reduced to fair evaluation, or even down to undervaluation, before undoing your defensive stance.

In this regard, some people use mathematic measurements to judge how fairly valued the overall stock market is, such as the price/earnings (NYSE:PE) ratio of the S&P 500 index. This figure is currently nearly 19. However, the average ratio going back to the 1870s is 15.51. This makes it 18% more highly valued than average. Other investors use a more conservative price/earnings ratio calculation called the Cyclically Adjusted PE Ratio (CAPE), devised by 2013 Nobel Prize winner Robert Shiller. It shows a current ratio of 24.75 vs. an average of 16.51 over approximately the same period. That represents a 50% increment over its long-term average!

I personally use a research-based approach to determining over-, under-, or fair valuation, which I have discussed in detail in many of my prior Newsletter articles. Even simpler, I have found through my own research that when either the market as a whole or any particular mutual fund exceeds returns of 15% annualized over five years, the odds are high that the market or that particular fund will perform considerably below average over the following years. (See, for example, Aug. 2008 and Sept. 2013.) Since the S&P 500 index currently shows a 5 year annualized return of about 19%, this agrees with those who use the above PE ratios in assessing the market as rather highly overvalued.

When using the annualized 15% threshold as a dividing line between more reasonable valuations or overvaluation, one will note that the great majority of stock mutual fund category averages as well as mutual funds themselves are currently too high to pass our test of fair valuation.

So, if one accepts any of these three measures of valuation, one might decide to only become less defensive once these measures drop down to below their long-term averages. Or, perhaps simpler still, one might wait for a substantial correction in stock prices. Perhaps a drop of at least 15 to 20% or more might be enough to induce some value conscious investors to reverse the above process, tiptoeing back into a more aggressive stance. For others, it might even be an extended period of bear market returns of -20% or more.

Source: Planning For The Winding Down Of The Bull Market