We all invest for different reasons but one thing we have in common is that we don’t want to lose money. As an investor you want to buy low and sell high. And you want to protect your nest egg from large market losses that may devastate your plans. But can you actually do this or are you going to be at the whim of the market’s movements? I think, yes, if you have the right plan.
For all the math and logic involved in investing, the reality is that investing is a very emotional thing. Research shows that our emotional reactions to suffering a loss are greater than the emotional reactions experienced when receiving a gain. For many investors, loss aversion is the most powerful factor affecting the failure of their investment plans.
Investors can be their own worst enemies when it comes to their investing success. How do you counter human emotion? There are a couple of key ways that I use to manage risk to help protect your nest egg from large market losses.
And given the fact that here in the United States we’re experiencing a bull market that is more than six years old it’s a good time to discuss how to protect yourself on the downside when – not if – the market has a correction.
The first thing to do: diversify. Put simply this means don’t put all your eggs in one basket. This is the basis of Modern Portfolio Theory (MPT). If you build a globally diverse portfolio with many different asset classes (bonds and stocks, US and international) you can position yourself to minimize losses. When one thing goes down it may be offset by other assets going up.
Cash Reserves: Keep Your Buckets Full and Your Powder Dry
Cash is one of those many asset classes in a diversified portfolio. So this is a subset of the broader part of strategic asset allocation.
Whether you are raising a young family, at the end of long career or already in retirement, cash is your friend. If you have enough cash, you can weather nearly any storm without being forced to sell other securities. This is why I’m a big fan of building up your cash reserves. Next to paying off high interest credit card debt, setting aside cash is a way to build your wealth and protect you from life’s curve balls.
This bucket can be funded with cash or other near cash, low-volatility type investments: money markets, CDs, very short-term bond funds for instance. What is the ideal amount of cash? That depends on your situation and your risk profile.
In your working years, this can range from three to 12 months of fixed overhead household expenses. In retirement, this can range from one to 3 years of expenses. I’ve discussed this in another post, Retirement Planning for the Long Haul.
Investment Rules: Avoid Losses
Rule number 1 (in investing): Don’t lose money.
Rule number 2: See rule number 1.
Warren Buffett’s investment advice sounds simple enough. Now how do you do it? Well, with a plan, of course.
Risk and Your Next Meal
OK, here’s a quick detour on measuring risk by looking at what’s in your kitchen. If you’re like me, you like spicy food occasionally. I like a good jambalaya or a five-alarm chili. It takes all sorts of ingredients to make these. You may start with a plan – a recipe – but add or subtract stuff based on your appetite and personal tastes. On their own, I wouldn’t want to eat a whole chili pepper or a mouthful of Cajun seasoning or an onion but in the right amounts these make the meal delicious.
The same with your portfolio. You add a little of this and then a little of that – diversification which we spoke about above.
Back to investing. When coming up with a recipe for an investing portfolio, we’ll look at how asset classes or individual securities have reacted to market conditions in the past. Their range of returns can be viewed statistically by something called standard deviation. And then we measure how these assets react to each other by a measure called correlation.
After we build the portfolio we can model it with special software that may show – on average – how well the portfolio may have performed as measured by investment returns, standard deviation and a host of other metrics. To get a sense of what kind of risk your current portfolio is exposed to you can use this free tool to analyze your risk attitudes and find your personal Risk Number.
Sometimes portfolios go down in value. For money managers or large institutions with deep pockets this may not be a problem. But what matters most to individual investors is how a potential devastating loss will impact goals. A devastating loss can lead to life changes like changing where your kids may afford to go to college or on a delayed retirement.
Example: For many long-time employees of Lucent Technologies (NYSE: ALU) nearing retirement around September 2000 when the stock price was around $85, their retirement looked secure since on paper they were millionaires with the stock they owned. Within a matter of months, their account values dropped in half and within a couple of years their accounts dropped again as the stock dropped to under $15, a mere 82% change – in the wrong direction for their retirement accounts!
Large declines that result from overheated markets happen often and quickly. And it can take much longer to recover from them – and almost impossible to recover from if it happens around retirement when you have no more time to rebuild and save.
Avoiding Drawdown Risk
Following the Oracle of Omaha’s advice, we have our own corollary to investing: Clients win by not losing.
This is why we focus on drawdown risk ( measure of the biggest drop from peak to trough than an investment has historically experienced). If we can avoid the drawdowns, we don’t have to have a portfolio work harder or be positioned to be invested in more risky assets just to regain ground to get back to even much less get ahead.
If you knew that on average it may rain less than 0ne-eigth of an inch on any given day, you’d probably be OK if you forgot your raincoat or umbrella. Sure, you may get wet but you’ll dry off pretty quick and your home and your car will be there where you left them when you return get back. But what if this average rainfall was calculated after knowing that once a year for thirty days it actually rained 20 hours a day at the rate of one-half an inch an hour and you lived in a valley near a river? If you knew the weather pattern, you may be able to plan ahead – leave town for a while, sell your home, build in a place not at risk of flooding or maybe just build an ark.
Dynamic Investing as a Portfolio Risk Survival Plan
This is where dynamic investing comes into play as a way to protect your portfolio nest egg from devastating market losses.
Instead of just relying on a buy-and-hold asset allocation approach used in Modern Portfolio Theory, we utilize an approach that helps identify when the market may be out of equilibrium – technical term here is ‘out of whack’. Then we can reposition assets into cash or less volatile assets.
This approach is a more flexible arrangement that allows the asset allocation to change over time. You’ll still be invested but maybe with a lot lighter equity allocation for a while – during that rainy season perhaps – and then rotate back as the market’s ‘weather forecast’ shows signs of sunnier skies.
Ultimately, investors want to get where they want to be with a smooth ride. And if they experience too many roller coaster twists and turns they may in a nod to loss aversion avoid investing in equities at any price. If they do, they often sell at the bottom and refuse to buy when the market is climbing. They lock in their losses and miss any upside market gains.
But by having a rules-based dynamic investing plan, you can still participate on the upside while minimizing the potential for losses on the downside.
For more on this dynamic investing approach, you can visit the links under the Investment Philosophy and Research section of our Managed-Risk Investing page on the website.