A little more than 17 million voters in Great Britain created turmoil in global markets when they voted to leave the European Union. According to analysts at Standard & Poor's, the vote led to $2 trillion in losses for investors around the world. These short-term losses reminded investors that markets are always volatile.
Volatility is also defined as risk, and is often explained in academic terms. From an investor's perspective, stripping away the academic jargon, risk is the amount of money you can lose on an investment. Risk is unavoidable, and arguably, risks are highest for passive investment strategies - the ones investors tend to view as the safest. Passive strategies include buy-and-hold investments in index funds. These strategies are intended to capture 100% of the market's upside and downside and become popular in bull markets. They are based on the belief that markets always recover their losses in the long run, and seem to ignore the fact that the long run can take decades to unfold. Passive investors would have needed 25 years to recover their losses after the 1929 crash, and 16 years after new highs were reached in 1966.
One of the best ways to reduce risk is to avoid buy-and-hold investments. Multi-decade bear markets can be life-changing if you can't access funds needed for retirement or other major life events.
To preserve wealth, investors should consider using active investment strategies that adapt to the current market environment. Active strategies should always include plans to manage risk.
One way active strategies limit risk is by limiting exposure to markets and allowing for gains to potentially compound faster. Active investors can build up cash as markets become overvalued and put that cash to work after markets pull back. Taking profits and rolling them into new investments can actually compound wealth faster than a buy-and-hold strategy. For example, a buy-and-hold investment might target gains of 10% a year. A trader can target gains of 10% in 3-6 months. This allows for greater potential gains. If you limit losses and are right at least half the time, you could beat a buy-and-hold strategy.
Because there will be times when any investor is wrong, it's important to have a plan for managing losses. Often, a stop loss order will be the first line of defense in an active investment strategy. A stop loss is an order, or at least a plan, to sell a position if the stock falls below a predetermined price. The advantage of a stop loss is the fact that it ensures an investor acts when prices fall. Many buy-and-hold investors ignore declines, believing that prices always recover. This is a dangerous belief, for two reasons.
Sometimes, prices don't come back, even in the very long run. One study reviewed the returns of 3,000 stocks from 1983 to 2007. Only about a third of the stocks (36%) beat the market over the 24-year period. Investors actually had better odds of randomly picking a stock that lost money than picking a stock that beat that market, since 39% of the 3,000 lost money over the test period. About one-fifth (19%) lost at least 75% over that time. This shows the daunting odds a buy-and-hold investor faces, since 64% of individual stocks underperform the market in the long run, according to this study.
Underperformance might be the biggest risk a long-term investor faces, but it is also possibly the least-considered risk. Investors in Cisco Systems (NASDAQ:CSCO) who bought the stock at the bottom in March 2009 might be pleased with their investment after a 148% gain. However, instead of patting themselves on the back, they should be revising their investment strategy, because they had actually found one of the many stocks that underperformed the market, which provided a total return of more than 260% over that same time. Many investors fail to consider relative performance and focus solely on the fact that a stock delivered a gain. Investors who understand risk know they cannot afford to underperform in a bull market, and they don't even want to match the market performance. They want to outperform because they know what's needed to build significant wealth.
These two facts - many stocks deliver losses even in the long run, and most stocks are likely to underperform over time - define the need for risk management.
Managing losses is the simpler problem. Some investors set a stop loss some percent below their entry price - for example, a 10% stop loss. This might be the most ineffective way to place a stop. Stocks have different personalities, and volatility is one of the dominant characteristics of their personality. A high-volatility stock could trigger a percentage stop that is too close to the market price to account for normal volatility. A low-volatility stock might never trigger the stop because it doesn't move enough to create a loss, but it also doesn't move enough to deliver a market-beating gain.
A better way to set stops is to use the average true range (ATR), as we discussed in an earlier article. The ATR is customized to the personality of each stock. The true range is the distance between the high and low accounting for any gaps that occur in trading. A 14-day average of the true range is an indicator of a stock's normal movement. Multiplying the ATR by 3 finds the size of a price move that should only be reached in extraordinary circumstances. Subtract 3 ATRs from the closing price to find a stop level that accounts for the stock's personality. This will place stops far from the current price on volatile stocks and near the market price on stocks that hardly move at all, like many utilities stocks.
The 3 ATR stop can also be trailed higher as a trade moves in your favor. If the stock gains 10% after you buy it, you could reset the stop to account for the recent price action. Stops could be reset weekly or monthly, but should always be updated to account for the most recent price action.
When recalculating where stops should be, you should also consider how long a position has been open. This will require more work, but it's only a little more effort, and could dramatically improve your results.
Underperformance carries a high opportunity cost, because owning a stock that is lagging the market prevents you from using that money to invest in a stock that could be doing better. This is an opportunity cost, and it can never be recovered. If you held CSCO for seven years after the 2009 bottom, you would have turned a $1,000 investment into almost $2,500. But an index fund would have grown to $3,600. Your opportunity cost was at least $900, and more if you were a more aggressive investor.
To avoid this, you can consider using time stops. With a time stop, you give an investment time to perform, and if it doesn't, you move that money into a more promising opportunity. Six months should be enough time for an investment to prove itself. If a stock you bought has underperformed the market for six months, it could be time to switch to a different stock. This avoids the problem of dead money that hurts your goal of maximizing wealth.
Markets are now, always have been, and always will be volatile. As investors, volatility offers opportunities. To benefit from volatility, we need to sell at times. Planning your exit when you enter a trade can be the best way to raise cash in volatile times. Consider a 3 ATR stop that you update frequently, combined with a time stop on all open positions. These small steps could help you avoid sticking with losers and riding bear markets to large losses.