Saturday, September 25, 2010
This story 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 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 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 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 short-duration, corporate bonds that are trading at a discount to par.
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.
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.
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.
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.
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 Tom Dyson's The 12% Letter.
As I pointed out last week, Tom is avoiding traditional income investments, which desperate retirees have bid up to dangerous levels. And he's still managed to put together a fixed-income portfolio that spins off an average 8% on his readers' money.
If you'd like to learn more about what Tom is recommending now – and how to put together a similar portfolio – click here for our video presentation.
Date Range:9/16/2010 to 9/23/2010
Date Range:9/16/2010 to 9/23/2010