Dealing with Market Risk

Norm Boone / Aug 29, 2018 / Investments

It’s fun when the investment markets go up. Your nest egg is growing and so is your net worth.

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Unfortunately, markets go in cycles. They don’t always go up. In fact, the US stock market (as represented by the Standard & Poor’s 500 Index, which approximates the 500 largest US companies) falls roughly once every four years. Sometimes that decline lasts for almost three years, as it did between 2000-2003. Or, it may be more intense, but only last for a year or two (2007-2009). Sometimes it’s just a week or two, if just to remind you that markets go down.

As an example, look at annual returns of the S&P 500 Index by year since 1980. Over those 37 years, eight have had negative full-year results, but every year has experienced a drop from peak to trough, many of which were pretty scary.

Even the good years have periods when negativity reigns supreme.

What is an investor to do? It seems to me there are three choices.

The first two choices may not be sound.

1. You could play it “safe” and avoid the markets altogether. This would probably allow you to gloat when all your investor buddies are sharing their worries. That said, it would also leave you far behind those same buddies over time, because you “safe” investments provide little or no return, after considering inflation.

2. You could put money into stocks and be smart enough to pull it out (sell the stocks) before the downturns arrive. If people could do it that way, this would be the solution to choose.

Unfortunately, life isn’t so simple.

 

The Cycle of Market Emotions

Prescient investors are few and far between. Not many experts have been able to call the big downturns. Those who have rarely are also able to call the next one. Downturns are, by and large, surprises, so by definition, are not easily predictable. So, most predictions are wrong.

If you are able to be invested when the market is going up and out of the market when they are going down, you’d have unique success in the market. No one has shown themselves to have that ability.

Let’s say you were smart enough to pull your money out at the right time. Now you have to also be right about putting your money back in at the right time. Research suggests that those who are quick to pull out of the markets have a hard time deciding to get back in. They like a sure thing and seem to always be worried about the negative possibilities. Until they are sure the market is on its way back up, they feel more comfortable staying out of the market. That is rarely early in the market recovery, and, is in fact, generally relatively late. 

As a result of this emotional cycle of investing, most investors don’t do very well. They tend to buy high and sell low, the opposite of what successful investing requires.

Point of maximum financial opportunity

As a result of the emotional investing cycle, many investors miss out on the biggest days, when the market’s price rise is the most significant. Typically, this happens when much of the news is still bad. For example, six of the best 10 market days from 1997 to 2016 occurred within two weeks of the 10 worst days. Investors have a hard time changing course until the trend is clearly evident. But, the biggest moves tend to happen early, which means they get missed by most investors.

 

3. The only real way to beat that emotional cycle is to have a long-term plan and stick to it.

What does a good investment plan look like? It should be well diversified—cash, stocks, bonds, real estate and probably some other kind of non-correlated strategy. It should have healthy exposure to different kinds of bonds (e.g. different maturities, issuers, credit quality), different sizes and geographical locations of company stocks (e.g. large and small, international and US companies, developed and emerging market countries). If you have enough so you wouldn’t be hurt if it were to be lost, then you may also want to have some of your money in higher risk venture funds. Your asset allocation provides a guide for how much to put in each of these buckets, based on how much risk you are willing to take and what kind of returns you need or want to shoot for.

Ideally, you would steadily and regularly be adding to your investment pool, so that you can take advantage when stock or bond prices are down.

When the market changes in big ways, you should rebalance. If your target asset allocation, for example, calls for 60% in stocks, then when it gets too far away from that target, you should “rebalance” at the margins to bring the current allocation in line with the target. What this means in practice is that when things are down, you are going to buy more and when things are going especially well, you are going to sell some. Buy low, sell high. Over time, this can add nearly 1% to your overall returns.

 

A world without risk doesn’t exist

While investors are naturally interested in mitigating their investment risk, the truth is that such risk can never be completely eliminated. Investing in real estate or the market is not without risk, as 2008 showed us, but selling those stocks to increase cash assets isn't a surefire thing. It simply swaps equity risk for currency risk, as cash decreases in its value if it does not gain interest at the same rate as inflation.

Placing money in annuities decreases that equity risk as well, but exposes you to counterparty risk and inflation risk.

The truth is: risk can never be truly eliminated. It can be managed by investing in a diverse portfolio that does not hinge on one single aspect of the market but instead capitalizes on the advantages of all of them. Think of it like the tires on your car; if one starts to lose a little air pressure, the other three will keep you going.

Lastly, don’t forget the power of time, the ultimate way to mitigate marketplace risk. If you have the time to ignore the day-to-day shifts in the markets, the risk of a permanent impairment in your assets decreases the longer the investment remains.

Be calm, and don't worry about a single bad day in the market. The next one could be much better. Time can alleviate your risk concerns, but it’s up to you to make the most of that time.

The best way to deal with market risk is to have a plan and stick with it. Those that plan avoid being too influenced by emotional swings that come with watching the markets too closely.

If you plan to invest regularly, have an asset allocation that works for you over the long term, avoid trying to make changes when market excesses occur, and periodically rebalance, you will become a successful investor.

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Topics: Investments