How to handle a financial crisis
Today's Digest is deeply personal. It involves real people, who I care about a great deal. These people have known me most of my life. They have always been generous – to a fault – with me. Unfortunately, they are in the midst of a personal financial crisis. It has paralyzed them with fear. It has led to depression. And it's a crisis I'd bet sounds familiar to many of our readers...
Since the beginning of 2008, these wonderful friends have lost more than $1 million on mutual funds – roughly 60% of their net worth. They held on thinking their mutual funds would bounce back, like they did in '87... like they did in '99... and like they did in '03. They were philosophical about the losses... for a while. They'd never considered themselves "rich." So they were willing to take a risk (like having almost all of their savings in stocks). They figured even if they lost everything they'd still be safe and happy.
But it's not working out like that. Instead, they're facing impossible choices about which assets to sell now (at depressed prices) simply to finance their daily expenses. They are terrified at the risk of a further drop in stock prices, which could now wipe them out completely. After spending a lifetime of living below their means and saving every spare nickel, they feel cheated and robbed. They are ashamed they didn't do a better job husbanding their wealth, so they're afraid to ask for help. Most of all... they simply don't know what to do or who to trust. They're paralyzed.
While you may not be in the same exact situation, I'm sure you know dozens of people who have lots in common with my good friends. These issues are hitting millions of baby boomers and retirees. Not only did assets collapse in price (both stocks and homes), but thanks to the Federal Reserve's super-low interest-rate policies, it's more difficult than ever to simply generate income. That's why my friends can't simply hold on this time. They're being forced to sell assets just to pay for necessities. What should they do?
I'll tell you the strategy I recommended. It's based on converting all of your available savings into income-producing assets. But before I give you the details about how to go about doing this, I want to look backwards. Let's consider what investors might have done differently over the last several years. Yes, I realize hindsight is 20/20, and it's too late now. But many of our readers are not yet retired. They must learn from these mistakes and try not to repeat them.
My friends made three critical mistakes... First and foremost, they held their savings in a relatively small number of mutual funds that were highly correlated. That is, all of these funds held assets that were similar and tended to go down together instead of some going down and some going up. My friends thought their portfolio was diversified because they owned a dozen different funds. It wasn't...
The funds all held the same kind of large, so-called "blue-chip" stocks, headquartered in the U.S. and Western Europe. If you looked carefully at their holdings, you would have discovered they owned a lot of stocks like General Electric, Pfizer, Microsoft, etc. These are the stocks that have gotten crushed.
Only 248 mutual funds (out of 21,639) in the United States have returned more than 10% a year for the last 10 years. The top 18 funds were all invested in precious metals. The top 127 funds were all either invested in gold or obscure emerging markets, like Indonesia.
My point is, unless you were invested in gold funds or high-risk emerging market funds, you probably didn't do well with mutual funds over the last decade. My friends didn't understand these asset classes and didn't own any of the funds that did well.
Second and even more important, these folks didn't hold enough fixed-income investments – hardly any, in fact. They were pretty much all in stocks. At their age, they should have had at least 50% of their liquid savings in fixed income.
Here's a handy way to think about it: Keep your age in fixed income. If you're 65 years old, at least 65% of your portfolio ought to be in fixed income. This would have made all of the difference in the world. Even though bonds fell alongside stocks in 2008, almost all bonds have continued to pay their coupons. The income stream would have continued, despite a fall in the value of their bonds.
Now, I know what you're thinking... Why would I want to hold bonds when you've been warning me about the coming inflation every day for the last two years? Just because you own bonds doesn't mean you're necessarily exposing yourself to the risk of inflation. In particular, I strongly recommend (again and again) short-duration, corporate bonds that are trading at a discount to par.
We feature these kinds of bonds in our True Income publication, which is written by a 40-year veteran of the fixed-income markets, Mike Williams. In my mind, these kinds of corporate bonds are the best investment vehicles for retirees. They offer both high levels of current income and plenty of capital gains, too. Mike proves this regularly, picking bonds that go up 100% or more. If you don't yet own bonds or you simply want to understand more about them, please read True Income.
If you're unwilling or unable to buy individual bonds, you should consider corporate bond funds, like the iShares Corporate Bond Fund (HYG). It's yielding 9%. These bonds do carry some risks, unlike U.S. government bonds. But they're safer than stocks and they provide one of the few good ways to get a reasonable amount of income.
Finally... the third critical mistake these folks made was they failed to understand the basics of sound investing. As a result, they equated size with quality. They thought, as all index-fund investors implicitly believe, that bigger was better when it comes to investing. But that's just not so.
We've spent the last few months building a new index of the world's highest-quality stocks, based not on size, but on quality. We are putting this list of 40 stocks together to show you how we'd build an index that's comparable to the Dow Jones Industrial Average. We didn't pick our list based on stock performance, but on business performance. Even so, over the last 10 years, our list is up 97%, while the Dow is up only 14%. The performance of our index is what people were expecting when they invested in so-called blue-chip indexes, like the S&P 500 and the Dow Jones Industrial Average. But it's not the performance they got. (See my essay about why you should never buy a regular index fund here.)
