Part four of our week-long series on Becoming a Better Investor focuses on reaction strategies. If you’re just joining us, you can catch up by reading Monday’s, Tuesday’s, and Wednesday’s editions. In essence, the goal of the Becoming a Better Investor series is to simplify the investing methods employed by average individuals. Typical investors overcomplicate their portfolios, and pay for it when the market moves in a direction that wasn’t prepared for.
Reaction strategies are a broad description for how to react (or not react) when economic uncertainty, turmoil, or market volatility enters the picture. Investors are infamous for their herd mentality when rushing for the exit. But this is among the worst times to be in the market trying to take a position. Consider the following:
1. Markets dramatically lose their functionality when confidence is lost. If there is uncertainty in the integrity of other side of the market, then spreads grow wider and costs skyrocket. Further, no one can say with certainty what the “real price” of a given asset may be, so volatility swings and mis-priced securities are common.
2. Economic cyclicality and the law of probability state that downswings are inevitable. Yet, it appears that every time a new unforeseen event occurs – whether it is natural disaster, market swing, or bubble burst – it’s as if humans are coming across one for the first time. This situation only multiples the cycle of uncertainty.
3. Even seasoned market professionals are put out of business by the overwhelming force of the market. Amateur investors and the average investor should take this mindset into their portfolio planning. How can they best protect their assets without exposing themselves to substantial market swings? More importantly, how can they protect their assets in the seemingly Wild, Wild West of investing?
In reality, reaction strategies should be among the highest planned components of any given portfolio. Having discipline and processes already in place when market turmoil hits is priceless. Further, maintaining a focused mindset when all others are running around with hysteria is a highly valuable trait. Many a fortune have been lost simply because investors didn’t have an established contingency plan for when things got choppy. Outlined below are several strategies to get you started:
1. Establish a set of portfolio rules to be followed when markets become stressed. These must be well-defined instructions for how to protect wealth and minimize market involvement when volatility is an increasing factor.
2. Unless the ultimate future of a security you hold is at risk, avoid exiting a position at all costs. While we would never argue for keeping a “loser”, tremendously uncharacteristic price action is the norm in these situations. Don’t be a victim of them.
3. Hold multiple accounts with cash and cash-equivalents. This will protect your ability to access your capital at any time – in its most liquid form.
4. Don’t be afraid to buy value if it’s available. Uncharacteristic price action can allow investors to buy top-notch securities at rock-bottom prices. Be sure to properly protect yourself when getting involved in any uncertain market situation, but be assertive in your beliefs.
5. Ride out the storm. Every economic downturn ends eventually, but it never feels that way at the beginning. Be patient with your portfolio holdings, and trust that the planning you did will protect your hard-earned assets.
As mentioned previously, it’s argued that reaction strategies must be one of the more planned for components of any given portfolio. It can have the biggest long-term impact on return, and meaningfully impacts an investor’s mindset. Indeed, maintaining calm when others aren’t can be a powerful feeling.
Agenda: Monday: Introduction; Tuesday: Basics; Wednesday: Cash Flows; Thursday: Reaction Strategies; Friday: Advanced Options
— Nick Smith