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How Do You Respond To Stock Market Risk?

Summary

Warren Buffett says that diversification is overrated.

How can bonds be protection for stocks in an environment of rising interest rates?

Active investment management should be considered as the solution.

Stock market risk has increased significantly this year. The Dow Jones Industrial Average fell 3083 points (over 11%) from January 26 to March 23. Stocks have continued on a rough ride since.

When sharp stock market declines have happened in the past, have you heard financial advisors have say things like, “You can’t time the market”, “You have to invest for the long run”, “You can’t sell now” or “We didn’t see this coming”?

I believe the time for dollar-cost-averaging (investing on a regular schedule regardless of share price) is mostly in the past for those who are older. Those approaching or entering retirement do not have the years needed to recover from deep investment losses. Answers like those above can be disconcerting to investors who are paying professionals a lot to help minimize stock market risk in their portfolios – especially for those who have described themselves as low risk investors. I have seen such investors become frustrated and angry when their account balances evaporate.

Diversification is another strategy used by financial advisors to potentially lower risk. Diversification sounds like a great strategy on the surface – and in certain ways, it can be. However, when stocks, stock sectors and stock indexes all decline together, how much risk protection does diversification provide? Warren Buffett said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Simply viewing one’s account statement may provide insight into whether diversification has helped mitigate your risk.

Typically, financial advisors add bonds or bond funds to a stock (or equity based) portfolio to lower overall portfolio risk. Generally, using this strategy to protect against future stock market risk is based upon the changes in interest rates. Bond prices generally move inversely to those of interest rates. As rates increase, bonds and bond fund prices decline. The Federal Reserve has said that we should see more interest rate hikes both this year and next. If stock prices decline, how can bonds and bond fund prices increase during a period of rising interest rates? The strategies advisors have used during the past 35 years of interest rate declines may not work during a period in which interest rates rise.

Further, most of the experts that I follow have no bonds or very few. For example, Scott Malpass, Chief Investment Officer of Notre Dame Endowment Fund, has said, “There’s a misconception about risk. Some people might characterize a portfolio that’s plain vanilla — 75 percent equities and 25 percent bonds — as low risk. It’s actually high risk.” Warren Buffett added similar comments: “It is a terrible mistake for investors with long-term horizons — among them, pension funds, college endowments and savings-minded individuals — to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.”

What is the answer to the question of how to lower stock market risk?

How does one minimize stock market risk? Based on my work and research around this, I developed a mathematical model which is designed to minimize stock market risk. While there are no guarantees, this approach is designed to lock in gains before market corrections occur – in most circumstances. I believe that historical patterns of the ups and downs of previous stock market periods can influence our thinking as we look to the future. I see that historical periods in which the market rises to high levels are followed by periods when it experiences deep declines.

Investors often wring their hands after deep declines and try to understand why they are experiencing another “ride down” … and how could it have been prevented. They wonder why they weren’t told about the coming risk.

I believe active management, which allows your advisor to move your investments from one asset class (i.e. equities) to another (i.e. money market) BEFORE downside risk occurs, can assist in minimizing risk. While no strategy is perfect, it seems that the use of a well-designed mathematical model, which eliminates judgement and emotion as much as possible, can potentially achieve the goal of minimizing risk with higher returns.


Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Past performance is no guarantee of future results. While active management seeks to produce higher returns than those of passively managed portfolios, historical pricing patterns, which are a component of our mathematical model, may not necessarily be repeated in the future. This type of strategy is not suitable for all investors and there is no guarantee that your investment objective will be met or that you will not incur losses, including loss of principal.

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Reppond Investments, Inc. is an independent investment advisor registered in the States of Montana and Washington. We may not transact business in states where we are not appropriately registered, excluded or exempted from registration.