I have previously warned that short ETFs won’t save you in a bear market. In fact, they’re likely to increase your losses.
Buying and holding a short ETF to protect your portfolio from share price falls is therefore a bit like getting a man-eating lion to keep away the wolves.
So what can you do if you fear a falling market? Is there any action you can take to reduce or offset the decline in your stock market investments?
Price falls are in the game plan
First things first: Investing is a long-term endeavour, which requires you to create a plan and stick to it.
If you’re getting nervous because the stock market seems high or vulnerable, you should first consider if taking any action is sensible. Does your plan really involve you making market timing decisions, or valuation calls?
If you’re an active investor – who is willing to risk under-performing the market as a consequence – then you may have decided in advance that you’ll reduce your allocation to equities if the market looks expensive or over-extended by some specific metric. Perhaps you’re watching P/E ratios, for example, or 200-day moving averages.
Passive investors, however, should typically ignore all that, and instead drip feed money in over the long-term, rebalance according to age and asset moves, and ignore pointless prognostication from stock market pundits.
For you, a volatile stock market is to be welcomed. It increase your returns.
If you’ve set up a passive plan and you’re worried, then maybe you’d be better served by a game of tennis, a trip to the cinema, or just generally not looking at your portfolio for a few weeks – or even a few months.
I’m serious! Most people should allocate their money between different asset classes based on factors such as their age, risk tolerance, and their future financial requirements.
Changes after that should be made according to your own pre-determined rules, not rumblings in your stomach.
For example:
- A good reason to sell some of your equities would be that your holding has risen 50%, and now exceeds your pre-determind allocation band. You’re looking to reallocate some of that money into bonds, which locks in your gains, reduces volatility, and brings you back to your original asset allocation.
- A bad reason to sell is because you saw Robert Peston or Jim Cramer on the TV last night, frothing about an economic slowdown. Or because you fear the Russians are coming.
Turning from a passive grin-and-bear-it investor into an active trader just because the market is falling will probably prove a losing strategy.
You get none of the benefits of either approach to investing. You’re arguably even worse than a chump who dives in and out of the markets based on gossip in the pub – because you’re a well-informed chump who should know better.
Ways to reduce risk before a market fall
All that said, if you’re a newish investor and you discover you’re more risk averse than you thought, that is nothing to be ashamed about.
Investing shouldn’t be about emotions, but it definitely involves learning to handle them – and also learning more about yourself as you go.
You get a gold star if you have this revelation after making strong gains – as opposed to getting the fear too late, and deciding ‘to thine own self be true’ once the stock market has dropped 25%!
(In that case, I’d consider trying to be true to somebody else for a couple of years and taking action only after the recovery, rather than selling out at the lows).
Whatever your motivation, if the market feels over-extended and you want to take action, here are some better alternatives to buying short ETFs.
Rethink your asset allocation
Perhaps you’re more nervous about the ups and downs of equities than you anticipated. Maybe you’ve realised a few years of falling stock markets would really ruin your day.
Revisit some model portfolio ideas, and adjust your positions to something less risky, at the cost of less rewarding. Typically this will involve holding much more fixed interest (bonds) and allocating less of your money to equities.
Hold more cash
Don’t dismiss holding more cash to dampen down volatility in your portfolio. Private investors in the UK can get comparatively decent interest rates on cash (certainly compared to government bonds) and while cash clearly doesn’t rise in value like bonds when the stock market drops, it obviously doesn’t fall, either.
It’s also easy to deploy your cash reserves into a falling market, meaning your cash pile can do double-duty as a plunge protection fund.
Sell down your positions
A professional trader once told me that the best way to reduce risk is simply to turn your positions into cash. To sell, in other words.
There’s no feeling quite as nice as “going liquid” when you trade shares. No messing about with options or short ETFs or a pairs-trade.1 Just sell until you feel comfortable again.
Remember Capital Gains Tax. You may be best selling up in ISAs or SIPPS first, depending on your circumstances, since these are exempt from taxes on gains.
Open an offsetting spreadbet or contract for difference (CFD)
This is closer to what semi-active investors are looking for when they stumble across the short ETFs that don’t actually fit their needs.
Here you bet against the index (or a basket of shares) with a carefully-sized spreadbet so that if markets do fall and take your holdings with them, at least you’ll make something back on the spread bet.
You’re basically hedging your portfolio like a long/short hedge fund would.
The advantage is that you’re gaining some downside protection – if the market falls, the value of your bet against it will rise – without having to incur the trading costs of selling your portfolio, nor the potential capital gains.
