Playing Defense in Today’s Uncertain Stock Markets
People have been concerned for a while now about the risk of an upcoming pullback in stocks. There are good ways to protect yourself, but you have to actually take the reins.
While we usually think of investment as the pursuit of positive returns over time, and that’s a big part of the reason why we invest, there is another side to it, which is doing so while managing risk properly.
While we speak of investors needing to manage risk quite a bit on the site, the great majority of the focus is on the returns, even though a great number of investors do have some real concerns about risk, especially when risk increases.
The proper way to manage risk hasn’t really changed much over the years, as the principles of doing this apply as much today as they did back in the bubble of the 1920’s. It’s almost a century later, and while we might think that we have learned quite a bit about this since, the truth is that we’re still as bumbling as we ever were overall.
The biggest obstacle to ever getting to the point where we actually seek to manage risk well, like a good trader would, lies in the sad truth that we want to have our risks managed but we actually just refuse to do it. We’re looking for some formulation that can manage this without our having to do anything, just sit back and take whatever comes and somehow be comforted that we’re being taken care of here somehow.
We should never be looking at either risk or return in isolation, and this includes looking at return in isolation by just ignoring risk or not doing much to help ourselves. If we just focus on risk, or focus on it too much, we best manage this by not taking any risk or severely limiting our risk, which can really hurt our returns.
Not many investors or people who advise them actually seek a balanced approach to risk and reward, even though they might claim to. The two approaches we’re told to follow are ignorance or dilution, where we either don’t look at the road at all or reduce our speed, and all the while we refuse to take the wheel and just hope that we won’t go off the road.
If we’re not looking, although the road tends to be pretty straight, there often are some curves ahead that we can’t see, ones we can but pretend that not steering is still the best approach, even as we hear the thud. The ditch is then held to be at fault, after which we change our spare tire and assess the damage to our car and just fire it up and keep going.
Dilution involves putting less of our money at risk, like slowing down the car, but still refuse to steer it. When we go off the road at the next bend, we suffer less damage, and we then count our blessings and resume our meandering journey.
While it should be obvious enough to us that the best way to drive a car down a road is to use all the controls, like the steering wheel, the gas, and the brake, we look to those who have travelled down a similar road before, and see most of them made it in decent shape anyway, and consider that to be the ideal.
Just like with driving a car, if you have never learned how to do it, there will be plenty of trepidation when you first get behind the wheel. Driving can be dangerous if not performed properly, and this can put us off from learning. We need to realize though that we should not just turn the navigation over to some simple computer program that doesn’t know how to drive every well at all even though it might limit the damage when accidents happen.
Maybe we don’t want to be on this road at all, at least driving, and we may then choose to walk instead by seeking to be very conservative. We won’t get very far very fast that way and this is especially a problem if we have a long way to travel to get to where we need to be. Pedestrians also can get run over but the big risk here is simply failing to get anything close to a good return.
We Need to Seek to Optimize Both Risk and Return
Risk and return therefore both need to be considered, just like we need to worry about balancing how fast we drive with the risk of an accident. We can’t drive too fast because we’ll lose control, and if we drive too slowly, we’ll end up putting too much weight on being careful and sell ourselves too short.
We need to approach risk and reward together, although it is a myth that these are competing things, and in fact when we manage this properly, we can achieve a complimentary relationship, where we can both reduce our risk and increase our return.
At some point the pullback that many are afraid of right now will come, even though this is not on the immediate horizon. Despite Trump’s exaggerations, he has been a friendly president to the stock market, and even though he’s smacked it around with his tariffs, his helping the economy with tax cuts has more than made up for this.
The next president will either be Donald Trump or a Democrat, and Trump is the only candidate that can save us from taking a lot of punches. If he is not re-elected, at a minimum, his tax cuts will be turned back, in addition to whatever other taxes that we are smacked with. Higher taxes constrict the economy, and that’s the last thing our economy needs right now.
There are two risks here, which are the subjective side of things, the market’s negative reaction to these things, as well as the actual damage to the economy and business that would occur. Of the two, the subjective side does the most damage, which would in itself deliver a crushing blow in reaction to changes in government policy that are by their very nature quite harmful to stocks and business.
Whenever we put our money at risk, we need to account for that risk and manage it alongside our pursuit of reward. We should not be looking to avoid doing the sensible thing by just ignoring risk or just trying to water it down. Using mix in your drinks might keep you from getting as drunk as you would from straight liquor, but you can get plenty drunk anyway.
