Protecting your nest egg in a recession

Laura Bruce

Anyone nearing retirement is old enough to remember the recession of 2001.

While the experts were debating whether the country really was in a recession -- and if so, when it would bottom out and when the recovery would start -- your portfolio was probably losing value.

It's rotten enough to see your nest egg decimated when you have 10, 20 or more years for it to recover.

But millions of Americans on the cusp of retirement experienced the devastating effect of a recession on their portfolios just prior to, or shortly into, their retirements.

9 tips from the experts:

  • Understand risk
  • Why a recession is coming
  • How to create a defensive strategy
  • Insure your portfolio
  • What to invest in now: Barber
  • What to invest in now: Lancz
  • Be proactive
  • Know when to sell
  • Be aware of costs

    Now, six years later, the news is peppered with stories of a slowing economy and talk of a possible recession. If retirement is in your near future, or even if it's years off, consider taking steps to protect your assets against a potential downdraft in the stock market.

    We spoke with two money managers, Dean Barber, of Lenexa, Kan., and Alan Lancz, of Toledo, Ohio, who talk about what they're doing for their clients.

    Where to invest now:

  • Dean Barber, Lenexa, Kan.: "Late 2008 is when the real pain will start." Read more ...
  • Alan B. Lancz, Toledo, Ohio: "Buy and hold is becoming outdated." Read more ...

    In his own words: Dean Barber

    Dean Barber is CEO of Barber Financial Group in Lenexa, Kan. Barber says his main job is to prepare people for an independent retirement. He's preparing for a market downturn that he says may be hard-felt by late 2008.

    The main thing people have to understand is that there is a lot of risk in our market. People get a false sense of security when the market has been up for quite some time that, this time, it's going to be different. There really is risk in the market and unless people have a well-thought-out plan, there's no way they can protect themselves.

    So the first thing that has to happen is they have to have a written plan; they have to know how market fluctuations will affect them. They have to know what percentage of their money they can afford to lose before they have to get out. Most people don't know where their breaking point is. They don't know how it affects their ability to retire or how it affects their overall plan because they don't have a written plan.

    Most people invest for what we call an absolute rate of return, which is looking at how much money can they make without regard to how much risk they are actually taking in order to gain that return. In their plan they should know what kind of risk-adjusted return they need. How much risk do they need to take in order to get to the return that they need to accomplish their written objectives?

    Get ready for a downturn
    There's no question that there's some sort of downturn on the horizon. You can't see a market that goes up for five years in a row like we've seen without some sort of substantial downturn. We think by late 2008 is when the real pain will start.

    I believe that any time you're in the position like we are today, that you must have defensive strategies in place to help protect you from a potential market downturn. Those defensive strategies can be things like the put protection that Clark Capital uses, or inverse funds, such as the ones at Rydex, Profunds or Prudent Bear, for a portion of the portfolio.Put protection takes a lot of time (to understand). Puts are an option so they're a zero-sum game. What that means is for every winner there has to be a loser. What individuals don't want to do is compete with Wall Street. Those people do it for a living and they're trying to win.

    You've heard the same commercials I've heard on the radio -- "We're going to show you how to make money in any market, we've got these trade-by-colors type thing." Well, if you're 25 years old maybe that's OK. But if you're 50-plus and you're gearing up for retirement, the last thing you want to do is play with your future.

    People need to understand how those strategies work.

    Don't use defensive strategies as a gambling technique to try to get rich while the market's falling, but rather as a hedge to try to prevent event-driven declines, or a decline you're not expecting, from destroying your portfolio.

    Insurance for the portfolio
    It's all about greed. It's all about how much can I make on the upside. Our contention is, it's not how much money you make, it's how much you get to keep that's most important. Bad markets can take a heck of a lot of money away. When you're 40 years old, you've got lots of time to recover. The bulk of our boomers are past 50 and there are no mulligans after that age. The only mulligan you get is to work for 20 more years.

    People who have protection strategies on their portfolios need to understand that when the markets are racing ahead, they won't keep up. They'll lag behind a little bit because a portion of their money is in a strategy that's designed to protect. It's like paying an insurance premium to protect your portfolio. If you were just looking for pure return on real estate, for example, you'd never buy insurance on your house because it's just an expense that takes away from your total return. Well, that's just silly. No one would own real estate without insuring it. Yet people all day long want to talk about their investments yet they don't want to pay a little bit extra to ensure that something bad is not going to take it away. Somehow they're magically smart enough to predict what's going to happen.

    How to choose an adviser
    If a client is getting ready to retire in five years and we know out of the $1.2 million that person has that $750,000 of it is absolutely critical to their ability to retire and the other half-million is going to allow them to do the extras, we probably don't need to insure the half-million but we need to insure the $750,000.

    What to invest in now
    I think we have some room to go before the recession hits and that technology is going to be one of the leaders over the next several months. In any industry, when a new product comes to market there's zero market penetration for that product. It takes quite some time to get from a zero percent market penetration to 10 percent. And then you have a very rapid movement from 10 percent to 90 percent. It takes as long to get from zero percent to 10 percent as it did to get from 10 percent to 90 percent. And then it takes as long to get from 90 percent to 100 percent as it did to get from zero percent to 10 percent. Most of our major technologies that have been driving our economy for the last 16 to 17 years are at about 80 percent market penetration. Once we hit 90 percent market penetration, that technology will cap out and the profits in those companies will begin to fall. But companies are going to fight to get that last 10 percent. I think it will create some euphoria in that arena that will allow technology to make a splash.
    I think the area you want to avoid right now is financials. By and large I think the subprime issues and how deeply involved were the banks in loaning to hedge funds -- those are things that are kind of unknowns at this point in time.

    I think you also want to avoid the small-cap stocks now.