If you really are a good stock picker, you can even gain if the market goes up, provided your own portfolio rises more than your bet against it.
Remember: This can be very risky. The most you can lose in a traditional share investment is the money you invest, but your losses are unlimited if you short a rising market. Because spreadbetting is tax-free, you can’t offset any losses against capital gains, either.
Read up on sensible spreadbetting before going any further. (A contract for difference is another option, and a whole other post. They are also risky!)
Trade options
Options are the professionals’ way to buy protection. That doesn’t make them a good idea for you or me.
I’ve never traded options. Pricing is non-trivial. Prepare to do plenty of your own research.
Create your own Guaranteed Equity Bond
If you’re very nervous, you might be tempted to invest via an opaque structured product from a bank, instead of putting your money into tracker funds or buying shares.
You might consider creating your own guaranteed equity bond instead.
It’s easy to tweak your DIY GEB to suit your risk appetite, and you’ll know exactly what’s under the hood.
Don’t believe the hype: The reason banks are selling billions of pounds worth of structured products is because they are very profitable for the banks.
It’s not because they’re a good deal for you and me.
Downside risks
All of these alternatives to a short ETF have their own pros and cons, ranging from the potentially substantial frictional costs of trading and taxes, to introducing new types of investing risks.
The biggest risk is the one you’ll hear the least about – that you sell off some or all your shares yet they keep rising afterwards, forcing you to buy back in at a higher price or leaving you with a permanently reduced exposure to equities as you vainly wait for the market to come back.
Markets do rise and fall, but in the long-term most Western stock markets have risen.
Many people wait too late before buying back into a rising market. Academic research suggests that trying to run you portfolio like a hedge fund is a losing proposition for the majority of private investors.
Even the pro fund managers have lost to the simplest tracker combination in recent times. A passive approach with occasional rebalancing will likely do better for most people in the long run.
If you’re going to meddle though (and I write as a meddler) then I think these methods have a greater role to play in sensible investing than short ETFs, which are more like Scooby snacks for day traders.
- This is where you try to offset one share that falls with another that will go up. You might hold an umbrella maker, say, if you are worried about your big position in a sunscreen manufacturer. [↩]
I have to dispute this 🙂 From the following sentence I think you mean a falling stock market, and that’s entierely correct. Volatility, OTOH, unless you have some sure-fire strategy to buy on the dips isn’t good for anybody except those treating stressed-out investors…
With the offsetting spreadbet, if you are shorting assets you own, and the short is smaller or equal to the asset, the downside isn’t unlimited. You’ll get kicked out of your short while your assets go up and still smile at you. As long as you sell as soon as you get margin called, if you screw up that way, you’ll still be better off. I’m a fan of shorting shares you own, if you get windy all of a sudden. I’ve paid good money to IG with a happy heart, because I’ve only shorted half the shares I own. All I did was get a little bit of peace of mind and give up half the potential gains. Sometimes that works for me, it’s like insurance.
I’m worried that TI is looking for a tin hat, mind you 😉 The Ermine is a nervous enough beast as it is, and I am looking to buy in a big way over the next five years! Head tells me that is good, but when good men start looking for the emergency exits and adopting the brace position it’s hard to stay with the theory…
Hi ermine 🙂
You’ll be pleased to hear I’m right. 🙂 You don’t have to have a falling market, just a volatile one, provided — as I say in the sentence above the one you take issue with — that you’re drip feeding money in regularly. The mathematics means it will nearly always (I hesitate to say *always*, because it’s been a while since I’ve done the maths, and I can’t remember if there are boundary cases) help you if you’re investing regularly throughout it.
If you follow the link I gave under ‘increase your returns’ to Mike’s video, he does the maths to prove it there.
Regarding the spreadbet, yes, fair point that on a technical level you’ll be booted out by the average spread betting shop when you run out of firepower. However:
(a) See your terms and conditions. In some instances you can still be on the hook (there’s a reason they sell guaranteed stops! 😉 ).
(b) not everyone has the same margin requirements, high-rollers don’t necessarily have to put up as much as you’d think for example
(c) more importantly, I don’t think it’s a good way to think about investment risk. If I bought a value share, I might be prepared to continually put money in as it fell, if I was convinced I was right, and so meet repeated margin calls. The same should be true of my offsetting spreadbet (in theory, anyway). It’s the theoretical unbounded risk that is so dangerous in this sort of operation, the actual amount of time you can stay solvent while the market continues to be irrational is just a mundane practical detail. 🙂
To turn from the scientific to the disreputable: Regarding the market, you know I’m going to say anything can happen over the next 3-12 months (or more!) For what it’s worth I am still very bullish on a 5-10 year view. Only the US looks at all richly valued to me, and that may be warranted given the growth prospects.
