John Mauldin continues his 'Train Crash' series, this week with some things you can do to protect yourself from the coming problems

By John Mauldin*

Standing in front of a speeding train is rarely a good idea, but most investors are doing it right now. They survive only because the debt train is still way down the tracks. It is nonetheless coming, and you will want to move before then. But which way? 

Over the last two months I made the case (summarised here) for a coming worldwide debt default/restructuring/financial engineering. Call it whatever you want but it won’t be good. 

Here's the full list of links for the previous articles.

While I think we have a few years, I see little chance we can escape some kind of painful reckoning which I believe will culminate towards the middle to the end of 2020s. The opportunities to change course are behind us now. Yes, there are things many countries can do to put things back on track, but most are not politically possible in this fractured world. It will require a crisis to muster the political will to fix this.

While we can’t do anything about that—and the people who can do something are choosing not to—we cantake steps to protect ourselves and maybe even profit from this approaching train crash. Many of you have asked for specific advice. I’m somewhat limited in what I can say, both for legal reasons and because we have readers in many different situations. Not everything is suitable for everyone. But I can give you some general ideas and rules to follow. Today, we will start with the smallest investors and then move on up.

Some of my Mauldin Economics colleagues also have ideas, which I hope you read in the special reports we’ve featured in the last few days. More on that below. But now, let’s consider how to dodge the train. I have four rules to follow, all of which would be good practice even if we weren’t in front of a speeding train.

Rule #1: Get Active

Remember when fund managers were Masters of the Universe? Few qualify these days, and not because they are any less talented. It is because the last decade’s generally rising markets favored passive “buy and hold” investment strategies. Why pay a manager when you can get great results for lower cost—nearly free for some index ETFs?

I’ve never been a buy and hold fan. I am aware of the Nobel laureates who say it’s the only way to succeed in the long run. They’re right about the numbers—but I think wrong about human nature. Any investment strategy works only as long as you stick with it. Telling people to throw their money in stocks and not worry when a bear market chops it in half does them no favors. Most will panic and sell at exactly the wrong time. Every advisor/broker has seen it happen.

Ideally, you would pair your passive indexing strategy with an advisor who keeps you from making rash decisions. The problem there is advisors can only do so much. It’s still your money and they have to pull it out of the market if you say so. Furthermore, advisors have to get paid somehow, which reduces the cost savings that justified passive investing in the first place.

That doesn’t mean advisors are useless—a good one can save your bacon. But it should be someone philosophically aligned with you and in whom you can place enormous trust. They aren’t easy to find. The largest investors in family offices generally have a team of people giving them advice.

An active manager worth his or her salt will manage risk as part of the deal, and risk management is exactly what you need when you live on a railroad track. It doesn’t have to be perfect, just good enough to mitigate the major drawdowns. If everybody else loses 40% and you only lose 25%, you’ll be way ahead of the crowd. And the right manager should avoid even that scenario and keep you near break-even.

Some Advice for Small Investors and Those Starting Out

A brief pause before we go on to Rule #2. If you are early in your investing career or still consider yourself small, the most important things you can do are:

  1. Simplify your lifestyle and save more money. That’s not particularly fun, but in the long-term will pay huge dividends.
  1. Get out of debt. Do not carry debt on credit cards. Pay your credit cards off as quickly as possible. Saving is easier when you aren’t paying 18% interest. You’re not going to get 18% on your investments.
  1. There are a whole host of options for how to save. For small investors, there is not much magic. Some of you are going to roll your eyes, but I suggest reading some books by my good friend Suze Orman, or (if you have a more religious bent) Dave Ramsey.
  1. Move as much money as possible into tax deferred accounts. Taxes are the #1 killer of investment returns (more on this below).

Where to invest? Now I’m going to talk out of both sides of my mouth. For smaller accounts, use low-cost index funds or ETFs. But consistent with my philosophy, you do not want to buy and hold forever. You need some kind of risk management rule. If nothing else, use the web to run a 200-day moving average on whatever index funds you choose. Check once a week and if your fund goes below the moving average, then rotate into a short-term Treasury fund. Jump back in when it crosses above.

