There’s more than one answer to these questions
Pointing me in a crooked line.
And the less I seek my source for some definitive
The closer I am to fine.

~ Indigo Girls, “Closer to Fine”

Those of you who have been reading Balance Junkie for a while you know that my economic forecast is as follows: Cloudy with a Chance of Hurricanes. As such, I’m going to start with the assumption that we will be living with elevated volatility in the stock, bond and currency markets for the foreseeable future. That means we could see breathtaking downdrafts like the one on May 6th and we will also likely witness violent rebounds that will shake out short sellers (those betting the market will fall).

Many market watchers have sounded the all clear siren in light of the huge stock market rebound and genuinely improving economic data. They say that we are at the beginning of a sustainable economic rebound following the steep recession of 2008-2009. Others would liken the period of relative calm we’ve enjoyed over the past year to the eye of the storm. They submit that the outer eye wall of this financial hurricane is just offshore and that it behooves us to prepare for another onslaught.

There’s really no way to know which camp is right, but I would put myself on the eye of the hurricane side of the debate. Even if things don’t get as bad as some indicators predict, I think those that paint this recovery as “normal” are off base. There are just too many warning signs out there right now to expect business as usual.

3 Ways to Prepare for a Financial Hurricane

If we continue the hurricane metaphor, you might say that we are at a point where a hurricane warning has been issued. What do you do? Well, it depends on your personal situation, your risk tolerance, and your resources. Do you have a family to think about? Are you naturally risk averse, or do you like to flirt with danger? Are you young and healthy, or older and more vulnerable?

Once a hurricane warning has been issued, you will generally see people fall into one of three main approaches:

1. Stay the Course

These are the people at the hardware store stocking up on plywood and bottled water. They believe that the storm is never as bad as the forecasters say it will be, so they are staying put. Investors who stay the course when financial trouble is on the horizon argue that ups and downs are part of the stock market, they are young enough to ride it out, and they are confident in their asset allocation and rebalancing plan. We always bounce back from these things, right?

This position is well-articulated in a recent post at Foreigner’s Finances that says Stock Market Swings Don’t Matter. Or you could just turn on any business channel, ask any financial advisor, or read a personal finance blog. This position represents conventional wisdom, and there’s a lot to be said for it. (Can’t you just hear me building up to a big “but . . .”?)

If you are young (under 40), fairly knowledgeable about investing, have a fairly high risk tolerance, and a stable source of income, staying put is probably the course of action I would recommend for you. But if you are over 40, unsure about the mechanics of the stock market, hate losing money, or have some doubts about the stability of your income, I would probably recommend that you at least lower your risk level.

I recently wrote a guest post over at Invest in the Markets that described 5 Ways to Manage Market Risk. If you are concerned about your risk level in this environment, the fastest and easiest way to lower it is to reduce your position size. If the nasty stuff really hits the fan, I think both stocks and bonds could be dangerous places to be. The safest place is cash. If you’re worried, raise your cash allocation. *Please note that I’m not saying you should sell all of your investments. As the old saying goes, just sell down to the point where you can sleep at night if things get rough.

Just one final thought for those of you who have advisors who have whipped out that very long term chart of stock market performance. The charts are correct. Over very long periods of time, most markets have risen. But most of us do not have a 100 year time horizon. The bulk of our investing probably takes place during a 20 year period between the ages of 40 and 60 when most of us experience higher incomes and gradually reduced expenses as our children grow up and leave home.

There have been times when market returns have been flat to negative over that type of time horizon, and we are in an investing climate that has that potential right now. Japan experienced a huge real estate boom and bust a couple of decades ago. The Nikkei 225 (Japanese stock market) peaked around 1990 and hasn’t even come close to regaining those levels 20 years later. (Click on the chart for more information.) I don’t know whether that will happen to North American indices or not, but the potential is definitely there.

2.  Get Out of Dodge

These are the people who are risk averse either by nature or circumstances. If you fit into more than one item on the list of risk averse characteristics I described above (ie. older, hate losing money, unstable income, less knowledge about markets), you may want to avoid stocks and bonds altogether and stick to cash. This is a pretty extreme position, so I wouldn’t advocate it for anyone but the most risk averse among us.

I happen to be in this group because of our unstable income situation, my aversion to risk, and my worries about the global macroeconomic picture. But be aware that I am a worrier by nature. My son once compared me to Melman, the giraffe from the movie Madagascar. He’s not really all that far off base.

3.  Go Surfing

If you are an experienced and agile trader who lacks my tendency toward extreme risk aversion and analysis paralysis, you might just be like those crazy people brave souls who grab a surfboard and ride the waves produced by the oncoming hurricane. If things become as volatile as I believe they might, it will be a time in which those who know how to trade may reap the rewards of large intraday moves.

But be aware that this kind of activity is best left to those who know what they’re doing. If you fancy this kind of action, but aren’t sure of your skills, trade small. Keep your position size down and your risks minimal. I’m pretty sure we’re in for some big waves. Adjust accordingly.

You Can’t Beat the Basics

Incidentally, it is possible to choose any combination of the 3 options above that fits your particular situation. If you are concerned about a global debt crisis but do not wish to sell out of all of your investments, you could just cut back on your core equity exposure, raise your cash allocation, and, if you have some trading knowledge, try to benefit from the oncoming volatility. Know thyself. That proverb has never been more apropos.

Regardless of whether you’re involved with investing in stock, bonds, currencies, or any other vehicle, there are a few things all of us can do to prepare for uncertain times:

• Thoroughly understand where your money is: investments, spending, saving, etc.. If you don’t know where your money is, why it’s there, or where it’s going, it’s time to figure it out. There’s no downside to that no matter what happens.
• Pay down debt: This is a great idea no matter what the financial climate, and more so if the forecast is choppy.
• Increase your emergency fund: An emergency fund is the financial equivalent of sand bags. Load them up now.
• Reduce Risk: This is not a great time to go all-in on anything. Wait for clearer skies and calmer waters. Even if the forecast is exaggerated, you’ll still be better off.

These measures will serve you well whether the hurricane hits with full force or fizzles out offshore.

What do you think? Is a hurricane coming our way or have the forecasters got it wrong? What’s your plan?