Crafting an Investment Plan for a Downturn

Central bankers managed to keep the financial world from falling off the cliff over the past few weeks. Between China's rate cut, Federal Reserve chairman Ben Bernanke's comments that the Fed is ready to act, and news that Spain was poised to ask for a bank bailout all managed to soothe some investor worries.

Jeremy Glaser 25.06.2012
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Central bankers managed to keep the financial world from falling off the cliff over the past few weeks. Between China's rate cut, Federal Reserve chairman Ben Bernanke's comments that the Fed is ready to act, and news that Spain was poised to ask for a bank bailout all managed to soothe some investor worries.
But at best, these moves have just bought a small amount of extra time. The Greek elections still loom large on the horizon, and some extra cash for Spain's banks is not going to suddenly revive the European economy.

There is still an unusually large amount of uncertainty in the global economy, and the choppiness of the stock market in recent weeks is a reflection of that. Unless Europe pulls a rabbit out of its hat, it seems unlikely that the choppiness is going away anytime soon. So far, the concerns over the health of the global economy has sent stocks from being almost fully valued in March to looking 13% undervalued today according to our staff of equity analysts. But even that 13% discount is a far cry from the 23% discount we saw in October of last year or the 45% discount at the peak of the financial crisis. It is very possible that some of the worst-case outcomes from the ongoing saga in Europe are priced into stocks. Markets could easily fall from here if the situation continues to deteriorate.

For value investors, a big sell-off can present a great opportunity. You can pick up stocks at a huge discount to their intrinsic value and then reap the gains as the price moves back to the fair value over time. But there is also a huge amount of risk. There is no guarantee that the market won't keep falling or that the market will eventually agree with your assessment of the intrinsic worth of a stock. The risk doesn't mean you shouldn't put money to work when stocks fall, but it does underscore the need to have a solid plan for investing in a downturn and to stick to it.

First Things First 
Before thinking about how to put money to work in a downturn, it is important to make sure your baseline investing house is in order. One of the first steps is making sure you have a sensible asset allocation. Choosing the right mix of stocks, bonds, cash, and alternative assets is one of the most important things an investor can do to ensure success. It's also important to make a frank assessment of your tolerance for risk. Could you handle a 50% fall in the value of your equity holdings? Are huge swings in the value of your portfolio going to keep you up at night? If so, it might make sense to have less exposure to risky assets (like stocks) when there is trouble brewing in the market. Of course, this lower exposure can also lower your potential return, so you might have to compensate by saving more or working longer. Your risk tolerance should be an important factor in picking your asset allocation.

Be Careful With Security Selection
Once you feel comfortable with your desired asset allocation, you'll have a concrete idea of just how much money you have to move around to reach that mix. Oftentimes, if the equity markets are moving sharply downward, investors will find that they are far away from their ideal stock allocation. And because stocks are getting cheaper, this can be a good time to put cash to work and optimize your portfolio.

But that doesn't mean just buying anything when the market is down. Buying on the dips might be great, but you want to make sure you aren't catching falling knives. Creating a downturn watchlist of firms you'd like to own is a good first step to make sure you don't step into any value traps. This is a watchlist of great companies that you'd love to own but aren't necessarily cheap enough to warrant buying right now. Putting together this list now, while the markets are taking a breather, can give you the time to really do your research and make sure it is really the company in which you want to invest. And of course, expanding positions in your existing holdings can be a great way to put money to work.

In this market, it makes sense to look for firms with a global footprint, sterling balance sheets, strong brands, and great competitive advantages. These mostly wide-moat businesses are hardly immune to the economic downtown (see 2008), but they have the ability to survive a financial storm without their earnings power being permanently impaired. With the prospect of another financials-led crisis, finding companies that don't need constant access to the capital markets to stay afloat seems like a sensible bet. Great businesses are only great if they are able to live through the storm to fight another day

Armed with a watchlist, whether it's short or long, it's relatively easy to put money to work when the market is deep in the red. Assuming the news that's sending the market down has not permanently dinged the names on your list, you can confidently load up on shares without having to scramble to do research amid the din of the market correction. Having a solid asset allocation in mind ensures you don't load up on too much risk, and it also helps you guard against being too timid.

It could also make sense to not make the changes in one swoop. Even after a big drop, stocks can keep heading down. Given the huge swings we've seen out of Europe, it seems more likely than not that investors will get several bites at the apple. Keeping some powder dry could help lower your cost basis if the market did keep falling.

The real key here is to create a plan and then stick to it. Wildly deviating from your asset allocation, taking on more risk than you are comfortable with, and blindly buying stocks just because they have gone down is unlikely to produce a good outcome. Instead, by working within your existing investing framework and being disciplined about picking up the most durable names at a discount, you can possibly make the best out of volatility in the markets.

Jeremy Glaser is a Markets Editor with Morningstar.

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