HOW TO AVOID STOCK MARKET PAIN
I have noticed a recurrent question/statement among people that I talk to about the financial markets. That question is some variation of the following:
"Why does my financial advisor not get me out of the market when it goes to hell and a hand basket?"
"I wish that there was a way to avoid having to hold my stock portfolio through a market crash!"
"How can I avoid the financial pain of the next stock market crash?"
You probably have had a similar question as the recent COVID-19 crash was unfolding around you.
It's an age old question and a great question at that!
So, is there a way to protect your hard-earned money from the next market crash?
Let's talk about how to do just that.....
If you are a "buy and hold" investor like Warren Buffet, then you have a very long time horizon. The Oracle of Omaha will be the first to tell you that he is not a market timer. He has done a great job for his investors since the inception of Berkshire Hathaway throughout all of the various market crashes that have occurred over his career. But, during the market crashes, I'm sure that his investors were not happy as they watched their portfolio values decrease in real time. That sense of dread and fear was very real for his investors as they watched the stock market plummet during those rough years. While his performance has been great when taking a look from a long term perspective, he did have periods of poor performance during market crashes. One way that he was able to overcome those difficult times was knowing that the dividends from his stock holdings had grown over the years and had become a very significant contributor to his long term results. He also was confident in his long term thesis and was not going to change market strategy in the middle of a market crash. The worst thing that he could have done was to sell his holdings at the bottom of a market crash.
On the flip side, if you're not viewing the market from a 40 year holding time perspective, then it is very painful to watch your portfolio value evaporate as the market crashes.
So, what can we do so that we can avoid the market crashes?
For starters, we must define our stock holding time frame. This time frame will have a dramatic impact on our investing plan. Let's compare the following 2 different investors: The first investor holds their stocks/ETFs for a month at a time whereas the 2nd investor has a 5-10 year holding period. Each of these investors is going to have a very different approach to their portfolio management. Our first investor who has only a 1 month holding time may not have any type of stop loss other than a time stop. They know that they are going to switch their holdings every month and they know that they will exit at the end of that 1 month holding time. The longer term holder may need to set a stop loss, such as a trailing percentage stop or volatility based stop loss.
The trailing percentage stop loss works in such a way as to trail the price up and if the price reverts by their set percentage (25%, for example), then the stock/ETF will be sold. In this way, the trailing stop only moves up and never down. This type of stop loss allows for the market to move up, but protects against a market crash.
The volatility based stop works in a similar manner. The stock market volatility goes up as a market is starting to crash. Once the volatility hits a certain number, then the investor can liquidate their holdings and go to cash. In this way, they protect the vast majority of their capital and can wait to reenter the market when the volatility has calmed down. You can think of this volatility sort of like a weather forecast. If it's sunny outside, then the weather is good for holding stocks/ETFs. If the weather starts to get cloudy and you hear thunder coming in the distance, then that is a warning that bad stock market weather is on the horizon. There are several ways to measure market volatility. You can look at the VIX, which is the stock market fear gauge. If the VIX is under 18, then the weather is good for investing, but when the VIX gets above 18-20, then bad weather is coming. You can also look at the average true range of daily market moves as a guide to know when things are getting dangerous. When the market is slowly grinding higher, the daily moves are small from low to high on a daily basis. When volatility starts to increase before a market crash, then you will see this average daily range from low to high get bigger.
Let's say that we used our volatility based guide to get us out of the market in the early stages of a market decline. The next big question that everyone wants to know is......
"When do we get back in the market?"
While we can't pick the highs of the markets or the lows, we can get close enough to these extremes. For example, while we can't pick the exact bottom, there are certain market factors that are screaming out that the bottom is near. The first of these is market sentiment. When everyone is scared to death and fear is rampant, then you are getting to the point where you should be buying. There is an old saying that rings true, "Buy when everyone is fearful and sell when everyone is greedy." Over the last 30+ years, there has been a bull market in bonds. When the market would start to crash, there would be a "flight to safety" and people would sell stocks and buy bonds. This is where the stock / bond allocation model came from and it worked well......IN THE PAST. If people held 60% in stocks and 40% in bonds, then they would be hedged when the market crashed and could avoid large losses during market downturns. However, that stock / bond relationship has broken down. With bonds returning such small amounts these days, there is a real risk that with the next market decline bond returns will go negative. If that happens, it means that you are buying an asset with a guaranteed loss of value. People are starting to use other assets as a bond proxy, such as gold or dividend-paying stocks. This is part of the reason why gold has been on a tear lately. People are starting to realize that there is no "flight to safety" in bonds anymore.
When we start to see the "safety" assets start to sell off just like the stocks during the market crash, then we know that market participants are experiencing maximum pain. They may be getting margin calls and not only having to sell stocks, but also having to sell their "flight to safety" assets, such as bonds and gold, in order to satisfy their broker's margin calls. This is capitulation and this is the time to start buying! You most likely will not pick the market bottom, but you are going to be close enough.
I hope that this article helped relieve some anxiety about what to do in the next stock market panic. If you are interested in learning more about how to navigate the stock market, then you can sign up for my free 8-Part Email Trading Course.
To Your Success,