How to Plan for 2011

Should investors pay attention to the turn of the calendar?

Putting aside the seasonal effects — the Santa Claus rally, the January effect, and the Presidential mid-term rally — it is an important psychological time.  People reflect and plan.  Here are a few simple but important suggestions for 2011.

Four Simple Ideas

  • Look inward, not at the pundits.

Most investors pay far too much attention to the market, the global economy, Fed policy, the Obama administration, and the advice of various pundits.  They pay too little attention to their own personal needs and risk tolerance.  There is a great irony here, since most people are terrible at economic and market forecasting, but experts on their personal situation.  Why not focus on what you do well?

  • Don't play poker with your investing.

This is not like a TV poker tournament where you win by guessing when to go "all in."  Develop a sound plan that recognizes your personal objectives.  The most important question is whether you are preserving wealth or whether you still need to create wealth.  It makes a difference.  You should set aside any money you will definitely need in the next few years and develop a strong plan for the rest.

  • Recognize and plan for risk.

The investments with the greatest potential payoff usually come with the greatest risk.  Investors emphasizing income often underestimate risk.  Investors in stocks do not appreciate the corrections that are part of normal volatility.  While we all try to dodge the big declines, it is not so easy.  Here is a rule of thumb.

The historical volatility for the S&P 500 is about 16.  The VIX is currently at 17.5, but VIX futures for next year are higher — in the twenties.  What does this mean?  This is merely a general rule of thumb, but it is good enough for general planning purposes.

A volatility of 20 implies a 16% chance that the market will be 20% lower than the expected annual change.  It also implies a similar chance that the market will be 20% higher.  If you expect a gain of 10% in 2011, the implied volatility of the market suggests a distribution of possible returns with a mean of 10%, a possiblity of a small loss, and a possibility of a big gain.

To summarize:  Investors should plan for a distrbution of possible returns, not just the expected outcome.

And also:  The path might be rocky.  The nice gains in 2009 and 2010 came after significant losses.  During these times there were many sources warning that this was another collapse like 2008.

You need to plan for risk in advance, knowing what is acceptable to you.  If a 16% loss at some point in the year is too much, your stock exposure is too great.  It is much better to have a reasonable risk level that lets you hold a position through expected declines, than too get too big and bail out at the market bottom.

  • And Finally — Don't Get Scammed.

Every year the scammers find new ideas.  This can happen to anyone.  My recent article citing some of the biggest scams includes things that entrapped many intelligent people.

The "too good to be true" voice in your head is your initial line of defense.  If you do not see the trap, call your investment advisor before making a commitment.

Conclusion

The simple steps I have outlined take only a few minutes.  Your investment advisor can help, but no one can do it for you.  Analyzing risk and reward is a personal thing.  Please read this article carefully and plan in advance how you will handle the market fluctuations that we already know will happen.

As I will demonstrate in my annual preview, this is a good time to invest.  It means that you can be a little more aggressive than your normal posture, but you still need to plan.

Best of luck to all of my friends and readers for 2011!

 

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5 comments

  • jb December 31, 2010  

    “A volatility of 20 implies a 16% chance that the market will be 20% lower than the expected annual change.”
    How does one get to 16%? Thanks!

  • Proteus December 31, 2010  

    So simple, but hard to do.
    Interesting thoughts about creating vs. needing to preserve wealth. Are you saying that if one has achieved a financial goal, one’s asset allocation should significantly change to a more conservative strategy? (Maybe regardless of age, or risk tolerance.)

  • oldprof December 31, 2010  

    jb – For the simple rule of thumb here I am just using a normal distribution of returns. About 2/3 of the cases are +/- one SD, so 16.67% are more than 1 SD in each direction.
    At some point I’ll do a longer article on this piece alone. The distribution of stock returns is actually based on a lognormal curve, but it has “fat tails.” Events generate an extreme result more often than we would expect.
    Good question. For the planning purpose, I am trying to emphasize the sort of risk we are likely to see every year.
    Jeff

  • oldprof December 31, 2010  

    Proteus — That is exactly what I am suggesting, and how I advise people. If you have what you need, job one is protecting those assets.
    You are right in observing that it is difficult to do. It is important to think about.
    Jeff

  • mike January 2, 2011  

    Ah, the Investing Sirens…demands a firm hand on the wheel. Not just difficult for me, but VERY difficult.
    Thanks for sharing your insights, Jeff. Happy New Year.