You can't miss crises, but you can plan for them

(MoneyWatch) For good reason, investor concerns about market risk have heightened over the past few months. As a result, I've been receiving lots of questions from both advisors and clients about what they should be doing. Thus, I thought it would be helpful to provide some perspective and insight into the issue. We'll begin with a quick review of the global economy -- but first, an important reminder: Everything you're about to read is well known by the market. That means the information should already be incorporated into prices.

Almost everywhere we look, the news isn't good. In the U.S. we have had unusually slow economic growth, characterized by stops and starts. The inability for the economy to generate what has been called "escape velocity" has meant that unemployment has remained stubbornly high. Adding to the concerns is that the most recent figures on manufacturing, employment, and GDP growth have all been discouraging. Some businesses are also facing huge increases in regulatory burdens and the uncertainty surrounding them (such as the Dodd-Frank Act and the Affordable Care Act).

On top of that, we have the expiration of the Bush tax cuts, including a large increase in the tax on dividends (which can't be good for stocks). Finally, we have the uncertainty surrounding what has been called the "fiscal cliff," which resulted from the last round of budget negotiations -- if there's no budget agreement, there will be large automatic cuts in both defense and entitlement spending. And while those cuts might help address the budget deficit, in the short run at least, they will likely have a negative effect on the economy.

The situation is much worse in Europe, with most countries already in recession and unemployment at a record 11 percent. In the emerging markets that have been providing the economic engine for the world, growth has been slowing. For example, China has slowed from double-digit to single-digit growth, and India has seen its growth rate cut from about 8.5 percent to about 6.5 percent for 2012.

Another problem is that economic history demonstrates that crises that are financial/housing-related tend to take a long time (e.g., 10 years) to recover from, as the deleveraging process works its way through the private sector and excess capacity is worked off.

And now the eurozone crisis is accelerating. We are likely at a tipping point with the Greek elections, which are set for June 17. If the Greeks elect an anti-austerity government, that would almost certainly lead to the country defaulting on its debt and exiting the euro. There's no way to predict how that would turn out. The markets are concerned that we could see a run on banks, and such financial panics are difficult to stop. The fear is that the contagion could quickly spread to Spain, which is seen as "too big to fail," but also maybe too big to save. The result could be a liquidity crisis that could make the Lehman Brothers situation look like a bump in the road.

Markets hate uncertainty. Risk premiums can rise and prices can collapse quickly. Of course, there's another alternative. The Greeks could elect a government that will negotiate to stay in the euro, the Germans could agree to support a eurozone-wide bond to help prevent a run on the banks, and they could also agree to allow more wiggle room in terms of fiscal and monetary stimulus (or at least less austerity). Before you discount this possibility, history teaches us that it often takes crises to get governments to act. Such actions would likely be seen as a positive surprise; risk premiums could fall, and we could see a sharp rally.

Unfortunately, the crystal ball is forever cloudy. Though it's hard to keep your head while others around you are losing theirs, it's always important to keep a proper perspective -- even more so when times are difficult.

With that in mind, it's important to note that there are some positives in the economy. One result of the slowdown in economic growth is that commodity prices are falling, with energy prices leading the way. Oil prices are plunging. West Texas Intermediate crude oil closed on June 1 at $83.23 per barrel, down more than $26 from its 52-week high of $109.95. Falling commodity prices act like a tax cut -- they stimulate other spending. In the U.S. at least, housing prices appear to have about bottomed out. In many markets around the country (notably the ones that never experienced overbuilding) prices are even beginning to rise. The collapse in natural gas prices has also led to a revitalization of the manufacturing sector. In industries that are capital- and energy-intensive, the U.S. now enjoys a significant cost advantage. And valuations, while not cheap, are certainly not expensive.

The S&P 500 Index closed May at 1,310. The trailing 12 months P/E ratio is now around 14. Reflecting the heightened perceptions of risk, the P/E ratios for rest of the world (EAFE and Emerging Markets) are somewhat lower. While current valuations aren't cheap (as they were in March 2009), you have to keep in mind that we also have a risk-free rate of 0. Thus, the equity risk premium appears to be fairly large, reflecting the risks the market perceives. That leaves us with the question of what you should do in the face of this uncertainty.