    They tend to perform best in the early part of a bull market and they perform the worst in the latter part of the bull market, and what we have seen lately is that small caps have begun to lag pretty significantly behind large.

    And large caps will typically perform best at the latter part of the bull market.

    In his own words: Alan B. Lancz

    Alan Lancz is president of Alan B. Lancz and Associates, a money management firm in Toledo, Ohio. Lancz says one of the key factors in a successful portfolio in any type of economy is managing risk. He has also has taken the unusual step of fully disclosing to his clients, on a real-time basis, the holdings in his personal and retirement portfolios, and his company's corporate holdings.

    It's important be strategically in the right areas or sectors of the market. In May, we recommended selling the real estate investment trusts (REITs), utilities and financials. The financials comprise more than 20 percent of the S&P 500. If you look back at 2000, technology was over 20 percent, and whenever you get a sector that comprises so much of the market it's usually a concern, a red flag should go up to investors.

    They've gone down quite a bit, so it's not as worrisome, but in our estimation there's too much uncertainty. We don't know if another shoe will drop as far as subprime. Usually when there's fallout that will take longer -- just like with technology, it took more than a year for the sell-off to correct all the excesses in technology -- and we kind of see that with the financials, so it's an area that we would still avoid.

    Being in the right areas and, if we're looking at potentially a recession or at least an economic slowdown, being in more defensive areas is important.
    We're right now underweight on consumer discretionary mainly because a lot of the economic growth has been the consumer, and with the problems with housing and credit concerns, we think it will be much more difficult for the consumer to be the main catalyst for the U.S. economy. We're overweight on more defensive issues such as health care, telecom and technology. And we're equal weighting consumer staples.

    Be proactive, not reactive
    It's more a matter of being in the right companies. Even in technology we're overweight, but our overweight is from a year ago. We plan on selling, and that's my second point: being proactive rather than reactive. What I mean in that regard is we recommended selling the financials and REITs and the utilities in May -- we're going to be selling into the technologies because all of a sudden technology has become a safe haven because it doesn't have the subprime and credit concerns.

    If there is a recession, we'll definitely see an economic slowdown that's going to affect technology, too, but investors, with their myopic view, aren't looking at that. They're just looking at, well, you know, there are some hot products that don't have any credit concerns with subprime and this is the sector to be in.

    Look overseas
    International is another example. If you talk with other advisers, that's probably going to be their No. 1 answer -- go internationally if you see an economic slowdown or recession in the U.S. That concerns us a little bit. We've been overexposed internationally for most of the last seven years. It initiated with us buying a lot of the infrastructure plays after seeing the growth in some of these BRIC (Brazil, Russia, India and China) countries. We've been taking profits in some of those the last year or two and buying more defensive plays in (global consumer staples and pharmaceuticals).

    International is a good way to participate as far as outperforming a slowing U.S. economy, but it's to the point that most advisers are saying 20 percent of your portfolio should be international. That concerns us. You have to look at the market globally, but it's not a panacea that you just have international and it will cure all the problems. Just like being in the right areas of the U.S., you have to be in the right areas globally. But that's one way to help the investor who might be close to retirement or retiring and worried about a recession.

    Two common mistakes
    When we get new clients, they often have a great portfolio in terms of great companies. But the two mistakes we see is whenever the bank trust or whoever managed it before we got their money, they just bought a selection of high-quality companies and they didn't really look into the price or valuation, they just bought across-the-board, good-quality issues. So, 20 percent or so of those companies will be overvalued because they were bought at or near their highs and are now historically high-valued.
    But the biggest mistake we see, and why a lot of new clients come to us, is that they never sell. Buy and hold is becoming outdated. It's easy for the adviser or the trust company or the mutual fund manager to do it from the standpoint of just buying across the board and just hanging on.

    It reminds me of the index funds. You're buying 500 companies in the S&P 500 and whether there's an Enron in there or whatever, you're holding it until you're forced to sell or S&P has finally decided to eliminate it from the index.

    Remember to take profits and redeploy them into lesser-risk, low-expectation areas. The best example of what we're doing now is in the energy sector. It's been very hot so we're overweight, but we're decreasing our overweighting. If you still want energy exposure and income, sell some of the high-flying energy companies that have done so well and buy some of the leaders in natural gas.

    For the long-term investor, it's a nice way to reduce risk in one area that's done so well for years and still participate in the energy sector, but with less risk.

    Cash and CDs
    Cash is important and it's part of profit-taking. For example, when we take profits in tech, as it becomes more and more favorable, if we don't find other places to redeploy those assets we'll put it in cash. And if you're close to retirement, having that cash or fixed-income component is going to be critical.

    I think (high-yield) CDs are a good route. I wouldn't do Treasuries because the flight to quality this summer has depressed those yields. High tax-bracket individuals should select high-quality municipals. They're at historically high yields now compared to what you can do with a CD.

    If we're not finding the bargains to redeploy as we're taking profits in these areas that are moving up, our cash just automatically builds up. If a client is closer to retirement and more conservative, there will be fewer bargains to buy because we're not going to buy aggressive-growth-type companies, so their cash would build up more quickly than an average investor or younger investor.

    The other big mistake I see the average investor making is not being aware of cost or risk. If you're in a quasi-index fund, make sure you don't have extra fees and costs. What I've seen throughout the country is people selling these good, low-cost funds and then charging 1 percent or 2 percent to asset allocate them. That means you're getting an index-type performance, but now you've guaranteed yourself the cost of the fund plus the 1 percent or 2 percent you're paying an adviser. So, you're guaranteed to underperform the market by 1 percent or 2 percent. If you can get active management for that, why are you paying for an asset allocation? If you can put together your own group of mutual funds and avoid the added cost, many times you're going to be better off.

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