In poker, if you have a bad hand, you “fold.” In investing, the commonly accepted philosophy is to “buy and hold,” even during a bear market.
So which of the two is really gambling – poker or buy-and-hold investing? Today’s market, which is putting buy-and-hold investing to its biggest test since the Great Depression, may provide the answer.
The Dow Jones Industrial Average has dropped thousands of points, yet the prevailing advice has been to stay put. Does it really make sense to leave your investments where they are when you know that financial institutions hold trillions of dollars worth of bad debt?
Today’s bear market is the 15th since the Great Depression. During the last bear market, which began in September 2000 and lasted until March 2003, the S&P 500 lost 49% of its value. If all of your money were invested in the S&P 500 stocks, you still would not be at the breakeven point.
And now your money is invested in a market that’s being compared to the Great Depression. While that may be hyperbole, consider that if your money were invested in the S&P 500 stocks during the Great Depression, it would have lost 86.7% of its value from September 1929 through June 1932 – and it would have taken you 25.2 years just to break even.
Managing Risk To Increase Rewards
Those who advocate a buy-and-hold strategy will tell you that you need to stay invested, because you can’t “time the market.” They’re correct.
No one knows how the market will perform tomorrow, next month or next year. But historically, changes in factors such as corporate profits, interest rates, inflation, unemployment and other variables have provided strong indications of when we were entering a bear market and when we were entering a bull market.
Active management uses technology and economic data to identity the impact of these variables. Using proprietary models based on these factors, active investment managers can determine whether investors should be heavily invested in the market – or whether they should temporarily pull money out of the market.
You may miss days when the market makes significant gains, but it is even more important to miss days when the market suffers significant losses. If your portfolio were to fall in value by 50%, for example, you would need a 100% gain just to break even.
Models used by active investment managers generate “alerts,” which tell them when it is time to buy a specific investment and “stops,” that tell them when it is time to sell. A stop loss point is established whenever a new investment is made. If the investment appreciates in value, the stop is moved up to protect the gain. If the investment declines in value past the stop loss point, the investment is automatically sold.
Unlike active managers, buy-and-hold managers do not react to changing economic conditions, because they believe a diversified portfolio can withstand any market conditions. In theory, if your portfolio is properly diversified, losses in one area should be offset by gains in other areas. Today, though, diversification hasn’t worked because virtually all types of stocks and corporate bonds have experienced losses.
Active managers also advocate diversification, but it is only one tool for reducing risk. Along with stops and alerts, active managers use other tools, such as hedging and setting price targets.
Hedging is used to reduce the risk that an investment will decrease in value by investing in an offsetting position in a related security, such as an options contract.
Price targets, like stops, determine when an investment should be sold. If, for example, a stock increases in value and reaches an expected target value, the manager sells all or a portion of shares in the stock, guaranteeing the gain.
Like any investment strategy, active management cannot guarantee gains – but it sure beats gambling.
Brenda P. Wenning is president of Wenning Investments, LLC of Newton, Mass. She can be reached at Brenda@WenningInvestments.com or (617) 965-0680. For additional information, visit www.WenningInvestments.com or her blog at www.WenningAdvice.com.