Market timing is extraordinarily difficult. There is no perfect system. I have spent 30 years looking at money management systems from some of the greatest traders in the world. All of them will have problems from time to time.

We’ll discuss this more in future letters, but you get the general idea.

Rule #2: Use Multiple Tools

The problem with active managers is none of them are perfect. That’s not a reason to avoid them; it is a reason to use several of them covering different strategies and asset classes. Assembling the right combination takes some skill, though. It does you no good to have three managers who make and lose money at the same time. You succeed only in creating more paperwork. They need to be uncorrelated.

Further, an “active manager” who never goes to cash is not really active, at least from my viewpoint. He is simply a stock picker whose portfolio will get crushed in a bear market. I can give you literally hundreds of examples. Look at the portfolios of some of the great stock pickers in the last 20–30 years. Then see what happened during bear markets. It was ugly.

Multiple managers are the core of my personal strategy. I have money allocated to several different managers who use it to trade ETFs. In other words, they’re actively trading a passive portfolio. I think this is an ideal combination. You know what the ETFs’ components are, and you know (or at least think you know) whether they are in favor at the moment. If so, you want to own them and avoid them if not. The key is having the ability to adjust quickly.

I also am a strong believer in quantitative systems rather than human discretion. Do not, and I mean do not ever, give your money to gun slingers who “have a feel for the market.” They will lose their feel right after you invest your money. Trust me.

Also in my portfolio are multiple private hedge funds whose managers use more sophisticated techniques that you can’t do with ETFs. Their edge is the ability to move quickly and quietly. Look beyond the common long/short equity strategies. There are all sorts of interesting markets available. As I’ve written in the past, the “alpha” in long/short equity has evaporated where passive investors simply buy everything. Even the dogs go up. It’s very frustrating for a value investor, which I consider myself to be. Our time will come but for now let’s do something else.

Having said all that, I should note I do have some long-term, buy-and-hold investments—mostly small-cap biotechnology stocks that I think have a good chance of achieving a moon shot. They would be hard to sell quickly even if I wanted to, but I’m fortunately able to hold them without too much worry. They are bonuses, not critical to reaching my financial goals. I’ll be disappointed if they should drop to zero value but it won’t affect my family or lifestyle.

And frankly, the world will be better off if we find a cure for cancer or can reverse aging. In my own small way, I’m trying to own investments that do some good.

Rule #3: Sell Liquidity

This one takes a little more explanation. If we see a serious possibility of a global debt default, then it seems obvious you don’t want to be a lender. But in reality, it’s practically impossible not to. Even stashing your money in a bank is technically a loan; your savings account is a liability on the bank’s balance sheet.

Or maybe you avoid corporate bonds and buy equities… but you might still be an indirect lender, if the company, say, leases equipment or real estate to other parties. Those are a form of debt.

The only way not to lend your assets to someone else is to invest in physical, storable property. Gold is an obvious candidate and I think it’s a good idea to own some. But I also wouldn’t go whole-hog into precious metals. What else can you do?

The answer is to keep lending, but be smart about it.

Maybe you can’t avoid lending or predict whether a debt jubilee will annihilate your principal. You can, however, make sure that you earn yields that compensate you for the risk. And the best way to do that is to sell liquidity.

The nice thing about bank accounts, money market funds, and Treasury bills is you can always trade them for something else, with no notice. They are highly liquid, in other words. But we forget that liquidity isn’t free. You “pay” for it by receiving lower yield on those assets.

This can make sense if you really do need that money available instantly, but that’s often not the case. People leave cash in money market funds for months and even years, earning much less than they could by simply buying a three-month CD and rolling it over. There’s no significant difference in credit or interest rate risk. It is simply a lost opportunity—a gift you hand to other parties.

Obviously, you want some liquidity because things happen, but most investors want too much of it and it cuts deeply into their returns. With very little effort and almost no extra risk, you can enhance your return on cash by 100-200 basis points (that’s 1-2%) annually, just by accepting lower liquidity on money you don’t need to keep liquid anyway.

