When I wrote an article a few months ago about how to protect against colossal loss in a strange investment environment, little did I know that a major sell-off was just around the corner. My argument was based solely on the combination of very optimistic market prices and general investor complacency about risk. These factors argued for guarding your wealth against unforeseen negative outcomes. My approach to investing is based on prioritizing safety of principal over reaching for speculative returns, and as a result the partnership that I manage was prepared for any contingency.
Now that we are in the midst of the Coronavirus-induced stock market sell-off, how should we proceed? The markets have been extremely volatile. Fear is rampant. Investors are reverting to their worst behavioral biases and habits in such an environment. You need to do better than the crowds and continue to invest rationally. Here is how.
First, you need to think about events, including the coronavirus-induced market panic, in terms of ranges, not point outcomes. Nobody knows exactly how this will play out. However, we can bracket the vast majority of the probability between the following two scenarios:
A. The Benign Scenario: Coronavirus blows over in a few months as prevention measures and warmer weather help. We avoid a full-blown recession, most businesses recover by year-end, except perhaps a few of the most affected that take a bit longer. Markets stabilize and investing returns to normal.
B. The Gloomy Scenario: The health impact on our society is far more severe than we hope. The global economy is tipped into a deep, multi-year recession. This recession is accompanied by an initial credit crisis that causes many financially levered companies reliant on the capital markets to go bankrupt. Many other companies’ profit streams are depressed for many years to come. Stock markets spiral downwards for years before stabilizing.
You might say: “Wait a second. These are pretty different possibilities. How can I possibly prepare for both??” Exactly. Speculators bet on their ability to foresee specific future outcomes. Investors need to invest for the full range of outcomes and create a portfolio that meets their financial goals no matter what comes.
To be clear, preparing for the full range of future scenarios is not free. It means giving up some of the upside that a maximally aggressive portfolio would produce in the Benign Scenario to significantly lower the negative impact of the Gloomy Scenario should it come to pass. Doing the following 5 things should put you well on your way to acting like a rational investor in the midst of a sea of panicked speculators lurching from news item to news item:
1. Continue to practice your routines that help maintain your mental equilibrium. It’s easy to get mesmerized sitting in front of a computer screen watching stock prices wildly swing around. Don’t. Instead, practice the healthy routines that you typically would to keep yourself calm and centered. For me, it’s a combination of regularly going to the gym and practicing my Bonsai (making miniature trees in pots) hobby. On one of the biggest down days for the stock-market last week, I calmly put in my purchase orders, and then left my computer and made a little Pine Bonsai. Whatever you think you will lose in productivity, I can assure you that you will more than offset in being able to remain calm and continue to make rational investing decisions.
2. Stick to your investing process. Yes, your investing process should evolve and improve over time. However, a crisis is not the time to make these changes. The whole reason that we have a rigorous investment strategy and process is to help us guard against behavioral mistakes and emotional decisions. Trust the years you have put into honing your process and just follow-through, no matter how uncomfortable it feels.
3. Make sure that you can never be a forced seller. Value investing only works if you have a long-term time horizon. Don’t invest in the stock market any capital that you think you will need for the next 3 (or perhaps even 5) years. This way you can act with confidence with the capital that you do have invested in the market, knowing that the short-term price gyrations cannot harm you. This also means not using leverage on your portfolio. If you do, wild stock price action can cause unfortunate margin calls to wipe you out. Surviving with a good outcome is way better than reaching for a great outcome but failing to survive.
4. Communicate. Whether it’s to your significant other, your clients, your boss or even to yourself, make sure you over-communicate about how you are applying your process to the environment. Document the rationale behind your decisions. This will both help you stick to your process and help others maintain their faith in you amidst a turbulent market environment.
5. Act slowly, but deliberately. Cheap stocks can go a lot cheaper. And then go down some more. Markets can decline more than you can possibly imagine. We have just left one of the longest bull-market runs in history. This might lull you into thinking that you need to go all-in on the first major decline you see in a stock that you have been watching or even the market as a whole. Don’t do that. Keep in mind that the future is uncertain and the range of outcomes is wide. However, also remember that you need to execute your process, or you will fall prey to your behavioral biases. So act in the direction that your process suggests, but do it gradually rather than all at once.
What does all of this mean if you are an average investor? Sure, some investors can successfully invest in individual stocks. There aren’t many of those (even though many think that they can). More investors can pick the few good active investment managers out of a sea of mediocre marketers posing as investors. These investors are still the minority, as most people can’t really tell the difference between a good investment manager and a slick marketer. What’s left is a simple, albeit unexciting strategy outlined below. It won’t make you the next Warren Buffett, but it’s likely to keep you out of trouble, help you produce decent returns and meet your financial goals:
1. Make sure you have cash, cash equivalents or a government bond ladder to meet your next 5 years of expenses
2. With your long-term capital not used for #1, dollar-cost average into broad, low-cost index funds regardless of how scary the markets get, what you read in the news or what your neighbors do. Invest the same amount (or same % of your income) in each time period.
3. Go on about the rest of your life and don’t think too much more about the stock market or investing. The more you meddle with #1 and #2 the worse this strategy will work for you.
Article source: https://www.forbes.com
Cover photo: valueresearchonline