Even Passive Investors Need a Back-Up Plan
Master trader Jesse Livermore once said: “it’s not the return on my money [that counts] but the return of my money.” And these words of wisdom are especially applicable during difficult periods in the stock market.
Certainly Jesse, who made a fortune by evading the market crash of 1929, would not be a passive investor if he were alive today. Nevertheless, for many reasons, among them convenience, many investors follow this approach.
Investing on Automatic Pilot
Passive investing, the practice of buying an index related product such as an exchange-traded fund (ETF) and holding on to it for the long term, whether the market rises or falls, has been a growing trend in investing since the early 2000s.
And why not? Despite the 2007-2008 and 2020 bear markets, the major indices such as the Standard and Poor’s 500 (SPX) have bounced back and made new highs.
As a result, investors have become accustomed to remaining patient when markets go down in expectations that eventually they will bounce and that everything will work out just fine.
Unfortunately, the stock market can be an unpredictable place, which means even long-term investors need a back-up plan in case there is a prolonged bear market which could severely sidetrack their strategic goals.
In this article, I provide three methods which can be useful in preserving your portfolio’s value through difficult markets.
Success Requires Adaptability
I don’t have a problem with long-term investing. I’ve been an investor going way back to 1987 and my account has grown steadily since the day I started. But by the same token, I am not a traditional buy-and-hold investor.
I will adapt my investment style to whatever is working in the market at any one time. That’s not so say that I’m a day trader, although there have been times when day trading has worked well for me.
My point is that successful long-term investing, meaning that you’re still investing and making money 30 years from when you started doing so, requires the ability to adapt to different markets. Moreover, the key to successful adaptation requires a broad knowledge of the market as well as a keen attention to detail.
Sometimes it’s okay to be a passive investor, while at others it may not be the best way to save for the future.
Broaden Your Horizons
There are three keys to survival in any market. But they are especially useful in tough markets:
- Sound stock picking;
- Strict money management rules; and
- Portfolio hedging as applicable.
Every investor should decide whether these tactics are within their risk profile and whether they have the experience required to use them. Nevertheless, this triad is worth considering, and I will expand on them below.
Sound Stock Picking
This is the anchor of any stock market based investment strategy. That’s because by picking the stocks of sound companies, you buy yourself time to decide what to do when markets get volatile.
In a real bear market, most stocks will fall in price. Nevertheless, there are some useful stock picking guidelines which will help you make better decisions. Stocks with these four characteristics often outperform even in tough markets:
- Strong sales growth: companies that grow their sales 10% to 20% or better, quarter after quarter.
- Strong earnings growth: companies whose earnings meet or beat earnings estimates consistently.
- Products that transcend fads: companies whose products are always in demand.
- Management that delivers results consistently and shows an excellent ability to navigate rough waters successfully
How do you know this part of the strategy is working? It’s pretty simple. If the market is crashing and your stocks are holding up, you’ve made good choices.
Strict Money Management Rules
There are two useful money management tools that can be applied to volatile markets:
- Set a portfolio loss limit, and
- Continue with and adjusted savings plan.
The first rule is the most difficult one for passive investors because they often review their accounts once a quarter or in some cases less often. The advantage of this approach is that you don’t worry about the ups and downs of the market. The disadvantage is that sometimes losses can be shocking once you get around to reviewing your portfolio and it is when those losses are shocking that passive investors panic and sell their stocks indiscriminately.
To make matters worse, this panic selling often happens near market bottoms. Therefore, it makes sense to consider limiting portfolio losses during a down cycle.
For example, let’s say you have a $450,000 nest egg and that you have 10 years left to retirement. In this case, it may make sense to reduce your stock holdings if the value of the portfolio drops by a certain percentage such as 5% to 10% or maybe even a dollar figure, such as $425,000. If your portfolio gets close to that red-line value, it’s probably a good time to sell some shares to reduce losses.
Meanwhile, it’s important to keep up your savings plan. If you’ve been dollar cost averaging into an aggressive mutual fund, ETF, or a particular set of stocks on a monthly basis, during a tough market consider directing your new cash to a money market fund where it will be ready to invest when the market conditions improve.
Hedging a portfolio can be tricky and it’s not for everyone. Moreover, it’s not something that all investors are comfortable with. That’s because hedging requires the use of financial instruments that rise in price when the market falls in price, such as inverse ETFs.
At the same time, to hedge portfolios, there is no substitute for vigilance, which often means looking at your portfolio on a daily or more often basis. That’s because when the markets eventually turn around, your hedge will lose money rapidly.
However, if you decide to use this type of investment approach, you can consider using an ETF akin to the ProShares Short S&P 500 ETF (SH). This ETF rises or falls on a one-to-one basis with the Standard and Poor’s 500 Index (SPX).
Note the nearly perfect inverse correlation between SH and the SPX index (top panel).
Active Investing Requires Attention to Detail
Passive investing has been very successful since the market bottomed out after the 2008 bear market. But there are no guarantees that it will continue to be as successful in the future. This is especially important if you are near retirement age or are trying to either maximize returns or preserve gains from the past decade.
Russia and Ukraine may find peace, the Federal Reserve may eventually ease again, and inflation may recede, but the odds of any of these things happening any time in the next few weeks to months are uncertain. Thus, the odds of a bumpy stock market remain above average.
It’s always a good idea to have more than one investment approach, especially in volatile markets. If you’re concerned about the market and your life’s savings, becoming a more active investor may pay off under the right market conditions.
A Note From The Publisher: Our colleague Joe Duarte just provided you with valuable investing insights to guide you through tough markets.
Are you looking for a growth industry with unstoppable momentum? Consider marijuana.
Marijuana represents a powerful investment megatrend. As legalization of marijuana gathers steam around the world, sales of weed are skyrocketing and investors are getting rich. But pot stocks can be risky; you need to be selective.
That’s why we’re offering you a new book: The Wide World of Weed and Psychedelics, written by our editorial director, John Persinos. The product of years of painstaking research, John’s book is now available in hard copy.
The Wide World of Weed and Psychedelics is your one-stop primer for profiting from the booming marijuana and psychedelics industries. Click here for your free copy.