Bring Out Your Dead: The Shock of Anticipated Events
There is a great scene in the classic movie Monty Python and The Holy Grail where 2 castle guards are standing casually in front of an entrance. The camera pans to what appears to be a soldier off in the distance riding a horse swiftly towards the castle. The camera then goes back to the soldiers who don’t seem to have a care in the world. Cut back to the solider who, despite moving what appears to be at very fast speeds atop his horse, had made no progress towards the guards. This goes back and forth for a few times until all of a sudden, WHAM – the soldier is upon the guards and easily defeats them since he took them by ‘surprise’.
This is a funny construct that has an apt analogy in stock market investing. Financial prognosticators and individual investors alike predict, day after day, the impending doom of a market crash. Its arrival seems so obvious and imminent; it will surely arrive tomorrow given the terrible headline news, etc. This goes on day after day, week after week, with the confidence of the market’s demise growing by the day. Then, WHAM, the market shaves off 5% of its value in a couple trading days and everyone is in shock and awe, just like those poor guards who never saw it coming.
The reality is that some otherwise pretty smart people make a lot of money going on TV predicting the next crash. At some point they will be right and say, “I told you so” (even if the market went up 20% while they were calling for a crash and, despite the 5% pull back, you would have been better off not listening to them). The reality is that near-term market declines are for all intents and purposes not predictable. Yet shouting about doom and gloom gets a lot more attention (and thus advertising dollars) then does telling an audience to put money into stocks for the long-term and turn off the TV. So, such fortune tellers will always be in demand. The part that is ironic is how surprised people are when the thing they had been predicting ad nauseam actually comes to pass. Don’t get sucked into the emotional roller coaster. Rather set forth a plan and have confidence you will achieve your near and long-term goals regardless of what others say or how the market moves in the near term.
The Risk of Holding Cash
Financial commentators and investors consistently define risk inappropriately as short-term stock price volatility. In order to mitigate this perceived risk, investors will often hoard cash. In this case, they are letting the tail wag the dog. The question you need to answer is not, “will the market be volatile?” (to which the answer is invariably yes), but rather, “what goal am I investing for, and when will I need to convert my stocks back to cash?” If the answer to the latter question is 3-5 years or longer, then holding cash means you are taking risks, not reducing them.
What risk are you taking? That you will lose something around 15% - 20% of your cash’s value to inflation (which is currently running at over 5%), thereby not having enough money to achieve your stated future goal. Since you don’t need the money for 5 years or more, short-term price movements are of no concern (nor risk) to you. Stocks are often volatile in the near term. Therefore, your focus should be on what you can control, specifically your holding period and goals. If you need the money in the next few months, then cash is the appropriate asset at which point stock market volatility is of no concern.
Holding cash for things not needed for years in the future due to concerns over short-term market price movements is akin to someone in their 50s who has a family history of heart disease saying he does not want to exercise due to fear of getting injured. In both cases, risk is being misapplied.
We don’t always know what our goals are or often lack the emotional discipline and fortitude to navigate the near-term ups and downs inherent in stock ownership. Working with a Financial Advisor can help you set forth a clear plan and give you the confidence needed to remain on track regardless of the latest headlines or market vacillations.
Keep Your Options Open
One of the myriad strategies that we employ in clients’ portfolios is writing long dated and out of the money call options on underlying individual stock or ETF positions. While covered calls can limit some upside profit potential, they can be a valuable tool to provide additional income, downside protection, and an exit strategy at an agreeable price.
For example, let’s say you purchased a stock at $50 in July and sold Jan $55 calls (6 months out) for $1. In this scenario, you have capped your upside at $6 (plus any dividends along the way) in return for $1 of premium (downside protection). To be sure, this is a 24% annualized return (excluding dividends) which is nothing to scoff at.
That being said, with the phenomenal strength in equities over the past year, a potentially good problem to have is that some of these options become in the money (the stock price being above the strike price, so above $55 in this case) long before expiration date. At this point, it’s important to take into consideration the various factors when deciding what to before you: do nothing (especially if there’s still a few months to go and/or tax implications), close out the options position (perhaps fundamentals have changed on the underlying security), or roll the position (provide further upside capital gains potential while still offering some downside protection). Factors to consider:
Taxes – if this is in a taxable account, will there be tax implications on closing out, or rolling, the position?
Upcoming dividends – are there upcoming dividends that you are eligible for?
Time to expiry – even though the call option may be in the money now, if there’s 3 months before expiration, a lot can happen between now and then, and you could still be earning options time premium as well as dividends.
Do you want to continue to hold the underlying security?
Discipline, as always, is key. A knowledgeable, patient, and well-trained Financial Advisor (with deep experience in this case in using options in client portfolios) can help you determine which investment strategies are best for you and set forth a near and long-term plan to implement them.