Don’t Count on the Fed to Backstop Your Investments
Yes kids, stock prices can sometimes plummet. And they did during the first trading session of 2016. It’s a helpful reminder to forgetful innocents about this unforgiving fact.
The chart below shows how the SPDR S&P 500 ETF (NYSEARCA:SPY) has declined 1.65% over the past month. That in itself isn’t disastrous, but stock market volatility (ChicagoOptions:^VIX) has already popped 10% or more four times during the past month. In other words, the frequency and intensity of violent moves (NYSEARCA:VIXY) has increased.
Predictably, high beta darling stocks like Netflix (NasdaqGS:NFLX), Tesla (NasdaqGS:TSLA), and Amazon.com (NasdaqGS:AMZN) have nosedived even more than the broader market.
Back in 2008, the Federal Reserve was able to rescue the financial system from a complete meltdown. But eight years later, there’s a lot less certainty they’d be able to repeat another Hail Mary.
In new comments from Vice Chairman Stanley Fischer at a speech for the American Economic Association this past weekend, he flatly admitted the Fed’s limitations.
Here’s what Fischer said about the Fed’s inability to contain another financial crisis:
“We won’t know until it’s very late” whether the Fed has been constrained too much. It’s something “we have to worry about a great deal.”
Here’s what Fischer said about the Fed’s challenge in executing future rescues:
“In the United States, responding to such problems with these tools would require inter-agency coordination” between the Fed and other government regulators. It “could make their use cumbersome at critical moments.”
Instead of waiting for the Fed to save you from the next crisis, what should you do? The answer is to install a margin of safety within your portfolio immediately. It is the single most important thing you can do right now.
The prudent investor does not wait for a bear market or another adverse event to assassinate their net worth before incorporating a margin of safety. It should always happen before the event. Similar to insurance, you acquire coverage before the loss occurs not after.
Your “margin of safety” represents the capital or money that you absolutely cannot afford to risk to potential market losses. This amount of money gets set aside from your core and non-core portfolio to be invested in fixed accounts with principal protection and liquidity. Yes, protecting money – not just saving it – is essential!
The diagram below is explained in my online class Build, Grow, and Protect Your Money: A Step-by-Step Guide. It teaches you the the proper context of your portfolio’s margin of safety relative to the other two parts: Your portfolio’s core and non-core. It also shows you what types of assets can be held inside each container. Together, these are the three cornerstones of an architecturally strong portfolio.
To help you be ready, ETFguide Premium members get exclusive access to my Margin of Safety worksheet. It helps you to calculate the correct percentages of safety within your total portfolio.
Although the original application of margin of safety was to applied to selecting stocks by Graham and Dodd, the same principle applies to portfolio construction. It’s crucial that all investors have a margin of safety – even those who believe they need none. It’s always better to have it and not need it, than to need it and not have it.
In summary, investors themselves – not the Federal Reserve and most certainly not the Securities and Exchange Commission – are responsible for protecting the safety of their money. Do yourself a giant favor and do it right now.