Most people can make money in a bull market -- it's what you do in down markets that can make or break your long-term returns. Will you panic and sell everything? Or will you do the opposite: hold on for dear life and possibly miss the fact that one of your properties or stocks has truly taken a turn for the worse and will never recover?
I tend to lean toward active holding. That means not selling because of price drops but paying close attention to what's going on with all of your investments. I have a mixed portfolio of stocks and real estate, and I'm also proactively increasing my reserves, analyzing when I would sell my investments, and averaging into growth stocks. Here's a look at each of these actions.
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1. Reserves
Recently, one of our tenants let us know he'd be moving out in a month, and then a few weeks later messaged to say that a leak in the upstairs unit caused the ceiling to collapse. A few thousand dollars and seven or eight phone calls with the insurance company later, I decided to get serious about increasing our cash reserves.
That property will have at least one month and probably two or more without rent. Vacancies or slow-paying or nonpaying tenants are the main way long-term-focused real estate investors are harmed by economic downturns. The bank, local government, utility companies, and homeowners associations don't care if you have no rent money coming in -- your fixed costs will be due no matter what.
Pick either a fixed dollar amount (like $5,000 or $10,000) or a number of months (most experts will say three to six, but you can do more if you're nervous) of expenses for each property, and keep it in a savings account or invested in low-risk Treasuries. If you do end up facing a long-term vacancy, you'll have the cash to keep paying operating expenses.
2. Sell decisions
As a long-term real estate investor, I don't buy houses with the intention of selling them. I want to buy the house, receive a little cash flow from renting it, and have the tenant pay off the mortgage over the long term to build up my equity.
Usually, my wife and I will live in the property for a few years before moving and renting it out. This time around, we may choose to sell the house.
The real estate market in Utah, where we live and own four properties, got really overheated over the past few years. A property that I purchased for $90,000 in 2015 recently appraised for more than $250,000. You don't often see that type of growth in real estate prices, and I'd like to diversify a little, both geographically and out of residential and into commercial real estate.
We'll either sell our current residence when we move and put the proceeds into a commercial property somewhere else, or keep it to rent out and use other cash to diversify. The key will be valuation. When we get close to moving, I'll start researching local rent statistics and sales comps. If it looks like the annual cash flow from the house will be less than 8% (known as the cap rate) of a potential sale, we'll sell and invest elsewhere. For comparison, an 8% cap rate is the equivalent of a price-to-earnings ratio of 12.5.
3. Growth stocks
As for my stock portfolio, I've chosen several stocks to dollar-cost average into each month. Dollar-cost averaging is the practice of buying the same amount of the stock every month. That could mean trying to buy close to $100 or buying three shares, or whatever works for your portfolio.
I picked growth stocks that were hit particularly hard this year but have strong businesses that will undoubtedly survive even a prolonged economic downturn. Each month, I buy approximately $100 of each. That isn't close to a normal position size for me, but over time it should build to one.
Growth stocks are volatile, and even though I have faith in the business long term, the stock could fall another 50%. By averaging in, I guarantee that at least part of my position is purchased close to the bottom.
You should pay close attention to the business. When you start averaging in, write down some notes about what you expect to happen to the business over the next few years. How much will revenue grow? Is there debt that needs to be refinanced? What is management projecting for earnings? Each quarter, track down how the company is progressing with the metrics you choose, and make sure you still have faith in the business long term.
