With the primary indices all flirting with “correction territory,” it’s time for a market correction gut check.
As a reminder, a market correction is typically defined as any major stock index declining by more than 10% but less than 20% from its most recent peak. Once the drop hits 20% it can still be a correction, but it runs the risk of triggering a bear market.
As investors we’re all staring at a long list of concerns — future COVID variants, geopolitical and economic unrest, and Vladimir Putin amassing a scary number of Russian soldiers along the Ukrainian border all come to mind. Furthermore, the second year of a presidential cycle is historically the most volatile. All of this adds up to what the market hates most of all — uncertainty.
Is this anxiety justified, or are we borrowing trouble? If we look at some data points going back to 1928, we can give ourselves financial historical context. Over this 94-year period, the average drawdown was -16.5%, but 100% of the time the drawbacks ended up worse than the final results. In other words, things eventually go from scary back to normal.
To further demonstrate the calming reality, I’ll point out that the market experiences a correction of at least 10% every 1.6 years. Expounding upon this for emphasis, look how the data play out for an even more pronounced bear market movement:
● 20% (or greater) correction every 3.9 years
● 30% (or greater) correction every 9.4 years
● 40% (or greater) correction every 15.7 years
It’s easy to want to trade in and out of the market when you read the scary headlines about unstable stock market action. It takes discipline and experience to stay invested, even when that’s typically the right thing to do.
Not only do we have to demonstrate self-restraint in our investment approach, but we also should prepare for volatile times by owning and incorporating other areas of the market that tend to hold up when the world shakes.
After the COVID correction of 2020, I published an article on how investors can leverage dry powder in their portfolios to combat market volatility. Today’s market environment is a great time to dust off and revisit this concept.
Dry powder refers to the necessity of using dry gunpowder in the days when battles were won with muskets and cannons. “Put your trust in God, my boys, and keep your powder dry!” is a quote often attributed to English General Oliver Cromwell in the 1600s. The meaning of the explosive message stems from the fact that when gunpowder is wet it won’t fire. There’s no worse predicament than staring down an approaching army only to find your ammunition would prefer to sit this one out.
In broad financial terms, dry powder refers to the cash reserves a company or individual maintains to meet financial obligations in times of economic stress. Dry powder equates to the various ways you can fill your cash (savings, money markets, CDs) and income (treasuries, municipal, investment-grade bonds) buckets.
Which brings us to the Dry Powder Principle.
The Dry Powder Principle believes investors should hold at least three years of dry powder. Dry powder refers to safety assets within your portfolio.
The Dry Powder Principle
In short, the Dry Powder Principle means that folks should have at least three years of dry powder. To make that happen, there are two main driving forces.
1. Generally speaking, if stocks go down, bonds go up
If you need cash during a correction, it’s generally better to sell an asset that is either flat or up in price rather than one that has fallen significantly. Since 1976, the Barclays Aggregate Bond Index has relatively outperformed the S&P 500 during corrections of 10% or more. For the last 45 years, while stocks dropped 20% on average during corrections, bonds were higher by almost 4% over the same intervals. During a downturn you would generally want to sell your bonds if you need the cash. Of course, past performance is not a guarantee of future results, but it does serve as a guide.
2. Start with three years of dry powder
Since 1928, the average S&P 500 correction recovery time has ranged from slightly under one year to just over six years, with an average landing near three. This is why the Dry Powder Principle coaches us to have at least three years of dry powder to weather the market downturns while allowing growth and alternative buckets to recover.
Calculate your Dry Powder Needs
Follow these steps to cover at least three years of spending power in your portfolio with cash/income/bonds:
1. Calculate your annual income gap
Take your annual expenses (food, home, auto, medical, charitable giving, travel, core pursuits, taxes) and subtract your guaranteed or recurring income (Social Security, pensions, annuities, rental properties, deferred compensation, etc.). Let’s say you need $100,000 per year, and your guaranteed income from Social Security and pensions is $50,000. Subtract that number from what you need to find that your portfolio and dry powder require you to cover $50,000 per year.
2. Multiply your income gap by three
Using the Dry Powder Principle, we know that multiplying the income gap of $50,000 by three years shows us that you should have $150,000 of dry powder in your portfolio. If you have $1 million total, and you need $150,000 in dry powder, that means you need a minimum 15% of the portfolio. If you have $500,000, then $150,000 is 30% of your portfolio.
To help demonstrate, let’s run the exercise in reverse. Say you have $1 million in your portfolio and your income gap is $40,000. You have $400,000 of your portfolio in the dry powder category. Divide $400,000 by $40,000 to find that you have 10 years worth of dry powder to cover financial gaps during a market drawdown.
If you find yourself disagreeing because you are a true believer in the ability of portfolio income to cover all expenses, no need to put up your dukes. I’m not here to fight. A person with a need of $50,000 who consistently makes $60,000 in portfolio income could certainly argue that there’s no need for dry powder. The math speaks for itself. For some, dry powder is an important psychological tool for sleeping soundly once the lights go down. If that’s not the case for you, so be it.
Bottom Line
Market risk is systemic, meaning it is inherent to the entire market. You can try to run from it, but you can’t hide. It’s hard to separate emotion and investment, but using solid math combined with a sense of annual financial trends helps provide a calming perspective. We may not know how far a correction will fall until it hits bottom or how long the darkness will last, but the historical record provides a light at the end of the tunnel. Understanding how you can leverage dry powder during these uncertain times can often give you the space to feel more comfortable until the dust settles.
Our team believes so strongly in this powerful investment principle we have created the “dry powder calculator.” This can help investors figure out how much dry powder they need and even help them understand how much dry powder they have in their overall portfolio. The online calculator can be found at yourwealth.com.
This information is provided to you as a resource for informational purposes only and is not to be viewed as investment advice or recommendations. Investing involves risk, including the possible loss of principal. There is no guarantee offered that investment return, yield, or performance will be achieved. There will be periods of performance fluctuations, including periods of negative returns and periods where dividends will not be paid. Past performance is not indicative of future results when considering any investment vehicle. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions. Investment decisions should not be made solely based on information contained in this article. The information contained in the article is strictly an opinion and it is not known whether the strategies will be successful. There are many aspects and criteria that must be examined and considered before investing.
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