I recently received an e-mail from a “wannabe” hold-n-hope investor. This particular investor expressed a belief that selling positions through stop-limit loss orders or with the benefit of a 200-day moving average only proved beneficial in 1929 and 2008.
I countered with the reality that reducing stock exposure via selling or hedging benefited investors in every bear market on record, including, but not limited to, 1901-1903, 1906-1907, 1909-1911, 1912-1914, 1916-1917, 1919-1921, 1929, 1930-1932, 1937-1938, 1939-1942, 1946-1947, 1961-1962, 1966, 1968-1970, 1973-1974, 1976-1978, 1981-1982, 1987, 1990, 2000-2002 as well as 2007-2009. In fact, even in the scores of instances where a 10%-19% correction resulted in a small loss when a hedge is removed or a “get-back-in” purchase is executed, one should not ignore the sleep-at-night comfort that the insurance provided. (Note: There are plenty of instances when taking measures to minimize stock risk in 10%-19% corrections resulted in small gains as well, including 1998 and 2011.)
Classic Hedge
Consider the fact that when we buy homeowner insurance, we willingly give up a small premium to protect against a monstrous property loss. We actually prefer losing the insurance premium, as opposed to seeing the home devastated by a hurricane, tornado or earthquake. And yet, if the worst should happen, the protection is in place to restore the residence. In other words, the small loss of that premium payment is the price that we pay for peace of mind.
In my 25 years of debating the merits of buy-n-hold versus buy-n-hedge/buy-n-sell, I still marvel at the hardened positions of buy-n-hold advocates. Insurance in investing endeavors is not necessary? Would they say the same about all of the other financial walks of life – health, property, casualty, disability, liability, long-term care, vehicle and so forth? Or would they not find those types of insurance necessary to maintaining their livelihoods?
Let us pretend, for an instant, that stop-limit loss orders and the 200-day SMA were only beneficial in the catastrophic circumstances of 1929 and 2008. Isn’t that enough? Do earthquakes and tsunamis come only once every 79 years with reliable precision? That sounds like a prediction to me, that the Great Depression and the Great Recession represented such extraordinary unlikely outcomes, that there’s simply no need to worry again until 73 years from now.
Here’s the truth: Nobody has any idea what will happen next. Nevertheless, if we are going to use a timeline in history to make future decisions, we might as well note that a typical bear market of 20%-plus stock losses occurs every four to four-and-a-half years. This bull market is closing in on six years. The average decline in a bear? 33%. If selling some positions at all-time records in a late stage bull is foolhardy – if employing a multi-asset stock hedging approach with assets that perform better than cash in moderate-to-severe downturns is foolish – I will continue to play the fool.
Still not convinced? Then you ought to get a gander at the Dalbar studies. Over a 20-year period ending 12/31/2012, U.S stocks annualized near 8%, U.S. bonds annualized near 6.5%. And the average investor? Only 2.3%. Ironically, the data are widely touted as proof positive that one should simply buy-n-hold through thin and thick.
I argue the exact opposite. The overwhelming percentage of average investors increased their exposure to tech stocks in the dot-com fueled 90’s on the irrational exuberance of the “New Economy.” Had they had a plan to reduce stock exposure by selling or hedging, they would not have lost 50%, 60% or 70% of their tech-heavy portfolio while holding-n-hoping through the 2000-2002 “teck wreck,” nor would they have sold near that bottom, nor would they have struggled with the decision of when to “get back in.” Similarly, when the average investor slowly began putting money back to work in the 2002-2007 bull market, becoming more confident along the way, the average investor did not have a plan in place to lower the stock risk in 2008-09 systemic collapse of the financial system, nor did the average investor have a plan to reintroduce exposure as volatility subsided and trendlines turned positive.
Simply stated, you may set out to hold your core positions until you pass them on to your heirs. However, if you’re like a lot of investors, you won’t. You will sell in a fiery panic when the kitchen heat becomes too much to handle. And it will be at a lot lower price than at a stop-limit loss order that you set up in advance.
It Takes Discipline
Having a discipline for buying and selling/hedging from the get-go is indispensable. It is the reason that my colleague Rob Charette and I developed the FTSE Custom Multi-Asset Stock Hedge Index (a.k.a. MASH Index). This is not a “bear fund.’” The index does not look to go short or use leverage. Rather, the index is comprised of assets that often succeed when safe haven assets in the non-equity realm (e.g., currencies, foreign sovereign debt, U.S. bonds, precious metals, etc.) are desired by the investing public. Often the desire is greatest when stocks fall out of favor, but they may perform in stock uptrends as well. Year-over-year, the FTSE Custom Multi-Asset Stock Hedge Index has done just that, with 7%-plus gains to the S&P 500’s 9%.
The above chart represent year-over-year results through January 14. Yet on Thursday, 1/15, one of the index components, CurrencyShares Swiss Franc (NYSE:FXF) pole vaulted 10%-plus in a single trading session. Why? The Swiss Central Bank dropped its euro peg, apparently willing to hinder the country’s exports in an attempt to defend the currency from “QE-style” electronic money creation in the euro-zone. SPDR Gold Trust (ARCA:GLD) also received a 2.5% boost from perceived currency debasement. Gold is another index component.
One final word on late-stage bull markets. With QE3 ending this past October and stock-market volatility rising ever since, U.S. stocks as an asset class may be losing its place as the undisputed champion. A cursory glance at the above-mentioned chart – where MASH is achieving total returns that are not too far off the results for the more volatile S&P 500 – suggests that stocks may require an indirect boost from members of the U.S. Federal Reserve Open Market Committee. Specifically, the stock market may need to hear something that suggests impending rate hikes will be pushed back into Q4 2015 or Q1 2016; if selling pressure gets bad enough, a reversal might require hints of the potential for QE4.