Like last time the FTSE 100 approached 6,000 I stopped putting new money in since after Christmas though, and I even earmarked a windfall lump sum of cash that I mentioned to Mike (Oblivious Investor) the other day for cash not equities. As I did last Spring, I’ve also been rolling into slightly more defensive shares (e.g. Unilever, LLPC), though this isn’t the place to go into all my moves.
This shouldn’t be seen as bearish as such, it’s just a matter of trying to be sensible after being so almightily long for the past three years. (No bonds for most of it, very little cash held either). I’ve also been doing far too much fiddling with the active bit of my portfolio over that time, and the portion marked ‘active’ has grown, too (one reason I welcomed The Accumulator to the blog with open arms — I’d rather not preach what I’ve been practicing at the wilder fringes of my operations) although in total annual portfolio turnover is still only in the high teens at a guess.
Incidentally, I was also outrageously fortunate with my CGT defusing that I mentioned on Twitter this morning. Like you, I’d love a nice fall now to put all this cash to work.
My net worth was at a new all-time high around the end of March, and it doesn’t pay to be greedy. But I’m still very long equities, though not the indices so much, and not as full-on as I was.
Too much information, probably. 🙂 If I ever write in blow-by-blow detail about the active trading part of my portfolio, it will either be on a different blog or in some sort of members’ section of Monevator. I genuinely don’t think it’s the right course for most people to follow, however it turns out for me. (Academic research suggests you’d have to trade for well over 100 years to separate skill from luck).
Crikey. Okay, it’s been too long since I did maths at uni, though I might be able to rustle up the algebra. However, I’ll be a lazy bum and simulate this with Excel for a constant SP and regular purchases with variying amounts of random SP perturbations. And if it’s right a) fess up and b) seriously change how I accumulate shares, as the iii £1.50 sharebuilder allows me to buy in 6 monthly staged lumps for the same dealing costs as one instant trade. It’s extremely counterintuitive to me, but susceptible to testing.
An interesting ahem, ‘active’ rathole to consider for an article would be that active investors operate in two unconnected domains, though they’re usually lumped together as active. One aspect is stockpicking, skewing what you invest in. Even passive investors do this, albeit by the choice of the particular asset allocation. The other aspect is timing/buying/selling, ie when you hold an asset.
I’ve done okay with the first, but I am no good at the second. My turnover is moribund compared to yours, and what I have sold I shouldn’t have done. So I’m trying to go with the Charlie Munger lifetime 20 stock punch card idea.
Glad to hear you’re not yet in the brace position – the move to more defensive and cash sounds reasonable for someone who’d been full-on bullish into the teeth of the recession 😉 And yep, I could also use a good old market crash in the next year or so. There has to be some mileage in that Eurozone crisis yet!
Well I’m damned – you are quite right. Simulation appears to show volatility + averaging in has a small but repeatably positive effect. Even with a volatility that would scare any sane investor out of the stock. I will try the algebra to get an understanding of why, and whether it is applicable with real-world trading costs.
@ermine — Good stuff on testing the algebra with simulation, and you’re not the first person to find it counter-intuitive on discovering it. (I got to the front of that queue, albeit it many years ago).
Costs don’t matter (you’re only selling, not buying, and anyway into a tracker there are no costs). If you mean whether it’s worth keeping a lump sum back and dividing into monthly costs to take advantage of volatility, that’s more about your temperament IMHO then about what’s mathematically ‘right’. If I recall correctly, because markets generally go up, probability says you should invest a lump sum in one go, as you’ll probably lose by delaying. But many get a psychological benefit from averaging in even a lump sum.
I tell virtually all my friends to invest monthly into a selection of trackers held in stocks and shares ISAs and to forget about what happens for 20 years. Given all the benefits – of which turning volatility to your advantage is just one – the chances of them beating it by active fiddling approaches zero, I think.
Perhaps the most dangerous position to be in is an enthusiastic and stock market mad investor like myself. I *love* the challenge of active investing. But I’m under no illusions.
On a bad day it’s heartbreaking that investing is not like virtually all other human pursuits — where the more you study and the more active work you put in, the better you can be expected to do. In investing, for most people most of the time, the opposite is true.
