01 Nov Should I Stay or Should I Go
After double-digit gains in the US stock market year-to-date, clients seem to be asking the question above more frequently. Another question I’ve recently received is “How are you going to protect me against a 30% plus decline similar to what happened in 2001-2002 and 2008-2009?” There is no easy answer. In the decline of 2001-2002 (bursting of the .com bubble) I didn’t own technology stocks because the valuations didn’t make sense so I managed to escape. In 2008-2009 (crash of the housing bubble) while I didn’t own real estate, commodities or highly leveraged businesses I somehow managed to fully participate in that one! Market declines unfortunately are a part of investing, but there are a few things you can do to try and reduce such volatility.
One thing you need to know is that volatility and risk are two different things. I consider volatility to be no more than short-term market swings associated with news events, psychology, technical factors etc. You should view volatility as opportunity. Risk is a whole different thing. I associate risk with the possibility of permanent loss of capital — usually accomplished through paying too high a price for something or deteriorating fundamentals due to competition, too much debt, poor management etc. We have all experienced this type of risk and this is the type we strive to avoid. But what if you want to reduce the volatility, what can you do about that? There are multiple strategies to reduce volatility, but in order to gain more stability you usually have to sacrifice some return. Let’s take a look at a few simple approaches;
- Diversify your portfolio to include more cash and short-term fixed income investments. The downside here is that cash and quality short term bonds pay virtually zero and medium –to-long term bonds will likely be very volatile.
- Invest in funds and securities that have very little correlation to the stock market. Examples might include inverse exchange traded funds (they go up when the market goes down), gold, farmland etc.
- Buy put options — these are like insurance. You pay a premium to protect your portfolio from a severe market decline for a specific amount of time.
- Alternative investments — these types of investments tend to be rather illiquid and hard to follow, my feeling is that just because you can’t get a daily quote on something doesn’t mean the value doesn’t go up and down.
As you can see, there are actions you can take to reduce volatility and each investor has to decide what is appropriate for them. My job is not that of a ‘psychic’ trying to predict the future or guess when the market might go down. I only attempt to evaluate what I think I know and then make the best decisions I can from there. Here are a few things I think I know;
- The stock market hates uncertainty and in the very near future we are going to resolve two very big questions. Who is going to be the next President and what’s going to happen with the fiscal cliff?
- Real estate and automobile sales are improving and will likely have a positive effect on consumer confidence and employment. The devastation caused by Hurricane Sandy will be good for both.
- Corporate profit margins are at or near record highs but there is nothing on the horizon to indicate a near term reversion back towards the mean- valuations therefore appear very reasonable and downright attractive if you think interest rates will continue to stay low.
- The economy is moving forward at a snail’s pace, corporate capital requirements are minimal thus allowing for increasing dividends, debt reduction and share repurchases.
- Last quarter witnessed the lowest dollar amount of money raised via ‘initial public offerings’ since the market bottom in 2009 — just the opposite of what usually happens near market tops.
- And lastly, government debts in many developed countries appear to be at unsustainable levels and no one knows how they are going to be corrected.
So based upon what I think I know — what’s the plan? The most logical seems to be keep a reasonable amount of cash available for the inevitable market volatility government deficits are bound to cause and the subsequent opportunities that might be created and continue holding a portfolio of market leading, reasonably priced businesses that have the ability to forge ahead in a very tough economy.
Please let me know if I can be of benefit and my prayers go out to the citizens whose lives have been affected by Hurricane Sandy.