You might do even better. In the private credit world I’ve written about (see The Seven Fat Years of ZIRP), it’s possible to earn 300-600 extra basis points in additional yield. Those opportunities are legally accessible only to high-net-worth investors, unfortunately, but they are worth investigating if you qualify.

Rule # 4: Get Radical on Taxes

I’ve quoted Woody Brock’s prediction that the unfunded government liability problem will get solved with a wealth tax. Even if he’s wrong, I think the era of lower tax rates on wealthy people is drawing to a close. We had a good thirty years or so, but this most recent tax cut may have been the peak.

However, higher tax rates don’t necessarily mean you pay higher taxes. We’ll just have to get more creative in the business and lifestyle changes we’re willing to make, within what the law allows. I am aggressively exploring some options I would not have considered even a year or two ago.

Federal, state, and local taxes take a big chunk of my gross income. And, to the extent I receive government services, I’m happy to pay for them. I am not happy to pay for the follies and extravagance of politicians who have little interest in the public good and want mainly to line their own pockets.

I’ll have more to say about my own adjustments after I make a few decisions, some of which won’t be easy. I mention it now because it may benefit you to do the same: consider moves that you previously rejected. Times are changing and we have to change with them.

For instance, there are ways to use life insurance to defer your taxes. And there are very low cost annuities (as in $20 a month) in which you can control the investment and defer your capital gains until you sell. It’s just as liquid as a bank account, but tax-deferred.

If you own a small, privately-held business without many employees, consider setting up your own defined benefit plan. You can control the investments and place a lot more money into the plan than with a traditional IRA or 401(k). I know people with several of these.

Next week we will cover more options available to wealthier investors. But the basics apply to everybody, including me.


*This is an article from Thoughts from the Frontline, John Mauldin's free weekly investment and economic newsletter. This article first appeared here and is used by interest.co.nz with permission.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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35 Comments

Given the very favourable conditions in the post-GFC period for property and equities over the past 10 years it is easy to accept this as the norm, and there are many who have experienced nothing else. Even the relatively naive or incompetent investor would have done very well with soaring house prices and equities.

While some may feel that your premise of a forthcoming train crash is both all doom and gloom and extreme, it is well worth considering your comments even as a worse case scenario. Any prudent investor - especially those lulled into a false sense of security by the past 10 years - should consider this and the strategies you suggest.
Should they follow your advice hollis bollis without question? Of course not; successful investors critically listen and evaluate all information and make their own judgement accordingly.

Some Advice for Small Investors and Those Starting Out

A brief pause before we go on to Rule #2. If you are early in your investing career or still consider yourself small, the most important things you can do are:

1) Simplify your lifestyle and save more money. That’s not particularly fun, but in the long-term will pay huge dividends.

2) Get out of debt. Do not carry debt on credit cards. Pay your credit cards off as quickly as possible. Saving is easier when you aren’t paying 18% interest. You’re not going to get 18% on your investments.

3) There are a whole host of options for how to save. For small investors, there is not much magic. Some of you are going to roll your eyes, but I suggest reading some books by my good friend Suze Orman, or (if you have a more religious bent) Dave Ramsey.

4) Move as much money as possible into tax deferred accounts. Taxes are the #1 killer of investment returns (more on this below).

Plenty of good advice here... ...that you can already find in books by NZ's own Mary Holm.

It's pretty common advice when you look at the core components.
1. Spend less than you earn.
2. Pay off debts quickly
3. Save/invest what you don't spend
4. Minimise your tax and fees.

1, 2, and 3 is something everyone should be doing regardless of situation.

4. can be a bit harder to achieve when you are just a little fish. But there are still some options.

I am bitterly disappointed by this advice, it applies to anyone anytime. Of course it's good advice but I didn't need to read 12 articles over a few months written by a "financial guru" to learn "pay your credit cards off"

Hahahaha, thanks for that comment Yvil. I agree it was rather anticlimactic advice.

"Move as much money as possible into tax deferred accounts."

What's the NZ equivalent of this?