Hence why we bang on about drip feeding into trackers and mechanical rebalancing around these parts — these days mainly via The Accumulator’s posts.
I am drip feeding, but suppose my other half wasn’t – one-off lump sum.
Should she simulate drip-feeding by rebalancing regularly? As opposed to my advice which was “right, that’s your ISA limit full, same time next year?”
I seem to remember the Monevator rebalancing article I’ve read suggests there’s no big gain to be made from different rebalancing strategies, you just need to make sure and rebalance at some point?
“On a bad day it’s heartbreaking that investing is not like virtually all other human pursuits — where the more you study and the more active work you put in, the better you can be expected to do. In investing, for most people most of the time, the opposite is true.”
Being above average means you need to be above average. The average in the stock market is a fair amount of experience, knowledge and time invested so to be above average requires almost superhuman endeavour. I do still believe that with the right temperament (ability to learn from failure and to forever question your judgement) and enough experience and broad knowledge of company success and failure stories you can do well, but with competition so high it needs exceptional achievement to beat the average.
Investing is a very simple thing to do until you actually go and do it. Drip feeding into index funds is right for 99% of people, but I think its harder to do than active invested from a psychological perspective.
As always the best thing is the right allocation of assets in the first place.
A bit of a mish-mash of advice here. Some good stuff about sticking with your investments and steadily channeling your savings into buying more of the same holdings. But then you go off on selling into a falling market as some trader recommends and also using options and hedges. All of those are wonderful ways to lose money while looking incredibly sophisticated.
What you started with is the only good advice: pick your mix of stocks and bonds assuming that stocks can lose 50% or more just like that. Then simply stick to it at least until you get close to retirement. It’s not fun and sometimes scary but it’s the only rational approach.
@Long-term returns — No I don’t, with respect did you read or skim the piece?
With falling markets, I say try to sit tight, unless you have discovered something about yourself and your attitude to risk that you didn’t realise, probably because you were a new investor. It’s all very well telling every one to buy in bear markets etc, and I’ve been doing it for years here. But many people find it difficult. If a new investor discovers they are much more risk-averse than they thought, it’s better they live and learn then get a drinking habit and a divorce.
With options, I explicitly don’t recommend them.
A short/hedge against the market via a spreadbet is easy to implement. But I conclude with a warning very similar to the advice you give in your comment.
My apologies. I mistook the listing of possible things an investor might do in face of a falling market as implicit advice.
@LTR – No worries, thanks for coming back.
I would be grateful if someone could some recap the gist of Mike’s video for me please? It won’t play on this device and I’d love to know how the maths works.
Good overview, Investor.
To me, the worst part about unrealised losses is not the losses themselves, but how investors react to the losses. The average investor tends to sell when their shares fall in order to stop the pain (and buy when everyone else is doing so). It’s a natural reaction — we wouldn’t have survived long as a species if we didn’t try to avoid pain — but it’s the opposite of good investing. Selling low may relieve short-term pain, but augments longer-term pain.
We all have our breaking points, though. Anyone who could sit idly by when his portfolio loses 80% is either a robot or a glutton for punishment.
So the question becomes: “How much of a loss can I handle before I do something stupid?”
A lot will depend on your time horizon, other sources of income, etc. Perhaps the question we ask ourselves is – “If I lost 10%, could I afford not to sell?” If you answer no to that question, then you should probably rethink your equity exposure. Maybe 25-30% would be appropriate. That way, if the share market falls 25%, your fixed income portfolio would help buffer some of those losses and help you sleep better at night.
On the other hand, if your portfolio lost 30% and you’d be willing to put more money into shares, then equities should be a larger percentage of your portfolio. Buying when the market is down significantly is easier said than done, however, and it takes an ironclad stomach to do so.
The important thing is to be honest with yourself. There’s no shame in a 50% equity / 50% bond portfolio for a 35 year old, for example, if that matches your risk tolerance. You’ll end up making less mistakes and likely realize suitable returns in the long-run.
The rule of thumb I’ve seen proposed is to have your age be the percentage of fixed income in your portfolio — i.e. if you’re 45, then 45% of your portfolio should be in fixed income. I would say that’s what the average investor should do based on average investor risk tolerance, time horizon, and objectives. That heuristic doesn’t apply to everyone, but it could serve as a good allocation benchmark if you’re deciding how much equity/bonds to have in your portfolio.
My investing strategy is simple; mutual funds with 25% into each of these categories: aggressive, growth, growth and income, and international. That’s it! I like the passive nature of it, and I don’t have to try and time the market.