We'll be publishing this new index soon, as part of a blue-chip investing letter called Blue Chip Monitor. We call our index the BCM Index (Blue-Chip Monitor Index). You can see a comparison over the last 10 years of the BCM to the Dow Jones Industrial Average below. (Our index is the one in "bold.")
OK... so those are the mistakes that have been made. What should you do now if you're in the same boat? What should you do if you've taken a horrendous loss and you're down to capital that you truly can't afford to lose?
First things first: Forget the dream of getting it all back. It isn't going to happen. Retired investors who have lost more than 50% of their net worth would have to double their investments to get back to even. That's not going to happen because they can't afford to take the kinds of risks required to produce capital gains of that magnitude. So don't bother trying to hold onto the assets that have fallen in price. They're not coming back. Instead, focus on converting the equity you have left in the things you own into assets that will produce income for you.
For some of your assets, that will be easy. If you're still investing a large percentage of your portfolio into stocks that don't pay much in the way of dividends, it's time to move those assets into vehicles that will throw off 8%-12% per year in income – at a minimum. You'll find investments like that in several of our publications, including: True Income, The 12% Letter, and Advanced Income.
I also recommend looking into Matt Badiali's AOP sector investments. You can watch a video about this unique asset class here. These are oil and gas industry investments that have a huge tax advantage over other corporations. They typically pay dividends between 6% and 10% a year.
Bottom line, if your portfolio is worth $1 million or less, you have to arrange them so that all of your investments are producing 7%-10% a year in income for you. The next step is to maximize the percentage of your net worth that produces income for you. That means figuring out what to do with your real estate. If you own more than one home, it's time to sell the extra house(s). You're not going to get a good rental yield right now, so unload your extra house and convert the equity into investments that pay you at least 7% to 10% a year.
If you make these changes, you'll have plenty of income and won't have nearly as much "money stress." Let's say you have a net worth of something around $800,000 today. Two years ago, you were worth $2 million and felt rich. Now, even though you still have a large amount of assets, you feel poor. The main reason you feel poor is because half of your net worth is locked inside real estate. You have to sell one of those homes. Selling your primary property could free up $300,000 or so in equity and eliminate most of your overhead.
If you invest that money in high yielding stocks and bonds, you could easily end up earning $24,000 per year (8%). This income on top of the $40,000 you'll be making from your other income investments will provide more than enough income for you to live well again and be stress-free. Your assets can still provide you with monthly income of $5,000. The only thing you'll be giving up is the chance at large capital gains... but assuming you are retired, keeping what you have and getting the income you need is far more important.
New highs: Eldorado Gold (EGO), Market Vectors Gold Miners (GDX), Mag Silver (MVG), Odyssey Re (ORH-PB), Silver Wheaton (SLW), Anheuser-Busch InBev (BUD), DirecTV (DTV), iShares Silver (SLV).
In the mailbag... a strong endorsement for Interactive Brokers. I admit that I haven't tried the service, but I know many of our subscribers say it's the best. If you've tried several online brokers, let us know which ones you'd recommend to a friend. Send your comments here: feedback@stansberryresearch.com.
"I'm surprised at how few of your subscribers appear to use Interactive Brokers. Everyone always sings the praises of Fidelity or some other high priced broker. I have tried Ameritrade, Scottrade, Scottrade Options First, Think or Swim and Options Xpress. I can tell you that Interactive Brokers beats them all when it comes to trading execution, price and product availability. You can trade stock, options, bonds, preferred shares, etc all under one roof." – Paid-up subscriber Nick Vassello
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"Once again, I am asking for a current review of your doomsday prediction for GE. I can live with anerroe conclusion; I am not happy with evasion by you folks. Yur current push for 'alliance' level cannot sell with your curren t non response." – Paid-up subscriber Harrison Kornfield
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"You judged Clemens guilty, then criticized the Congressional LIARS in the same paragraph. You're a good investment analyst and I agree with much of your economics proclamations, but still think you are a pompous ass. It's a shame your success has taught you so little about life. I suspect you'll learn over time when you make a public fool of yourself, lose your money, or something happens to someone you love, and you can't do anything about it." – Paid-up subscriber Mac McDaniel
Porter comment: I stopped going to Orioles games about five years ago when I realized most of the players I liked were probably liars and cheaters. I think it's a testament to the quality of our society that not only have our highest-paid athletes become frauds but so many Americans don't care about the rampant cheating. And I don’t just mean steroids. Take the recent episode where Derek Jeter faked being hit by a pitch. Most fans seem to believe that it's not cheating if you get away with it. I think that's sad.
Regards,
Porter Stansberry
Baltimore, Maryland
September 17, 2010