Saturday, February 17, 2024

Are you prepared for the downside?

Over the Lunar New Year long weekend, I had time to do some reading.  I had borrowed a stack of books from the public library on my favourite subject (no prize for guessing what it is).

After completing the first two books, I noticed a common theme among the writers.  There was an emphasis on effective risk management and protecting our portfolios against the downside.

The downside here refers to the huge loss in our portfolios during a bear market.  An effective risk management strategy proposed by the authors entails selling down one's positions at the onset of the bear market.  This ensures that we retain sufficient cash to tide over the period and take advantage of the subsequent recovery.

Truth be told, I have never thought about squaring my positions just because we are entering bear territory.  The only times I have sold stocks are when:

(1) doing portfolio rebalancing;
(2) the company's fundamentals have deteriorated permanently; and
(3) the valuation of a stock is overstretched in a bull market.

The rationale for selling (as argued by the authors) is capital preservation.  Acting decisively at the cusp of a crash is crucial.  Markets can fall swiftly.  If there is no preset plan to liquidate equity positions into cash, investors can see their net worth vapourize as the market drops 10, 20 or even 50 percent!

Moreover, the recovery period is uncertain.  It may take years - decades even - for our portfolios to regain the original value.  Perhaps never.

The authors cited the Great Depression in 1929, Oil Shock in 1973-1974, Black Monday in 1987 and the Global Financial Crisis (GFC) in 2009 as examples of how bear markets had decimated the wealth of a great many investors.

Log chart of the Dow Jones Industrial Average (source: Macrotrends).

In our recent past, one can find examples too.  During the Asian Financial Crisis in 1997, the Straits Times Index (STI) lost 62 percent from its peak of 2127.99 points to a low of 805.04 points.  After the dot-com bubble burst in 2000 and the SARS epidemic in 2003, the STI sank 55 percent from its peak of 2608.48 points to a low of 1170.85 points.  During the GFC, the STI plummeted 62 percent from its peak of 3831.19 points to a low of 1456.95 points.  There were plenty of smaller market declines in-between.

Having a systematic plan to reduce position size as the market starts to plunge can help overcome investor paralysis due to shock and stem the losses.

On the surface, it sounds like a sensible plan.  But I still have doubt.

After some reflection, I figured out why.

Firstly, the authors perceive themselves as stock investors, and not company shareholders.   They seek to profit in the market by buying and selling stocks - any stock - as long as there is an adequate risk-reward ratio.  Replace 'stocks' by any item with supply-demand dynamics and it makes no difference to these folks.

"The stock is NOT the company", as one writer effuses.

On the other hand, I see myself as a participant in the growth of the company, with the aim of reaping future rewards as the business prospers.  The stock market is merely an entry point.  The share price is the participation fee.

Coincidentally, founder Jeff Bezos also agrees that the stock is NOT the company.  In his experience, the stock market does a poor job of reflecting actual business performance.

Secondly, the writers seek to maximize capital gain and minimize capital loss.  To them, no stock is worth holding forever.  In fact, there should be no sentiment involved.  (Rightly so, because the endowment effect can cause one to be blind towards selling the stock when it is warranted.)

Conversely, I take an active interest in understanding how the executives are steering the company.  I think about whether the current business strategy makes sense.  There is satisfaction in seeing profits earned every fiscal year.  A recurring dividend payout is the fruit for placing the right bet.  As long as the company continues to generate free cash flow, there is no reason for me to renounce my ownership, come bear market or whatsoever.

Legendary investor Warren Buffett assures us that by choosing the right companies, the portfolio will take care of itself.

That said, the authors did bring up a good point - capital is key for every investor.  You cannot invest if you don't have the money.

As the cliché goes, it takes a 100 percent return to recoup a 50 percent loss.
During a recession, which often occurs in tandem with a bear market, investors face a double whammy.  They may lose their income (due to retrenchment, business failure etc) at a time when the stock market is in the dumps.  Liquidating the portfolio at this point is possibly the worst thing to do.

So how can one avert such a calamity?

My personal 'effective risk management' is to strengthen my financial wellbeing in totality.

Firstly, I have emergency funds set aside.  I lead a low maintenance lifestyle, so my rainy day savings can last me several months.  Secondly, my equity portfolio is only a subset of my wealth.  I have my Singapore Savings Bonds which I can liquidate for cash as and when required, albeit with a one-month lag.  Thirdly, I am on track to fully repay my mortgage loan this year.  After which, I will be debt free with a secure roof over my head.  (It is hard to be made bankrupt when you don't owe any creditor.)  Lastly, I have my CPF monies and insurance policies to cover healthcare costs and to purchase an annuity.  I also have a company pension plan that is currently vested in a money market fund, which I can liquidate if needed.

Selling my shares will only be my last resort when I have exhausted the above.

Thus, I believe I am pretty well prepared for the downside.

One last point: If I sell my stocks and don't have an equivalent effective 'risk on' strategy to get back into the market, I will surely miss the subsequent upswing.  While not guaranteed, time has shown - again and again - that the equity market does eventually recover and continue its upward trajectory.

By investing only in fundamentally strong, healthy companies, I am optimistic that my equity portfolio will emerge from any financial crisis unscathed.  Selling optional.

Are you prepared for the downside?

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