Underinvested? It's Time To Worry

 | Jan 16, 2014 01:11PM ET

Investors Need Plans For Extreme Outcomes

In calculus, the concept of “limits approaching infinity” speaks to extreme outcomes. Like a mathematician, investors can look for holes in their investment approach by contemplating extreme economic and market outcomes. For example, we should be able to respond to the questions below with little or no hesitation:

  1. How would I handle scenario A where the S&P 500 rises sharply for three more years?
  2. How would I handle scenario B where the S&P 500 drops 50% in the next two years?

If we have plans in place for extreme outcomes, we can probably handle most scenarios, including those that fall in between scenarios A and B. We can’t predict the future, but we know bull markets/bubbles can last a lot longer than rational people believe, and it is not a question of if another 30-50% bear market is coming, but when.

Therefore, it is prudent to have contingency plans in place for both ends of the risk-reward spectrum. We will also touch on reasons to keep an open mind about another bullish year in 2014.

A Very Common Investment Stance – Too Much Cash

After countless conversations with investors over the last twenty years, I can confidently state that a common issue is having too much cash on the sidelines during bull markets. We are in a bull market now, and will remain in a bull market until the evidence shifts. How long will the bull last? No one knows, but another three years is one very real possibility. Fear of “bad things happening” is what understandably keeps vast quantities of investable assets parked under mattresses, in money market funds, and gathering dust in checking accounts. One way to combat that fear, while managing downside risk, is to “stay in the now” and adjust as the evidence changes.

Scenario A: Stocks Rise For Three More Years

In this article, we focus on scenario A, or stocks rising for three more years. Our purpose is not to forecast where stocks will be in three years, but rather to emphasize the importance of having plans in place in the event stocks surprise on the upside as they did between 1997 and 2000.

Chronic Underinvested Syndrome Can Kill You

We all know being underinvested speaks to opportunity costs, but just how much harm can it do to your family and net worth? Let’s assume we have three hard working people that had managed to build a $1,000,000 nest egg as of December 31, 1996. We will call them 100% Bob, 50% Sally, and 15% Dave. Our first contestant, 100% Bob, decided “we are in a bull market and I want to be in stocks”; he invests 100% of his $1,000,000 nest egg in the S&P 500 ETF (SPY). Contestant two, 50% Sally, has been so busy with her career and family that she could never find the time to do something with “all that cash”. Sally enters 1997 with 50% in cash and 50% in stocks. Contestant three, 15% Dave, is a common character in the hit Broadway production “Stocks Can’t Keep Going Up”. Dave enters 1997 with 15% of his $1,000,000 in stocks and 85% of it parked in cash. Since cash is earning next-to-nothing in 2014, for illustrative purposes, cash earns nothing in the hypothetical example below. The chart below shows the growth of $1,000,000 based on the S&P 500’s return (SPY ) and the three different allocations – 100% Bob, 50% Sally, and 15% Dave.