Prepare for the Next Black Swan with a Lifeboat Drill

The stock market collapse in March was triggered by a rare phenomenon known in the financial industry as a black swan event.

Black swans are sudden, completely unpredictable events that roil financial markets, catching investors flatfooted. Typically, some with the benefit of 20-20 hindsight say they saw these events coming, but they didn’t. By definition, no one ever does.

If you could see a black swan event coming far enough in advance, you’d have some time to make protective adjustments in your investment portfolio. But because you can’t, the only thing you can do is be prepared for them all the time because, when they hit, the stock market can fall so precipitously that it’s virtually impossible for individual investors to sell without significant losses.

How do you get and stay prepared for a black swan event? By constructing and maintaining your portfolio to withstand one without sustaining damage, and by making provisions for how you’ll get by if things get especially bad. Even if you prepare well, a black swan can still hurt you badly. The idea is to limit losses.

As surviving a black swan could be likened to staying safe aboard a sinking ship, the best way to prepare for one is to run a lifeboat drill. Just as an actual lifeboat drill assures that you can get to safety when the ship is going down, a financial lifeboat drill—an evaluation of your readiness—can help prepare you for when a black swan strikes.

Do I have enough cash—in accessible accounts, such as money markets—to pay living expenses for a year?

Is my stock portfolio focused on high-quality companies that pay reliable dividends?

Is my stock portfolio well diversified?

Am I sufficiently diversified by asset class?

This exercise consists of asking yourself a series of questions and taking action if the answers don’t bode well for your potential outcome. These questions should include:Many experts advise having an emergency fund sufficient to last for six months—but that’s more of a peace-time reserve. A black swan event, as the nation is now painfully learning, can be more like war, so doubling that figure is a good move.Income from dividends can help you get by while you wait for asset values to come back and keep you from having to sell low.In a steep market drop, some sectors take much bigger hits than other. In a recession, discretionary spending falls sharply, dealing a blow to the stock category known as consumer discretionary—goods and services that consumers don’t have to have and don’t buy as much of in a down economy. The leisure travel and hospitality industries, dealt strong blows by the virus, fall into the discretionary category. As these industries tend to be cyclical, it’s never a good idea anyway to have too much of your portfolio allocated to them. Instead, you want broad diversification to minimize exposure to any one sector.Considering my time horizon and risk tolerance, does my asset allocation make sense? This means having a portfolio that isn’t too heavily weighted in stocks for what’s known as your time horizon—your anticipated time until retirement. Bonds aren’t consistently correlated with—that is, they don’t always rise and fall with—stocks. That’s why, as investors get older, many tend to have more of their money in bonds and less in stocks.

How much of my portfolio should be in bonds?

If you have an asset allocation of 60% and 40% in stocks, and a black swan event cuts stock values by 35%, as the current black swan did to the Dow Jones Industrial Average initially in March, you’d lose about 21% your total asset value. This isn’t a rosy prospect, but it’s far preferable to losing 35% percent of your asset value from having 100% your portfolio in stocks when a black swan hits, as the recent one did.Bonds have been paying historically low yields in recent years, and current rates are extremely now. A good option for many investors in such times is to build what’s known as a bond ladder, using short-term bonds. This involves purchasing bonds with overlapping maturities of one to five years, and holding each to maturity before replacing it with another as you go along. This laddered approach generates gradual, reliable income while protecting you from declining values and the inflation that can whittle away at yields. Asset class diversification can also involve the addition of alternative assets such as real estate investment trusts (REITs), which have a low correlation with the stock market.

It’s never too soon to prepare for the next black swan. If you take the right precautions, you’ll be far less likely to see your portfolio go down with a Titanic market and more likely to survive the event from the relative safety of a dry financial lifeboat.

David Robinson, a Certified Financial Planner, is founder/CEO of RTS Private Wealth Management, an SEC-registered firm in Phoenix that provides fiduciary services to help clients achieve their financial goals. His practice focuses on helping wealthy individuals with custom financial plans, using a holistic approach to grow/protect wealth, manage taxes, identify insurance solutions, prepare for retirement and manage estate plans.