Current Opportunities for the Defensive Investor

A friend recently asked me whether or not to sell some stock options from his employer and what to do with the proceeds. This is a tough question to answer because each one's situation is different. So I answered him first with a set of premises that I believe are universally true and are to be followed as general guidelines at all times. And then, I mentioned a few twists for taking advantage of the current situation as well as some precautions.

Investing Premises for the Defensive Investor
  1. Emergency Fund. Always have at least a six-month fund in cash or ultra-safe investment for eventual emergencies.
  2. Money needed in less than five years should not be in stocks.
  3. Extra money not needed within five years should always be at least 25% in stocks, typically more. A 50-50 allocation between stocks and bonds is a good, no-brainer choice.
  4. Inflation is the enemy. Be weary of anything that ties up money for a long time and has no chance of benefiting during inflationary times. Inflation is always around, sometimes to a larger degree than others.
  5. The taxman is the enemy too. All things equal, paying less taxes is always better. Avoid taxes as much as legally possible. Delaying taxes is often an option, especially if one can choose between taking a profit now or later. Typically, avoid taking taxable profits at the end of the year, since taxes will be due sooner than if you took the profits early in the year (say, selling in November gives you 6 months until tax collection time in April, while selling in January gives you a year and four months to enjoy the money -- exceptions abound, so consult your tax advisor for details).
  6. Avoid over-relying on your employer. If you depend on employment income for a living, loading up on your employer's stock significantly increases the amount of risk you take. Sell those stock options when it makes sense. If your spouse works there too, that's even more risk, you probably don't need to hold any employer stock at that point.
As they are, these are general guidelines to be observed at all times. What does that mean right now, in terms of actionable items and the current situation? Let's take a look at the current investing scenario.

Current Investing Situation
  1. Low interest rates.  Money market and savings accounts yield next to nothing, so investors will lose money to inflation over time.
  2. Threat of higher inflation in the near future. With money printing and inflation officially at its lowest point in years, it's guaranteed that the only possible outcome in the future is higher inflation.
  3. Devaluing of the dollar. With the recent threat of collapse of american financial institutions, the rest of the world is scared of the dollar -- China is buying gold and Saudi Arabia is allegedly selling oil in Euros, not Dollars. Combined with fear of higher inflation, holding US Dollars doesn't seem like a good call right now.
Intersecting the current investing situation with the investing premises for defensive investors, what is my friend, a defensive investor, to do?

Current Action Items for the Defensive Investor
  1.  Get an emergency fund in place. My friend should sell enough of his stock options and get that emergency fund in place. A good place to park it is in Vanguard's Prime Money Market Fund or a muni fund from his state if he's in a high tax bracket. In his case, the California Muni Market Fund will do it.
  2. Diversify away from the dollar and hedge against inflation. With the funds my friend will need in the next 5 years, he should put them in inflation-protected places. My favorites are TIPS funds such as Vanguard's Inflation-Protected Fund and a CD of a basket of strong currencies, such as Everbank's Commodity CD, which contains 25% of each Australian, Canadian, New Zealander and South African currencies. Another good choice is the Debt-Free CD which has among others the Swiss Franc and the Brazilian Real.
  3. Invest for the long-run. With the rest of the money he won't need in the next 5 years, I told my friend to invest at least 25% in stocks, but possibly even more. A good choice is to go 2/3 stocks and 1/3 bonds with the Wellington Fund. To be more aggressive, I'd allocate 70% to Wellington and the rest into a Total International Stock fund or equivalent.
Regarding his employer's options, I told him to lock-in most of his gains now to start the above plan right away and to keep only a small portion for future appreciation, since his options vest continuously and are replenished by his employer annually (there are more where these came from).

My advice for Entrepreneurial  Investors would only be slightly different, and it would also include to a large extent the same defensive investments outlined above. The difference between the two types of investors is the amount of time and interest they have to devote to their investments. As such, a defensive investor should refrain from picking stocks and engaging in short-term arbitrage transactions. And every investor, seasoned or not, had better stay away from market-timing folly and listening to financial commentary in general.

Disclosures: I own shares of some of the funds mentioned above: VGTSX, VCTXX, VIPSX and the Commodity CD. I did not receive any compensation for mentioning the names or products of any of the companies cited above.

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