How we manage portfolios in up and down markets — Part 1

Zak Lutz here, partner and Chief Investment Officer at LifeGuide.

Today, I want to share how we manage portfolios in “up and down” markets. After all, helping our clients and their families navigate market turbulence is a major part of our commitment to them! And, by having a clear understanding and plan ahead of time, they’re better equipped to avoid the many pitfalls of reactive, emotional investing. Let’s jump in!

Note: This video was originally produced for our monthly client newsletter, Guidepost.

Before jumping in, I want to be clear: Neither we nor anyone else can predict what will happen in the markets. Beware of anyone who claims otherwise; no one can predict the future. Therefore, we do not try to time the market, which means we can’t sidestep the next market drop.

Remember: Prepare > Predict

So, how do we manage our clients’ portfolios in up and down markets? Here at LifeGuide, we take a twofold approach:

1. First, we prepare. Here at LifeGuide, this is a point we make (and will continue making) over and over! We proactively prepare for the market’s ups and downs rather than trying to predict exactly what will happen next. We do this primarily by leveraging diversification as well as our bucketing strategy.
2. Second, we aim to take advantage of the market’s ups and downs once they happen. We do this through tactical changes, which we call our Buy the Dip and Sell the Recovery Progression Strategy, and dynamic rebalancing.

There’s so much ground to cover here that we’re going to split this post into a two-part series. Today, in Part 1, we’ll talk about preparing for ups and downs through diversification and bucketing. In Part 2, we’ll explore the strategies we use to take advantage of the markets during ‘stormy seas’ through tactical changes and dynamic rebalancing.

Preparation Strategy 1: Diversification

Diversity is an age-old, time-tested approach to handling the uncertainty of the future. It is a way to prepare for what comes ahead. In fact, this principle goes all the way back to biblical times. In Ecclesiastes 11:2, we read: “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.” The same is true today. We don’t know if US stocks, or international stocks, or bonds, or real estate will fall on hard times going forward. This is so well accepted that we have the saying, “Don’t put all your eggs in one basket.” Same concept.

(Another quick disclaimer so we don’t give anyone the wrong impression: Diversity is certainly a useful tool that can help a lot, but it can never guarantee a result or protect against a loss.)

Now, it isn’t enough to pick several random things to invest in and feel good because you have things spread out. Diversity that helps you achieve your goals is more involved. You need to have a good reason for each area you are investing in.

And, really, there are only two reasons:

1. To provide growth, or;
2. To mitigate risk

To provide “growth,” we diversify between US stocks, developed international stocks, and emerging country stocks. Because we never know which part of the world might contract or expand the most, participating in all of these markets allows us to reap growth no matter where it shows up.

And to help mitigate risk, we diversify between bonds, inflation-protected bonds, and real estate.

• Bonds protect against economic decline or deflation because, during economic deflation, rates usually go down, which can increase the value of bonds.
• Inflation-protected bonds can protect against unexpected inflation because the interest they pay goes up as inflation goes up.
• Real estate is different because it is a physical, tangible thing—sometimes called a “hard asset.” Real estate is seen as a different source of inflation-protected growth. It diversifies risk because it isn’t dependent on any one company’s business model working like stock price or bond value.  And, with land in particular, it’s the only asset that has always held value, and God isn’t making any more of it.

We strategically and carefully allocate client portfolios between these categories depending on their specific situation, how much risk they want to take, and how much growth they need.

Preparation Strategy 2: Bucketing

The second tool we employ to prepare our client portfolios for the inevitable ups and downs in the markets is our bucketing strategy.

We all know it’s generally not ideal to withdraw when stocks are in a dip (you know, the whole “buy low, sell high” thing). Yet we know stocks inevitably go through dips—we just don’t know when. So, how do we prepare to not have to sell stocks for the withdraws needed during one of those dips? After all, you still need money to live on during a dip.

This is where our bucketing strategy comes in.

Our bucketing strategy helps address the issue of withdrawing from your portfolio at the wrong time by dividing funds into three “buckets” of money—one for short-term, one for medium-term, and one for long-term spending.

You see, matching up when we need to withdraw money with the volatility dynamics of an investment significantly reduces the risk of having to sell at a loss.

Let me break this down:

• Bucket One: The money needed for big expenses over the next three years, as well as an emergency fund. These funds are usually held in money market funds, CDs, and bank accounts (largely stable accounts unlikely to lose money nor grow significantly over the short term).
• Bucket Two: The money needed for a regular monthly budget over the next seven to ten years. These investments will typically be divided between bonds and real estate—more growth potential than Bucket One while still trying to minimize volatility risk.
• Bucket Three: The money needed to grow for the long-term future, usually 10+ years down the road. We invest Bucket Three money into stocks to provide long-term growth. You see, the odds of losing money on stocks, even though they are volatile, is significantly reduced by holding them over a ten-year period.

Buckets One and Two allow us to weather dips in the stock market so we can stay invested in Bucket Three for the long-term growth potential stocks offer.

Note that every client is going to have different amounts of money in each of their buckets as laid out in their unique Financial LifePlan. For example, a young family who won’t need much out of their investments for a long time may have a relatively small Bucket One and Bucket Two, with the majority of their portfolio in Bucket Three. Someone nearer to retirement, however, might have more in Bucket One and Bucket Two, and not as much in Bucket Three.  

I know we’ve covered a good bit of ground today, and I hope this gives you a better sense of how we manage your portfolio—and specifically the approaches we use to prepare—for up and down markets.

Stay tuned for Part 2 next month, where we’ll explore the strategies we use to take advantage of market ups and downs after they happen. Our in-house, fee-only investment management deeply integrates with your Financial LifePlan, designing your portfolio to support what matters most: your values, goals, and peace of mind.Our in-house, fee-only investment management deeply integrates with your Financial LifePlan, designing your portfolio to support what matters most: your values, goals, and peace of mind.