Investing has changed in recent years. Long gone are the good ole days of the ’80s and ’90s when stocks seemed to go up every day and all you had to do was buy one … any stock. Or buy a share of the latest and greatest mutual fund. These products gained wide popularity during this time because they allowed even small investors without substantial capital to achieve diversification through access to a basket of stocks. Diversification remains a key tenet of sound investing. It can help you reduce your investment risk by investing in companies that are non-correlated. For instance, take a look at this story and the accompanying chart below. You may have heard it before, but it goes something like this:
Say there are two companies: one that sells sunscreen and another that sells umbrellas. An investment in the company that sells sunscreen does great when the sun is out. But when the bad weather rolls in, sales hit the skids. Conversely, umbrella sales surge when it rains, but suffer dramatically when it’s nice and sunny out. In this example, umbrellas and sunscreen are negatively correlated.
To minimize your investment risk, an investment should be made in both companies. An investment split or diversified in each company should produce a decent and consistent return rather than alternating between great and terrible. Finding investments that are perfectly correlated in a very complicated world is difficult to say the least. But that is the idea behind sound risk management.
If only it were this easy. Today, there are many challenges to even a well-diversified portfolio. The list of threats is long and includes high frequency trading by computers that sometimes go bonkers, a growing short term trading mentality on Wall Street, and the struggle to find real non-correlation in markets. Markets are becoming more correlated than ever. The U.S. market and its economy is becoming increasingly tethered to other global markets and economies, making diversification a growing challenge. Add in massive monetary policy action and manipulation from central banks around the world, and the unintended consequences that most certainly will follow, and you have the makings of a more volatile market, increasing the likelihood of a systemic problem that can bring down markets, much like what we saw in 2008. Even a diversified strategy can sustain heavy losses.
The idea behind diversification is that when one asset is taking a loss, there’s a good chance that one of the others will be making offsetting gains. Hence, with a well-diversified portfolio of non-correlating assets, the portfolio can be quite stable, despite the fact that the underlying individual assets in the portfolio may be rising and falling dramatically in value (like in the graph above). But what if there are times when this doesn’t work like it should? What if conditions are such that no one wants to own sunscreen or umbrellas? Not because it’s not raining or sunny, but because there is a perceived risk to owning any stock. This happens from time to time and when it does, it is painful for investors. Stocks have lost significant value at times, most recently 38% in 2008 and over 34% in a period during 2001-2002. And given the seemingly tenuous climate for stocks globally, another event of this magnitude occurring sooner or later can’t be ruled out.
A young investor with a long career and years of future earnings ahead may choose to ride through these periods and stay committed to his investments. But this “buy and hold” approach is harder to stomach for retirees or those knocking on retirement’s door. Periodic investment losses are normal and to be expected, but significant losses like 20% or more can have a profound impact on one’s retirement picture, especially if they occur with little to no years of earnings potential left. Those types of losses can be doubly detrimental if you are living off regular monthly distributions from the portfolio. Protecting ones wealth can become just as important as growing it, if not more so, at times.
Managing money is all about managing risk. So when the risk is high for owning any stock, it pays to have a defined exit strategy: a point at which stocks are pared significantly or removed altogether. Small pullbacks in stocks are normal and healthy for markets, but the severity of an impending decline is always an unknown and highly unpredictable. During these times, having a proactive risk mitigation approach can potentially limit huge losses. If nothing else, having little to no exposure to stocks when there is severe downward pressure offers invaluable peace of mind. Rest assured, cash is not a long term investment strategy, especially at today’s rates, but holding cash can be a great short to medium term strategy to protect against a stock market in free-fall.
Good investment planning requires a disciplined well diversified plan for sure. But when traditional money management principles like diversification fail or are suspended indefinitely, like we have seen in recent years and are likely to see again soon, a defined stock exit strategy can serve to preserve your retirement plan.