Napoleon understood that battles are won in the preparatory stage, not on the battlefield itself. In terms of investing, this means that before you begin investing you should have a well-developed investment plan that incorporates the virtual certainty that you will face many severe and unpredictable crises over your investment horizon. That means that unless you can achieve your financial goals while limiting your investments to riskless securities like Treasuries and FDIC-insured CDs, you'll be unable to avoid these crises and their consequences. Thus, you need to be sure that your asset allocation doesn't entail taking more risk than you have the ability, willingness or need to take. (My book, "The Only Guide You'll Ever Need for the Right Financial Plan," walks you through the process of determining the right asset allocation for your unique situation.)

Once you decide to include an allocation to risky assets like stocks, you must accept the possibility that risks will show up that could lead to your plan failing to achieve its objective. (Typically, the primary objective is to make sure that you don't outlive your assets; a secondary objective might be to leave an estate for your heirs or a favorite charity.) Since even the thought of being alive without assets is unthinkable, your plan should include what I call a Plan B.

The need for plan B

Since we know that severe bear markets are likely to occur from time to time, and we cannot know how long they will last or how deep they will be, a critical part of the financial planning process is to develop a contingency plan (a Plan B). During the initial phase of the planning process (what we call the discovery process), when the ability, willingness, and need to take risk are determined, a valuable exercise is to discuss the need for a contingency plan in the event that a "black swan" appears. The discussion should focus on what, if any, actions would be taken if financial assets fall to such a degree that the investor runs an unacceptably high level of risk that their portfolio may run out of assets if Plan A isn't adapted to the existing reality. It might also be that an investor has an important bequeath goal that he or she doesn't want to put at risk (for example, a special needs child).

Plan B should list the actions that would be taken if financial assets were to drop below a predetermined level. Those actions might include remaining in or returning to the work force, reducing current spending, reducing the financial goal, selling a home, and/or moving to a location with a lower cost of living. Consider the following example.

Mr. and Mrs. Brown

It is 2003, and Mr. and Mrs. Brown are each 50 years old. Mrs. Brown is a successful doctor, and Mr. Brown is a college professor. They plan to retire at 60. Working with their advisor, they decided their risk tolerance meant holding a portfolio with a "worst case" cumulative loss of 25 percent. Thus, they decide to set their stock allocation at 60 percent. Based on historical evidence, the Browns knew there was a reasonably high probability their portfolio wouldn't experience a total loss of more than 25 percent. However, they also knew it was possible that a greater loss could occur. In fact, a Monte Carlo simulation showed their plan had an estimated 92 percent chance of success.

The mistake that many investors make is to focus solely on the high estimated odds of success and ignore the estimated 8 percent odds of failure. Making that error is the same mistake as not buying life insurance because the odds of dying in the near future are low. The Browns didn't make that mistake. They recognized that the possibility of failure existed. However, while they recognized that possibility existed, they didn't want to plan on that scenario as the "base case."

The worst case should not be the base case

Using the worst case as the base case means that ability to take risk is low and, therefore, returns are going to be low. It also results in investors spending far less than they would have been able to if the worst case never occurred.

The Browns had worked hard, saved well, and wanted to enjoy the rewards of their efforts. But they didn't ignore the risk of "failure." They agreed with their advisor that if a bear market occurred that resulted in a new Monte Carlo simulation producing odds of success of less than 85 percent they would consider taking some or all (depending on the size of their losses) of the following steps:

• They would sell their second home
• They would reduce their daily spending requirements by 10 percent
• They would reduce their travel budget by 50 percent
• They would continue working until at least age 65
• They would move to a region with a lower cost of living

While the Browns hoped that they would never have to execute any of these steps, they did recognize that there was the risk that it would be necessary to put them into action -- and they were prepared to do so.

The important part of the process is having the discussion and only listing options that you're actually prepared to act on. If you list an option that you wouldn't exercise in reality, that will cause you to make the mistake of taking too much risk in the first place. While it's not necessary to provide a written list of options one would be willing to take, the act of writing them down may cause you to be more careful to list only those options you really would be willing to exercise -- writing them down can cause you to see them as more real.

For the next five years, the Browns lived well and enjoyed their lifestyle. When the financial crisis of 2008 arrived, they were well prepared to take the necessary steps to prevent the plan from failing.

Having a well-developed investment plan is certainly important. However, it's not sufficient unless that plan is integrated into an overall estate, tax, and risk management plan and incorporates a contingency plan -- a Plan B -- that can be implemented if the markets "don't cooperate" with Plan A. The failure to consider what options can be taken can lead to the taking of too much risk. And that can be a very expensive mistake -- one that might be difficult, if not impossible, to recover from.