Kiwisaver at PIE tax rate of $28%
Family Trusts at 33%

Unfortunately while we let property speculators off tax by allowing them to pretend capital gains were unintentional, we don't do the wise thing vis-a-vis KiwiSaver and defer taxes until the money is taken out.

Although we don't tax capital gain at all in Kiwisaver.

I'm in the process of considering bringing my Aussie Superannuation over to Kiwisaver.
Aussie tax super at 15%, while Kiwisaver is usually at PIE rate of 28%. Yet Aussie super taxes capital gain (including shares etc within a superfund).

It's a bit to weigh up.

No you can't.

I challenged Mary Holm - via txt to RNZ Afternoons. Asked her if she was as tall as the Eiffel tower, given her Plunket-book records. Mulligan caught on - mentioned limits to growth - but she replied "not in my skill-set'.

So no, I don't regard her as any use, advice-wise, given what's happening and what's coming. Reminds me of Groucho Marx getting out of touch with his brokers, on tour in the late 20's. Found that the bellhops and shoe-shine boys had tips every bit as good.

Until they weren't.

So what's you're advice then, given what that you can foresee of the coming economic conditions? You don't think living within your means and paying down debt are of any use?

what use is paying down debt ...
All financial signals are to spend more ... thats what the system needs to stay afloat - we need to bring more and more spending forward to hold the debt/wealth up. Otherwise it becomes apparent we are insolvent (maybe thats what all those years of current account deficits followed by endless QE were trying to tell us)

I am bitterly disappointed by this advice, it applies to anyone anytime. Of course it's good advice but I didn't need to read 12 articles over a few months written by a "financial guru" to learn "pay your credit cards off"

Suck it up and realise you are now living in a descending interest rate environment, your yields are going to keep dropping. You may pick up the difference on the inversely related capital gains, but is your asset liquid enough to get out in time? There is a reason for the descending interest rates, and unless you get to grips with it then you are going to get burnt.

May you live in less interesting times :)

I like your post scarfie, can you elaborate on
"You may pick up the difference on the inversely related capital gains"
I assume you talk about capital losses but I don't get the "you may pick up the difference" part
Thanks

He means interest rates are perpetually headed downwards, and asset prices are perpetually going up. The new norm might be a halving of interest rates every 10 years.

The names of a few debt addicted commentators immediately comes to mind who get a thrill out of playing chicken with this train....

Some interesting comments about how many first home buyers are tapping into the bank of mum and dad to buy their first home :
Here, there is no comprehensive sector-wide data, but one mortgage broker, Mike Pero Mortgages, ran some numbers with its clients which suggest it's even higher here.

They report 60 to 70 per cent of first home buyers had help from their parents, and for buyers under 30, the figure was closer to 80 or 90 per cent.

That's backed up, anecdotally at least, by other mortgage brokers – although inevitably the figures in Auckland are higher than elsewhere.

Source: https://www.stuff.co.nz/business/opinion-analysis/105610474/generosity-a...

Here's a tip. Watch the graph once the farmers are in and the cap come off.....
https://www.commtrade.co.nz/

What do you invest in if you think almost everything is fundamentally over-priced to cheap credit?
I've been holding money in term deposits and missed out on most of the recent asset appreciation.
The correction has been slow in coming but I have a nagging feeling that the end-game has started.

Invest in things you think you will need in the future.

After all, isn't that the only reason to save?

Yourself.. Got bad teeth, get em fixed. Got a bit out of shape, invest in a personal trainer and get back in shape. Invest in the things that can't be confiscated and always retain their value. And take up a fun hobby. :)

Indeed, better proactive medical management costs which are far lower than reactive medical insurance which does not cover most afflictions or even any chronic conditions. Good to have both though because often no one can ever predict afflictions, even genetic issues can be a probability as to whether they develop. If you need vaccinations take them, it is also good to have more regular health & maintenance checks. This literally is the stitch in time save nine effect.

