“Guns, grendels, or nuclear bombs; take your pick.”
― James Rollins, Ice Hunt
If you have money in the market right now and need it in the next five years, you’re in a tight spot. The bond market is likely to implode when Janet Yellen and the Fed raise interest rates. The stock market has now had another long, stable run. Economic indicators seem to be slowing down.
Where do you run?
There’s a better question: When do you run?
The problem with running is knowing when the race to the door is starting. For the last few years bear market traders have talked about how high the market is now….and it just keeping going up.
For two years, we’ve also been talking about how interest rates are at or near all-time lows….yet the Fed hasn’t moved. See our recent podcast “How Does a Fed Meeting Impact Your Money” for more on the topic.
In both occasions, you missed some admirable returns. If you ran from the traditional markets, you performed horribly. You either earned a dismal amount in cash (less than one percent, most probably) or you turned to precious metals, which have lost enormous sums.
Don’t Play The Game
I’ve never been able to understand why we insist on playing the “I think I know when the market’s going to go down” game. How big is your ego that you think you can call the market? Abby Joseph Cohen, the famous Goldman Sachs strategist, successfully called the year 2000 downturn. However, she’s been wrong over and over on the markets since. I don’t mean to pick on Ms. Cohen, but if we assume that she has more data than you, how are you going to call it?
If you’re a young investor, here’s a lesson: don’t trust your gut when it comes to making the big calls on the stock market. Gut + data is wrong enough that to make a “gut-only” decision is just asking for trouble.
So How Do You Lower Your Market Risk?
There are a few better ways to hedge your bet. Let’s tackle three:
1. Stop Losses
You place stop losses below the current share price to ensure that if the market begins to tumble you automatically sell. The biggest advantage of a stop loss to individual investors is that you don’t have to sit in front of the computer to wait for the market to drop….it sells automatically. Most brokerages will allow you to set a stop loss for 90 days. Many will now even allow you to place “trailing” stop losses, which will continue to ratchet up as the stock market continues to go up. The biggest problem with stop losses? When I was first using them, I placed stop losses too close, and they’d trigger during a normal day’s trading activity. You don’t want to have you stop loss trigger and then the stock immediately rushes to new heights before you can buy shares back.
You can control risk in a stock by purchasing or selling options. The concepts are a little complicated for the scope of our article, but here’s a primer. If you own a stock trading now at $100 and you think there’s a chance it could plummet, you can purchase an option to sell at $100 in the future. Sure, you’ll pay some money for that option, but consider it insurance. You’ll pay some money but can ride the storm, knowing that no matter how bad it gets, you’re able to still get out alive. The problem with options? These can be expensive to purchase if the “group think” market position is that things are going to turn worse. The seller wants to be fairly compensated for the risk of selling you the option….so they’re going to gouge you when there are dark clouds on the horizon. Want more basics on options? Check the the Securities and Exchange website pages on the topic.
These are tricky, but interesting ways to hedge risk. Contracts for difference (CFDs) don’t trade the actual underlying shares you own….they trade the price movement. When you buy a CFD, you’re purchasing a bet that the shares are going to move one way or the other. Here’s the way it works: if you own those shares at $100 we discussed above with options, instead of purchasing an option, you’ll buy a CFD predicting a downturn. You’ll still hold the underlying security, and if the shares lose money, you can hedge some of that risk because you made money on the CFD. There are sites specifically set up to trade CFDs, too. The upside? With an option, you have to sell the security to exercise your option. With CFDs, you can recoup some of your money and still hold the stock. The downside? Just like with options, the price will fluctuate based on the market’s thoughts about the future.
While there isn’t a perfect way to control your risk, ALL of these strategies beat “I think the market’s going down, so I’m getting out today.” By realizing that you’re a tiny player in a huge market, you’ll understand just how challenging markets can be and create a good exit strategy.