Tom Basso, founder and former president of Trendstat Capital Management and author of The All-Weather Trader: Mr. Serenity’s Thoughts on Trading Come Rain or Shine. EnjoyTheRide.World
Many investors experienced opposing impulses in 2022 when the S&P lost one-fifth of its value. They felt fear and considered pulling their money out of the markets…and they saw opportunity in the lowered stock prices and wondered whether the time was ripe to invest more money. When the stock market rebounded in 2023, those who moved cautiously may have regretted not taking the more aggressive approach.
But there is a better takeaway from the market’s recent roller-coaster ride—any investment strategy that requires you to make crucial decisions in times of great volatility often fail. The fact is…we just aren’t very good at setting aside our emotions and making purely rational decisions in stressful moments.
Also consider that the advice investors typically receive for handling challenging markets is flawed. We are told to “ride out the losses”—but riding out the S&P 500’s 46% drop during the Great Recession 15 years ago was very painful for retirees living off savings.
Or we are told to “diversify our portfolio”—but diversification is effective only if the investments where you spread your money don’t all head down at the same time, something that has happened a lot lately. Bond values toppled together with stocks in 2022, for example.
Bottom Line Personal asked retired hedge fund manager Tom Basso what strategies readers can use these days to contain their risk more effectively. He is author of the new book about investment risk The All-Weather Trader and was dubbed “Mr. Serenity” in Jack Schwager’s classic investment book The New Market Wizards because of his emotionally stable approach to investing. Among Basso’s recommendations…
Have a plan in place to identify and respond appropriately to risky times. Experienced investors know that no one can accurately predict all the ups and downs in the markets. But if you’re a conservative investor, it often is possible to steer clear of truly massive losses.
Major market meltdowns tend to happen quickly and painfully. But there are indicators when the odds of these meltdowns are particularly high, giving risk-averse investors time to take defensive action and limit their losses.
One way to keep tabs on your investments: Track the S&P’s 20- and 100-day moving averages. Your broker’s trading platform usually has tools that allow you to do this…or it can be done on investment websites, such as Yahoo Finance…
When the 20-day line crosses below the 100-day line, the risk for a market meltdown is high and it’s time to take defensive action.
When the 20-day line crosses back above the 100-day line, undo this defensive shift.
This indicator isn’t perfect, and sometimes it will cause investors to miss out on gains—but if avoiding meltdowns is among your top priorities, it might be worth it. Example: The 20-day line crossed below the 100-day line in March 2008, before the bulk of the Great Recession losses—and it didn’t cross back until late 2009. Investors following this strategy dodged much of the losses, but they also missed part of the ensuing rebound. If nothing else, having a strategy such as this in place should help you sleep a bit better at night and prevent knee-jerk emotional reactions in difficult markets.
Helpful: The defensive action you take when this or another indicator signals trouble does not necessarily have to include selling shares, which could have tax consequences. Other options include taking a short position on the SPDR S&P 500 ETF Trust (SPY)…or investing in an Inverse S&P 500 ETF, such as ProShares Short S&P 500 (SH), which climbs in value when the market falls.
Use stop-loss orders and savvy position-sizing to reduce the damage any one investment can inflict. A portfolio’s best-performing stocks typically are the holdings that you worry about the least—and yet, ironically, these sometimes represent the biggest risks. Reason: As winning investments climb in your portfolio, a major setback for this one stock could devastate your savings.
Whenever you buy shares in a stock—or any liquid investment—consider your tolerance for losses with that stock. Would you be ready to give up on it and cut your losses if it dropped in value by 5%…10%…25%? Whatever your figure is, set up a stop-loss order with your broker at the right amount—that is, an order to automatically sell if the share values fall to the level you preselected.
Setting stop-loss orders in advance means that there’s no need to make sell decisions when share values are falling and emotions are running high.
Also ask yourself, How much of my total portfolio value am I willing to risk on this one investment? Example: If you decide you could sleep easily if your total loss from the investment was capped at 1% of your portfolio value…and you’ve selected a stop-loss for the investment that represents a 10% decline in its value…then simple math says that you shouldn’t allow this investment to grow larger than 10% of your total portfolio value. A 10% loss in a stock that makes up 10% of your portfolio equals a 1% overall portfolio decline. If this investment proves successful, peel off shares as necessary to prevent it from expanding to greater than 10% of your total portfolio value. Also increase your stop-loss periodically as your indicators allow you to, so that you keep pace with the rising stock price and your risk tolerance.
Some brokers’ platforms offer trailing stop-losses, which are stop-loss orders that automatically adjust as the stock increases. Example: Shares of a security are purchased at $10/share and a trailing stop-loss is set to execute if the shares fall 10%. The sell will trigger if the shares fall to $9, but if the shares rally to $12 before falling again, the trailing stop-loss will have followed it and will execute the sale at $10.80. Though you would not have sold at the peak of the rally, the sale would still be profitable.
Favor sector ETFs over stocks. Investing in individual stocks brings not just market risk but also corporate risks—the company could face a big class-action lawsuit…the CEO could pass away unexpectedly…or a competitor’s new offering could render this company’s most profitable product obsolete.
For conservative investors, one option is to avoid this corporate risk by putting money in sector ETFs rather than individual stocks. Many sector ETFs are very liquid, have low expenses and—unlike broader index funds—allow investors to target sectors they believe are poised for growth. Examples: Technology Select Sector SPDR Fund (XLK)…Utilities Select Sector SPDR Fund (XLU)…Financial Select Sector SPDR Fund (XLF)…Health Care Select Sector SPDR Fund (XLV).
Diversify into investments that actually provide diversification. You know that you are supposed to diversify your portfolio, but it isn’t easy to achieve true diversification these days. Example: Correlations between US stock markets and most foreign markets now exceed 80%, so spreading your money around the world won’t provide much protection from a bear market. Even dividing a portfolio between stocks and bonds failed to protect investors from 2022’s losses.
Which investments are not highly correlated with stocks? Commodities, real estate and precious metals. If you own a home, you’re already invested in real estate. If reducing portfolio volatility is high among your goals, consider putting some money in commodities and precious metals. You can invest in these through mutual funds, ETFs or futures.
Don’t overprioritize tax consequences. Weigh the tax implications before making financial moves—but when faced with a choice between paying a tax bill and carrying a huge financial risk, it’s often worth writing the check to the IRS.
Example: A woman nearing retirement had a chunk of savings tied up in stock of the pharmaceutical company she worked for. She knew this was a financial risk—if this stock fell sharply, her retirement plans would be devastated. But she didn’t want to sell shares until she was in a lower long-term capital gains tax bracket. The stock declined sharply in value before her tax rate declined, so her retirement funds took a hit. She saved on taxes but these were eclipsed by the loss she took on the stock.
Track your portfolio only once a week. One of the biggest risks you face is that you will make spur-of-the-moment emotion-driven investment decisions. Every time you evaluate your portfolio is another opportunity to make this error. That doesn’t mean you should ignore your portfolio entirely—check in every week or two to see if any of your holdings have been on such a winning streak that it’s time to adjust position sizes or stop-losses as described above…or if any stop-losses have been triggered, there might be money that needs to be reinvested. But between these check-ins, reassure yourself that there are systems in place to control your risks so you can worry about more important matters…like your golf game.