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Sunday Journal
Structure Your Portfolio for Turbulence
From the Wall Street Journal of Sat, 20 Dec 2014 23:41:57 EST

As we struggle with yet another bout of stock-market turbulence, keep two investment rules in mind:

Jonathan Clements
Jonathan Clements

No. 1: Never trade based on a market forecast.

No. 2: Design your portfolio so that short-term results don’t matter.

With oil prices down sharply and stocks sinking and soaring, Wall Street pundits have been out in force, offering predictions. These folks often appear at this time of year: This is when they roll out their forecasts for the year ahead.

I love reading those forecasts. They come with wonderfully convincing stories, backed by trenchant analysis and compelling statistics.

They are, alas, also utterly useless. Cast your mind back to early 2014. Wall Street’s chattering class was convinced that it would be a bad year for bonds and a decent year for stocks, though the S&P 500 was expected to rise around 6%, rather than the 30% clocked in 2013.

How have the experts fared? Bonds have defied the consensus and posted healthy gains in 2014. As prices rose, the yield on the 10-year Treasury has fallen from 3% to 2%. Meanwhile, stocks have performed closer to expectations, with the S&P 500 scoring moderate gains.

To be sure, smaller U.S. company shares, developed foreign-stock markets and emerging markets have had a rougher time. Still, if we’re generous, we might say the pundits were half right. Those are the odds of guessing tails correctly on a coin flip—which tells you how valuable the forecasts are.

I believe it’s helpful to have a handle on likely stock and bond returns over the next 10 years. Without that, there’s a danger you might save too little toward your goals or spend too much once you’re retired. I think U.S. stocks and bonds are expensive, so I’m assuming a globally diversified stock portfolio might notch 6% a year over the next decade and a high-quality bond portfolio might earn 3%, while inflation runs at 2% to 3%.

But that tells you nothing about 2015. Despite the pundits’ stories, we simply do not know what will happen to stocks and bonds over the next year—which means you need to base your investment decisions on something else.

My advice: Focus on risk. In particular, ask yourself three questions:

1. How much risk do I pose to my portfolio?

The stock market remains within spitting distance of its all-time high, while the 10-year Treasury yield isn’t that far from its 2012 low of 1.43%.

The implication: If you think you might panic and sell during a market decline, you should sell now, while prices are still at lofty levels. Few investment mistakes are more damaging than dumping stocks at the depth of a bear market.

In fact, I believe this is the chief reason to hire a competent, ethical financial adviser. In many years, using an adviser could hurt your results, because of the extra cost involved. But that extra cost will be well worth paying if an adviser can stop you from bailing out of stocks when the market next tanks.

2. Would a market selloff derail my financial plans?

If you have money you plan to spend in the next five years, it should be out of stocks and riskier bonds, and invested in nothing more exciting than short-term bonds and certificates of deposit.

Tim Decker, a financial adviser in Lancaster, Pa., tries to get his clients to focus on how much they have in bonds—and how that compares with the spending money they need each year from their portfolio.

“In 2008, what kept our clients in the ship was being able to show them that we had five to 10 years of spending money in investment-grade bonds,” Mr. Decker says. “Although their stocks were down, the fixed income did what it was supposed to do: It didn’t just hold up. It went up.”

3. How much risk do I need to take?

We invest now so we can spend later. What if you have enough saved for retirement and other goals? It’s tempting to continue gunning for healthy gains, so you amass even more money. But that extra risk could come back to haunt you—which is why you might want to scale back on stocks.

Instead, to lock in future spending power, consider building a laddered portfolio of inflation-indexed Treasury bonds, whose maturities match your expected need for cash. That way, you replace the uncertainty of the stock market with a flow of government-guaranteed, inflation-indexed income.


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