*This post was delivered to readers of The Stock Analysis Waiting List on December 31, 2016. Join if you would like to receive early releases of posts such as this here.
Ways to Protect Against a Market Correction (or Prolonged Bear Market)
We are at that point in the equity market cycle where each week there are articles discussing all time market highs, how likely a correction will come next month, what the prospects for investing in 2017 will look like and how to best position your portfolio.
For the most part it’s all noise.
I read an article by Jason Zweig at the end of November titled, Some of the Wisest Words Ever Spoken about Investing, that prompted me to write this post. Near the end Zweig talks about what Peter Bernstein taught regarding Pascal’s wager; “You must weigh not only the alluring probabilities of being right, but the dire consequences of being wrong.” The article goes on to talk about humility and respecting the market including an emphasis that we don’t know the future and should be humble about that.
An intelligent investor will obviously want to protect themselves from losses. That is why we set an asset allocation, we diversify and study systemic and non-systemic risk. This is why my portfolio is organized in the way it is. My true goal is to never beat the market in any single year but beat it handsomely over the long-term. I achieve this by minimizing my losses and giving up some of the potential maximum gains. This is why I might sell out at 30% vs. 50% or not participate directly in a commodity bull run. I am more concerned about the years the market is down 20-30% then if I get beat by 2-3% by an index during the good years. The down years are what kill your compounding returns and ability to gain momentum in your portfolio. They are also where your mistakes are exposed.
So how do you participate in the equity market for gains but protect yourself against steep losses? Multiple studies have shown that market timing does not work; no one is skilled enough to successfully and consistently time the right decision. We also know that you will be more successful if you are fully invested then sitting in a large cash position waiting for opportunities.
I can’t tell you what will work for your situation, but I can outline what I do and have done successfully in the past.
I like to always have a cash position as low as 5% at a minimum. This represents about 18 months of dividends in the portfolio. The reason I have set 5% is for a few key reasons.
5% is 1 full position in my portfolio or 2 half positions. If a stock were to get ridiculously cheap, an opportunity were to present itself that was simply too good to pass on I would have enough cash to add to an existing position by half or enter a new position fully. There have been times I have gone to 0% cash or up to 20% margin (2008-2009) but these have been rare. When I have gone to 0% cash I don’t stress; I am aware that it will take me approximately 18 months to build that position back or I’ll need to sell something to raise cash faster. Generally what happens is I trim my top positions back and build cash slowly in this manner or I add cash in the form of a contribution. Once I’m comfortable with my cash position I might sit on it or reinvest back into an investment with the lowest overall allocation.
Buying Under or Close to Allocations
I can never think of a time where each position in my entire portfolio sat at a perfect 3.57% (28 positions). The likelihood of that is very low given that each stock moves in a different direction on different days to different degrees. Allocations are always fluctuating a little but I do target maintaining certain positions near or close to their targets when markets get frothy.
Core positions (TD, BNS, SAP, CNR, VOO, ACO.X) I pay special attention to ensuring they are as close to target allocation as possible. The reason is simple; these tend to be the stocks that drive positive momentum in the portfolio over the long-term (10+ years). They will consistently raise their dividends and the more closely I am fully invested in them the better my compounded returns will be. If the market decides to gain another 20-25% in a short period of time their allocations will rise and they’ll be trimmed locking in gains. If the market falls they’ll get cheaper and I’ll add to them because I was never overweighted in those positions.
This concept is logical and shouldn’t seem new, but ask yourself how many times you’ve purposely completed this task and you’ll realize that often you’re over allocated because you’re getting greedy or under allocated because you’re trying to time the market for a better price.
Another really simple but often overlooked tactic is taking profits when positions get beyond your set allocations. I’m not talking about trimming a stock at 3.75% when it’s supposed to be at 3.5%. You need to be smart and trim positions when the brokerage fees (your $5-10 trades) make up less than 1% of the proceeds. What I’m suggesting is that if you’ve targeted a stock to be at 4% of your portfolio and its up near 5.8% or higher you need to trim that, lock in the profits and redeploy your capital to other positions.
Revisiting my Asset Allocation & Sector Groupings
After focusing on the individual positions I also want to look at my sector groups and overall allocations. If I’ve targeted financials at 12% and I’m up at 16% then I know I need to trim back on a position in order to provide improved balance to the overall portfolio. This is about risk. Again the focus is not about squeezing out an extra 1-2% over the index in any given year, but protecting your capital from a 30% loss with the broader market. Your holdings may drop collectively by 8% but that is a far cry from 30%. I tend to like the idea of riding the market down, buying in a few times near the bottoms and if I hold great companies they will rebound well on the other side. What I don’t want are poor companies positioned in a market who will make poor decisions.
Removing Waste, Non-essentials, Non-performers & Risky Stocks
No matter how disciplined you are we all take a little risk here and there in a short-term position, a momentum stock or something that doesn’t really fit the portfolio long-term, but was a good short-term opportunity. These generally are stocks you don’t want to hold during a down market. If the market goes down you want the best of the best in your portfolio. You want to add to those positions at more affordable prices. You want to take an opportunity to strengthen the long-term earning power of your portfolio.
A market like this is where I start to focus on removing waste, non-essential positions, poor performing stocks and risky positions.
At the same time I want to take note of my watchlist and ensure it’s updated, relevant and appropriate. I want to have a good sense of value in the short list of stocks there and that I have a game plan for which are priorities; which are wants and which are needs.
Often I may have placed a stock on my watchlist but have not read a few of the quarterly reports in as much detail as I would like. The choice is to either keep that name on the list and read those reports, or drop it off the list. If the market were to move quickly I would want to know the relative value of the companies on that list and where my entry points would be should I consider adding it to the portfolio. Most often these are stocks which are trading at valuations I cannot commit to in a bull market, but would be happy to pick up at a 30-40% discount.
Watching the beta of the portfolio is one of the last things I do and to be honest isn’t something you need to do. What I have noticed over a long period of time is that before a market turns really volatile I will start to see the beta of the portfolio move away from the targeted beta.
When I construct a portfolio I usually set a target beta (e.g.: 0.64) and measure the model against the target. When I start to see that beta move with great correlation to the market I really start to pay attention.
What this does not tell me is how far a market will fall and for how long. It won’t tell me the bottom or how many bottoms we will experience. This is simply an observation I’ve made and I start to pay attention to it more keenly when I see it.