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Many stock markets outside the US have been weak for some time, while US stocks finally started to crack after nearly seven years of continuous gains. Whether the current decline is the beginning of a bear market or just a temporary blip on an otherwise ongoing bull market (as we experienced in October when markets declined than rallied nearly 10% in both directions in a matter of weeks), time will tell. That said, it is often prudent to implement protection against stock gains and this article discusses several ways to make sure your hard earned money – and gains – don’t vanish. Which approach, if any, is best suited for you is largely dependent upon your particular circumstances, tax considerations, skill level, ability to monitor the market/positions, and other factors.
There are a variety of reasons why historically Coastwise has used mutual funds rarely, as detailed in my book The Power Curve: Smart Investing Using Dividends, Options and the Magic of Compounding. Specifically, actively managed mutual funds (where there is another professional money manager involved – the mutual fund manager in addition to your Financial Advisor) can have several disadvantages versus owning stocks/bonds directly (or low cost ETFs), specifically:
Rule #1: diversify, diversify, diversify. But why does the golden rule of ‘don’t put all your eggs in one basket’ give an investment portfolio the same strength and ability to endure as the U.S. gets as a country from the diversity of its people? Diversification has the dual effects of reducing risk and portfolio volatility, as often asset classes move in different directions and in varying degrees. Thus, by owning asset classes like stocks, bonds, REITs, cash, MLPs, commodities, etc. your portfolio will be positioned to withstand the inevitable material drop of any one asset class over the short or even medium term.
Further diversification can be achieved within a specific asset class, for example you can invest in foreign equity markets (as opposed to just U.S. based stocks) to take advantage of stronger growth in emerging markets. Professional money managers, like Yale Endowment’s David Swensen, have made a highly profitable career out of – and written books about – the value of proper diversification over time. It is true that with additional risk may come higher returns, but that is not always the case. The risk that an investor takes on by being overly concentrated – be it in a given asset class or worse yet, a singular investment within an asset class (think of those poor souls who had all their retirement money in Enron or GM stock) – may simply lead to permanent capital loss. Thus as investors we are always trying to find the optimal balance between risk and reward via diversification and other methods for our particular circumstances and objectives.
I have always thought that the term “correction” was a strange one for a stock market decline. It implies that stock prices were somehow “wrong” before the drop and “right” afterwards. Maybe the same person who invented the word “spank” to describe hitting kids also coined the term “correction.” In any case, it is not a matter of if, but when, such a market decline of 10% or more (the common definition of a correction whereas a drop of 20% plus is considered a bear market) will occur.
Why will it be so painful for investors this time around? I mean, 10% is 10% right? How can one 10% hurt any more than another 10%? And shouldn’t it be even less painful given large equity run-ups the last several months? You would think so, objectively speaking, but few people invest with the left sides of their brains. Rather, it is the lack of material and significant market declines in recent years that will make the next one seem so dramatic. Investing memories tend to be short, and investors typically feel more pain from stocks dropping than pleasure from stocks rising. The point here is – you are in a vulnerable investment place psychologically right now, so don’t over react. But if you do decide to take some action prior to, or if/when a market drop ensues, below are some ideas about what to do.
It is very important to note that everyone’s circumstances are different. If you have a 1 – 2 year investment time horizon and you are sitting on big investment gains from getting in the market at major lows in 2009, then hedging gains may be prudent for you. If, instead, you are beginning a 10 - 20 year investment journey for retirement, then not only might hedging against a market decline be unwise, you may welcome such a decline as a way to add more retirement dollars at lower prices. That said, here are some techniques to consider to counter a correction. Final important point: I am not attempting to predict the timing of the next market decline. One could have reasonably said the market was due for a precipitous drop every month for the last nearly year. These events are very hard to predict which is why we are not market timers. Rather, you should focus on your overall circumstances and whether now is a good time for you to hedge regardless of where the market may be in the months to come.
With US markets revisiting 2007 peaks, it is a good opportunity to address a timely topic. I regularly get asked the question: "is now a good time to invest?" The inquiry is typically driven by investors who fall into two camps: 1) those who sold stocks in a panic during the financial crisis and are now wondering if it is a good opportunity to get back in (the majority), and 2) those who are wary of a market decline after such a large recent run up (the minority).
While left largely unsaid, what both camps really want to know is, "will the stock market go up – or down - in the next few months?" Although we are not market timers in the traditional sense of attempting to dart in and out of markets (which over time is a loser's game), in reality 'timing' is an important issue when it comes to investing and trading. Let's examine further.
Draw a traditional four-square matrix. On the top left square write "Low Market Valuation", above the top right quadrant "High Market Valuation", to the left of the top left square "Long Investing Time Frame" and to the left of the bottom left square scribble "Short Investing Time Frame." For some context, while there are no bright lines per se, a low market valuation would be characterized as one with a P/E ratio reasonably below its historical average of around 15X and a high market valuation would be one with a P/E north of 20X. A forward P/E of 14X, about where we are now, would be considered a fair market value depending on things like interest rate other variables. A long investing time frame would be 10 years or more, a short investing time frame would be under a year, and so on.
The answer to the all-important question "Is now a good time to invest?" is not driven by some unknown near-term market prognostication, but rather where you, and the market, fall within this matrix. Have a long-term investment time horizon coupled with the fortune to be putting capital to work when stock valuations are low (think March 2009)? Then 'now' would be an excellent time to invest. And that is regardless of the dire macroeconomic or political headlines blaring from financial media talking heads. If, instead of being in the upper left hand quadrant, your circumstances find your 'X' in the lower right hand box (short time horizon, high market valuation) then today is assuredly not the time to put money in the stock market. But won't it be higher in 3 or 6 months' time? If someone says they know where the market will be in a few months, run in the other direction as fast as possible. A market with an exorbitant P/E ratio can certainly become an even more overpriced one (witness the NASDAQ in the first quarter of 2000 which shot up dramatically after having soared over 80% in the prior 12 months...only to come crashing down starting in the spring of 2000), but relying on the greater fool theory hardly qualifies as prudent investing.
If your situation falls into one of the other squares, then a thorough and objective analysis of ability to withstand capital loss (read: if stocks are down when you need the funds converted back to cash), how effectively your money manager can hedge, and other considerations must be undertaken.