Yesterday, a friend from Switzerland called me to ask how many bankers had tried to get my advice on what to do in these markets. I told him that the situation was calm and I had almost no requests. Famous last words…
In the subsequent hours as European stock markets experienced their worst daily drop since October 1987 and their second-worst day ever, the emails kept coming and the phone started ringing. It seems as if we have hit panic mode.
The questions I got broadly fell into the usual two categories: “When should I buy?” and “Is it too late to sell?” These questions show that investors are making the same common mistakes they have always made yet again. I could tell you all to buy my book and read it because in chapters 2 and 3 I provide tips on how to deal with situations like the current one. But I even got emails from people who I know have bought the book but obviously not read it, so let me give you a brief guide on how to survive a market like this.
Option 1: Buy, hold and look away
The best way to invest for most investors is to become a buy and hold investor, buy a well-diversified portfolio that meets your needs and then stick to it for a very long time through the ups and downs of the market.
But if you do that, you must be aware that you cannot get distracted by short-term market movements. Don’t look at your portfolio too often is the most important rule in bear markets. As I have said many times, my long-term portfolio is geared towards my retirement goals and I check it only once a year. I have not looked at this long-term portfolio for about nine months now when I checked it in the process of filing my taxes. I have no idea what this portfolio did in the last month or the last few days and I don’t care. Because I evaluate this portfolio in the context of my long-term goals, not in the context of the last few weeks.
So, if you are in a position where you haven’t reduced risky assets and you ask yourself whether it is too late to sell, congratulations, your options to handle this market have been reduced from two to one. If you sell now, you are locking in a steep loss in equities and other risky assets. Nobody can say if markets will go up or down from here, but you will definitely realise past losses and not be in the market for a while. And this will inevitably mean that you miss the bottom of the market and will get back into the market at a stage when a lot of the recovery has already passed you.
I know it feels horrible, but if you are in this position accept that you have become a long-term buy and hold investor (possibly against your will, but the market doesn’t care about what you want).
And now that you have accepted this, it is time to take the next step:
STOP WATCHING THE MARKET!
Nothing that happens today, tomorrow or over the rest of this year will matter ten years from now. Watching markets on a daily basis will make you crazy and rob you of your sleep. And that won’t improve anything.
Instead, go get yourself a good book (possibly several, but none of them investment-related), stop watching TV, read the news only once a day and avoid the market news and instead focus on the sports section and the culture section. Stay away from anything that relates to investments until the end of the year. Then you are allowed to look again.
Option 2: In & Out, Out & In
Many investors simply can’t suffer excessive losses and they cannot bring themselves to ignore the markets if the world is in turmoil. For them, the most important rule is to avoid drawdowns due to market corrections like the one we have seen over the last few weeks.
If they are smart and experienced, they use stop losses to sell risky assets before they have dropped too much. There are plenty of simple rules where to put stop losses like the 200-day moving average popularised by Meb Faber. If you are one of these investors your stop losses have by now been triggered and you are likely to take only two positions: cash and the foetal position.
You have likely avoided much of the fallout of the last couple of weeks and can feel pretty smug.
But why do you ask me when to buy assets again? If you have a stop-loss rule to sell risky assets, why do you not have a re-enter rule to buy?
A successful investment consists of two decisions: the decision to buy and the decision to sell. When you sell determines the return as much as when you buy.
But the same is true in reverse. A successful risk management system consists of two decisions: when to sell and when to buy. When you re-enter the market determines the success of your risk management as much as when you sell.
Having a stop-loss strategy in place without a clearly defined plan to re-enter the market risks you getting stranded on the side-lines for a very long time and ruining your long-term performance that way. There are a lot of permabears who are coming out of the woodwork at the moment. They have their day in the spotlight now because they claim they could have helped you avoid these losses. Unfortunately, the same people have warned against being invested for the past ten years and missed out on a 400%+ bull market.
Hence, if you are sitting on a pile of cash you may be tempted to put it to work after the steep losses of yesterday. Or you were already tempted to buy a week ago, or two weeks ago. If you got back into the markets last week or two weeks ago, congratulations, you have caught a falling knife.
In my view, re-enter rules should be defined mechanically just like stop-loss rules. The 200-day moving average is a great starting point to think about re-entering the market. If the index or the stock you are interested in crosses above its 200-day moving average, price momentum has probably become reasonably positive and stable to warrant an investment. If the market is still below the moving average, it is probably too soon to buy.
In my book, I explain the stop loss and re-enter rules I have investigated myself. The table below summarizes the rules. The stop-loss rule is based on the relationship between the current price and the most recent 12-month high while the re-enter rule is based on the most recent 3-month low. For stocks, for example, the rule tells you to sell a position as soon as the price drops more than 10% below the 12-month high. This way, excessive losses of more than 10% are typically avoided.
But because markets tend to recover pretty quickly after a correction or a crash, it is important to re-enter the markets faster than to leave them. Hence, the re-entry signal is given as soon as the share price rises by more than 5% above its most recent 3-month low. Admittedly, just like every other mechanical rule, these rules aren’t fail-save. These days, markets have moves in excess of 5% on a daily basis both to the upside and the downside. Common sense tells me that in these super-volatile times, you might want to double the re-entry rule and wait until the share price rises more than 10% above its most recent 3-month low.
If you re-enter the market and then get stopped out again, don’t worry. That’s part of the deal. The rules work on average and guarantee that you will be invested close to the bottom and stopped out as soon as the bottom falls out of the market – and sometimes that can happen several times in a row. But nobody, absolutely nobody can predict what the market will do next, so your best hope for long-term success is to stick with your preferred stop loss and re-entry rule.
But what if you can’t handle this constant in and out because it makes you dizzy and you panic every time a stop loss gets triggered or you re-enter what looks like an extremely fragile market? Well, in this case, your options to handle this market have been reduced from two to one…