Most stock investors worry about sudden sell-offs and plunging stock prices.
Here are some strategies that can reduce your worries.
1. The simplest strategy is to have a long-run time horizon that allows you to ignore short-run fluctuations in financial asset prices. Companies always move things and if you have invested in good ones, short-run downturns in the stock market are best ignored.
2. Buy a mutual fund or other fund that lags market turning points, especially the downward turning points. I once invested in TIAA-CREF’s real estate fund for exactly this reason. It always gave me time (it had a six-month lag in most cases) to get out of the market before suffering a substantial loss.
3. Allocate about 3 – 5% of your stock portfolio to a stock with an inverse beta. Beta coefficients tell you how correlated your stock is with the average. If a stock has a beta of 1.0, it is perfectly correlated with the average stock price. A beta of -1.0 will move exactly opposite to the average stock price. I use a stock (TZA) that is three times leveraged and has a beta coefficient of -3.4. While it reduces my gains, it also reduces my losses. Thus, it acts as a stabilizer. A severe down turn would result in significant capital gains in TZA that could then be used to invest in other stocks that went down the most and that will, presumably, increase the fastest when the upturn takes hold. Holding some low beta stocks in your portfolio will also reduce fluctuations in your overall stock portfolio and will reduce the amount of an inverse beta stock you may want to hold.
An additional active trading strategy you can use with an inverse beta stock like TZA is to sell some when the market is down and TZA is up and buy more TZA when the market is up and TZA is down. If you use this strategy, make sure to always keep a minimum amount (as determined by your own personal degree of risk aversion) of the inverse beta stock in your portfolio at all times.
4. You can also try and time the market but this is like driving on a curved road. You must be ahead of the market so as to enter the market downturn early and leave the market upturn early. This straightens the curves and results in a smoother (stock market) ride. However, entering a turn late (leaving the market when it is already down) or entering late (when the market is already up) will work poorly (pun intended). Since economists cannot predict economic shocks that cause severe downturns in the stock market (even a severe stock market crash that serves as the economic shock cannot be predicted), the only thing you can do is use trailing stops on all stocks so as to exit the market “soon enough.” Getting back in early is less difficult. You will recognize this situation as buying when everyone else is fearful. The converse of waiting for everyone to be complacent and overconfident at the market top will not work as well because, again, the shock that leads to a severe downturn will always be a surprise. Thus, you may exit too early and leave money you could have made on the table while waiting for a sell-off that may never occur.
5. Diversify to reduce risk. As indicated, low or negative beta stocks help in this regard. You can also hold more money as cash (or buy more of an inverse beta stock) if you think a downturn is an increasing risk. I notice that Warren Buffet tends to hold more cash when he perceives more risk. Holding index funds is another way to diversify. Holding a balanced fund that has both stocks and bonds is another way. Be aware that in an increasing interest rate environment characterized by economic growth stocks will tend to do well but bonds will be sold by the FED and lose value. Conversely, during an economic downturn stocks will fall in value and bonds will be bought by the FED and increase in value. Thus, evaluating balanced stock/bond funds during the “economic recovery” from the Great Recession in which the FED bought bonds will tend to favor those funds that hold relatively more bonds. You can also diversify the stocks in your portfolio by making sure the top five stocks you hold are in different industries. Last, you can increase the weight on a fund like VIG that only holds the stocks of firms that have increased their dividends every year for at least the previous 25 years and increase the weight on utilities and consumer staples stocks within your portfolio.
Unfortunately, risk and growth tend to be inversely related. That is, increasing the amount of defensive stocks is likely to reduce the rate of growth of your portfolio. On the other hand, as growth prospects increase risk may sometimes decrease. That may explain why the legendary investor Warren Buffet converted billions of cash into stocks immediately after the recent presidential election.
