“There’s no harm in hoping for the best as long as you’re prepared for the worst.”
― Stephen King, Different Seasons
What are the typical solutions used to soften the blow of a stock market downturn, and do they work? Surprisingly, some strategies commonly used to limit losses in a falling market are unreliable at best, whole most investors remain unaware of some of the most effective strategies.
In part one of “How to Prepare Your Portfolio for a Bear Market,” we looked at asset allocation, diversification, rebalancing, hedging and options as ways to prepare for or weather a market downturn. This week, in part two, we examine four more common strategies often used to navigate a bearish market: stop-loss orders, reverse ETFs, bonds, and alternative investments outside of the stock market.
4. Stop Loss Orders
Stop-loss orders can be way to prevent large losses in one’s portfolio, triggering a sale when the price of a stock drops past a certain point, such as a 10% drop. How many people wish they would have sold near the start of the 2008-2009 market crash? Only those with stop-loss orders or very keen instincts actually did.
Trailing stops (stop loss orders that rise along with the stock price) can be helpful to ensure that market gains are not simply lost during the next correction. Even then, be aware that stop loss orders can force a sale when, in most cases, the low is temporary and a rebound is imminent. (And after all, isn’t the idea of investing is to sell high, not sell after a drop?)
Under normal circumstances, stop loss orders can be helpful to avoid large losses in many situations. However, the May 6, 2010 “flash crash” demonstrated the stop loss orders won’t necessarily protect you. It is even theorized that stop-loss orders may have actually caused the flash crash. On that day, large sell-offs triggered further sell-offs, and when sellers found no buyers on the other side of the deal, the market was completely destabilized for a short period. According to an article on emarotta.com,
Between 2:40 pm and 3:00 pm, at some points no one knew what certain stocks or ETFs were worth. Consequently, the value of many ETFs hit virtual zero. Stop-loss orders for VTV set at $42.50 got executed for $0.10 a share. Then after every stop-loss order was finally triggered, the plunge came to a halt. Many stocks sold for just a penny per share. These trades show a market in free fall with a snowball of cascading stop orders and no market makers stepping in to set a reasonable price.
Thus the stop-loss order technique failed at the very moment it was supposed to save the average investor. It tried to sell in a free-falling market and only succeeded in dumping valuable stocks on a dime and for a dime.
The market recovered most of its value in the next 20 minutes, and after numerous investor and advisor inquiries, the NASDAQ mandated canceling these erroneous trades. But even after adjustment, “some investors lost 63% on a day where the stock market only closed down 3.62%.”
Limit Orders vs. Market Orders
According to Sheryl Nance-Nash in “ETF Lessons from the May 6 Flash Crash,” investors must understand the difference between “limit orders” and “market orders.” Market orders trigger a signal to sell which is “good ’til cancel,” selling at whatever the going price is, which triggered some hefty losses during the 20-minute flash crash. Limit orders are orders to sell at a specific price point, whether higher or lower than the current price.
Market orders go through automatically, triggered by hitting a certain price, but if the price continues to fall, they can sell for much less. A limit order will only be filled at that designated price.
However, while limit orders may prevent another flash crash, they still can’t protect you from loss (even below your selling price) if the market “skips” over your price. Stop loss orders aren’t helpful when needed most, when negative news causes the market to open significantly lower than it closed the day before.
Michael Sincere offers further thoughts in “Why I stopped Using Stop Loss orders” to help prevent other investors from inadvertently selling a stock low during a flash crash.
5. Reverse ETFs
Reverse ETFs are exchange-traded funds that operate as a hedge against the stock market by performing as the inverse of a certain benchmark. For instance, when the S&P 500 (or whatever index the specific reverse ETF is linked to) loses value, the reverse ETF that corresponds to that benchmark will gain value. This is achieved through derivatives, short-selling, futures contracts, and leverage.
By nature, reverse ETFs are highly volatile. They are not designed to ever be “buy and hold” stocks, but are instead popular with active traders who are willing to bet that the S&P 500 (or some other benchmark) will indeed fall, and are willing to suffer leveraged losses if they are wrong. They are only good strategy if you have a crystal ball and know for a FACT that a benchmark was heading downward, and could time the market with certainty. (And that’s something that not even Orlando the Stock-Picking Cat knows for sure, much less money managers.)
And this is precisely the problem with “investing for a bear market.” We all acknowledge that the bull market will not last forever. And yes, there is evidence of a market bubble, an education bubble, a potential liquidity crisis, perhaps a new housing bubble and increasing volatility. But when will we see a correction, a crash, or a bear market? We don’t know!