If we are looking to stay sober, we do not want to either drink whatever is given us or dilute it. We need to take action when a drink is raised to our lips and we do not want to drink. We need to turn our heads away and let it fall somewhere else other than in our mouths.
We need to start by defining our objectives, and then monitor our investments to ensure that they are performing in the way that leads to our achieving them. This does take some skill and deliberation, but if you want to invest well you need to realize that you will be using skills to increase your overall results, and doing nothing much to help yourself won’t get you there. There is no honor in investing badly although many believe otherwise.
This starts by managing risk, which is arguably even more important than managing returns, and at the very least is right up there with it in terms of importance. The two are also very much related, if we understand risk as deviations from our course, and to the extent that we manage this better, this will avoid losses and increase the expectancy for return.
Where people get this wrong is when they make assumptions in their model that are both questionable and unnecessary, and take on a lot of risk as part of their assumptions, as well as not allowing us to adapt to changing circumstances and seek to positively influence our fate instead of always just accepting it. We believe this is too difficult and we lock ourselves into our positions where we’re left with nothing else to do but hope.
When people speak to the timing of a potential bear market, they are not speaking at all to these people because they have chosen to willingly bare their buttocks to whatever spanking that the market may lay upon them. Turning the other cheek may have merit but not with investing.
From there, we have those who will get out but only after enduring a lot of pain, and these people usually end up selling at the bottom and not getting back in anytime soon, which makes this considerably worse than doing nothing.
Beyond that, investors will have various tolerance levels and they almost always fly by the seat of their emotions, with no real plan at all as to how they may act other than just hoping they just won’t have to.
Even if you are hoping to not have to cash out for 30 years, protecting yourself against even transient losses is still important. This does not require tight monitoring but it also doesn’t mean that you do nothing to help yourself ever. If you can even shave off 10% from a bear market, that sort of thing makes a real difference, especially given that these will be losing times and this cushions the blow.
Playing Good Defense Allows Us To Play Better Offense
Looking at high beta stocks serves us to connect this more with how proper risk management can enhance returns, as we can chase these stocks more when they are moving up, where a more stand pat investor will be more worried about the downside and will limit their pursuit of higher returns. This is because they have chosen not to defend themselves properly and feel committed to bear the entire downside of a move when it comes, which is indeed a bad idea.
It turns out that a managed approach not only reduces investment risk by limiting it, it also permits us to seek out higher beta stocks where we may both reap more rewards and give less back. This also lets our profits run and cuts our losses, like the best traders do. They do this because this is the best way to make money.
Investors can learn a lot from trading, which takes what they do and greatly speed up time. You don’t really gain much experience at all from trading with a longer-term objective, but you can pack in several lifetimes of this in just a few hours of trading practice.
There are two things to consider on the timeframes that investors use, which are technical and fundamental data. We need to keep our eyes on the charts, and we also need to look at what might be behind them.
Applying this to today’s climate, the charts simply look great and haven’t really given us much to be concerned about all year. We have a slower but stable economy that is projected to remain very stable for the foreseeable future, and this is what we need to be focused on the fundamental side, not things of a much lesser and temporary nature that make the market bob up and down each month lately.
At the present time, it should be full speed ahead, as those who are ready to defend themselves aren’t worried about events yet to come, which do not require defending. When the time comes, they will be ready, but dumping stocks on the way up because you are afraid and confused is either optimal nor sensible.
A good or even great economic outlook isn’t enough though, as we really need to be following the mood of the markets themselves and ensure that we’re not overly tolerant and take on too much risk.
Both of these elements are working in the favor of investors right now, and the economic outlook remaining so positive serves to bolster our confidence enough to be able to ride out the smaller bumps that we can take on when the sun shines but can be a call to action with darker skies.
This involves more than just setting a stop as a trader would do, as economic changes are outside the scope of trading, which is only concerned with the very short term. To investors, one given percentage loss may be quite different from another depending on the overall context of the move down.
We never want to let our guard down though, and should have some sort of plan in place so that we may be better prepared to decide better when we have to, if we plan on playing real defense that is.
We need to both seek to be in investments that we may profit well from and to look to defend our gains by considering taking them off the table whenever losing money for a while is the most likely scenario. Putting on a helmet to try to cushion the downward blow of a bear’s powerful paws will still hurt a lot and too much, when all we need to do in this case is step aside.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
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