Also avoid high risk sports & experiences. A serious concussion putting you out of work for over a year in an unlucky fall or blow will cost far more than switching to yoga, a gym, jogging or swimming earlier (which also will save you immense costs by reducing equipment & often little to no training or session costs if done using public facilities). There are many things a local park & facilities can offer along with options you can do at home. If you need an external mental boost & trainer then there are several free to low cost options.

Mind you though many people face far more medical risk in their jobs, so much so that even medical insurance is denied on job alone. I had an insurance manager acquaintance who was bragging about all the people they turned down on the basis of their employment or travel alone, (even a few office roles due to old school superstitions). It is sad but many people are turned down for medical insurance and cannot afford things such as basic medical costs making small issues develop into large financially devastating ones.

Also avoid high risk sports & experiences. A serious concussion putting you out of work for over a year in an unlucky fall or blow will cost far more than switching to yoga, a gym, jogging or swimming earlier (which also will save you immense costs by reducing equipment & often little to no training or session costs if done using public facilities).

You sounds like the boring old fart i work with.. totally terrified of everything and too tight to spend a cent. No point in being alive if you aren't actually living a bit!

Sure living yes, but I advocate being prepared, so many silly day trippers run out with their cellphones on multiday alpine hikes without even the minimal benefits of appropriate clothing, an emergency location beacon, map & compass (for when the cell GPS is useless anyway), small medical first aid kit and supplies for the trip/ and emergency. You cannot say the environment will be forgiving of ignorance or foolhardiness in bad weather. When you choose to take unsurprisingly silly risks without basic preparation any small accident can easily snowball. E.G. See the documentary on the darkness of Mt Everest, people choosing to literally put lives onto the knife edge of risk knowing full well when things go wrong they are deadly and often if you cannot get out yourself you get left behind, regardless https://www.youtube.com/watch?v=ZQZ_QzT4zho. People choosing to climb Mt Everest for thrill are entirely selfish putting their thrill above the lives of their family. Many who do not even have the health to enable them to go that high should not. Ability to do things is entirely variable, even on a given day. Conscious researched decisions is far better than unconsciously throw everything to the hands of fate.

Consider that I do not advocate not taking risks, after all we do so everyday. Travelling on any NZ state highway is literally putting your life into the hands of the fickle mistress of chaos. But making the right choices can be vitally important. Rugby players suffer more severe brain injuries and disabling critical ones than many other sports for a reason. Think critically and be prepared, if an action deliberately calls for unreasonable risks without any comparable benefits it is not worth it. Likewise if a job requires you to e.g. put your lungs and future capability to breathe at extreme risk, taking the all too common silicosis as an example, and the pay packet, safety gear and medical insurance benefits of the job do not match it is not worth being disabled for what could be half your life. I have seen all too many who have taken the risk & ended up disabled before they can be classed as middle aged, some just die before. ACC is often nothing that can be relied on.

Your 1st question is very pertinent but unfortunately remains unanswered by JM
I also agree with the pertinence of your 2nd point, the more important question in my view is WHEN will the crash arrive (see my post below)

The title asks "It (the train) is nonetheless coming, and you will want to move before then. But which way?"

I think that's the wrong question, the better question is how far away is the train and WHEN is the right time to make a move

"And frankly, the world will be better off if we …. can reverse aging"

Really? How many people do you want living on this earth JM? Or do yo suggest we stop procreating?

Yvil your quote ,

'Really? How many people do you want living on this earth JM? Or do yo suggest we stop procreating?'

Did you really write that?

Yes, why?

I'll stick my neck out and state: before the crash comes (good luck with the timing) sell your investments and keep the cash in your safe and a few other places.
Reactions???

Cash is nothing more than worthless paper/plastic/cotton.

Better to have the mattress, than the cash under it.

Try buying a loaf of bread with a used mattress and see how far you get.

So my question is, how at risk is your money in the bank ? It seems to me that money is always a worry. When I had a mortgage I was worried about servicing it and keeping a job and now it's still a worry after you sell it and put it in the bank.

Love the when will it arrive questions, as its impossible to know when a crash will arrive. i will go with the massive confluence of USA T bonds in early October and other big crashes where in October. so wonder no more you have a date the mid October 2018.