All we can state with certainty is that there will be ups and downs, and that the roller coaster ride of the market will surely continue. And knowing THAT, we recommend investing for ANY market.
We have been told again and again that bonds are “the” solution and perfect companion for the volatility of stocks. However, in this low-interest-rate environment, are bonds the best investment solution?
Rising interest rates would reduce existing bond values, and according to a blog post on WSJ.com, investment-grade bonds could the hardest hit. And already, the bond market is demonstrating some instability.
In 2014, municipal bonds, generally regarded as one of the safest of all investments, experienced record levels of defaults. In “The Untold Story of Municipal Bond Defaults,” an enlightening article from Liberty Street Economics, we learn that “default frequencies are far greater than reported by the major rating agencies” (as much as 40 times greater than what has been reported by Moody’s and Standard & Poor’s), “partly because the rating agencies’ default numbers only cover bonds that they rate, and the unrated portion of the market can be… bonds of lower credit quality, exhibiting a higher frequency of defaults.”
The article goes on to point out that investors also have less protection against defaults now that bond insurers have lost their AAA ratings and no longer play a significant role in the municipal bond market.
While muni-bond defaults are still fairly contained, now the threat of rising interest rates is generating much debate about the relative safety of the broader bond market.
“It’s Dangerous Out There in the Bond Market,” reads the headline of an April 28, 2016, Bloomberg article. “Yields on $7.8 trillion of government bonds have been driven below zero by worries over global growth, meaning money managers looking for income are pouring into debt with maturities of as long as 100 years.” The article reveals that if interest rates should rise, “investors are setting themselves up for damaging losses if average yields rise even a little from their rock-bottom levels.”
And the risk doesn’t stop with municipal and government bonds. In January of 2016, a CNBC special report on corporate bonds reported that low oil prices had caused record defaults in corporate bonds in the energy sector, accounting for 26% of all corporate defaults. According to Morningstar’s analysis, 75% of fixed income funds had exposure to energy bonds, which experienced a double-digit decline (and subsequent near-recovery) since the spring of 2015. So much for the stability of bonds.
Perhaps it’s time for American investors AND advisors to stop recommending the “stocks and bonds” combination. For those looking to balance the risks of the stock market, there are better solutions.
LISTEN: Learn more about why we’re not recommending bonds in this podcast: “Bye-Bye to Bonds”
7. Alternative Investments.
We believe that the best investments are outside of the choices typically recommended by “typical” financial advice. “Alternative investments” can be a huge umbrella, but what we mean by the term is investments that provide an alternative to stocks, bonds, and banking products. Some of our favorite alternative investments include:
- investing in commercial and investment real estate bridge loans
- cash flowing investment real estate
- life settlements, which allow individuals to invest in the secondary market for life insurance policies
- peer to peer lending such as Prosper.com and LendingClub.com
- private equity funds that invest bridge loans, life settlements, and other
One advantage of many alternative investments is that they are non-correlated, meaning that they can provide growth or cash flow whether the stock market is rising or falling. Some are non-correlated only to a point, given that there can be ripple effects between markets. We do not recommend REITS, which proved to be extremely volatile during the financial crisis. Other alternative investments, such as life settlements, are not affected by financial markets and interest rates.
Some of these investments can be purchased through a self-directed IRA as well as directly, although the qualified plan environment does not always make sense for a particular investment. For example, if you want to own rental real estate that you can also use yourself, such as a vacation home that is rented out when you are not there, you’ll need to own that directly as the rules for self-directed IRAs will not permit personal use.
An investment should not be dismissed just because a brokerage firm does not offer it. (Perhaps the opposite should be true!) After all, “alternative investments” used to be known as simply “investments.” They are only labeled “alternative” now because of the rise of government-sponsored retirement plans, the lobbying which convinced the Department of Labor to sanction Wall Street products, and a financial media which parrots “stocks and bonds” as the only options.
The bottom line is this: You don’t have to subject your dollars to the roller coaster ride of stocks or the inefficiency of banks, nor do you have to be a prophet who can predict the markets to make a profit! We have written at greater length elsewhere about alternative investments and investing outside of the stock market – follow links to learn more.
Is Your Portfolio “Ready for Anything”?
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Disclosure: Our content is meant for educational purposes only. While it’s our goal to help you learn about building a life of prosperity, we do not intend to provide financial advice. Please consult your financial, tax or legal advisor before making any investment or financial decisions.