The No. 1 Rule of All Successful Investors
One of the worst things you can do is leave your portfolio unprotected.
It doesn’t matter how bullish things appear, trading without protection is a great way to lose a great deal of money.
Markets hit all-time highs. Optimism and confidence in markets soared to unbelievable heights. There was nothing but euphoria. Nothing could stop the rally.
Investors were pouring money into stocks on the idea of an improving economy. Unemployment was at historic lows. Thousands of people were becoming millionaires every day. Investors were mortgaging their homes just for a piece of the market action.
Investors couldn’t lose. Or, so they thought.
Then the Crash of 1929 hit out of nowhere, and wiped it all out.
We saw similar crashes in 1987, 2000 and 2008. And each time, many investors were so caught up in the “can’t lose” euphoria that they never bothered to hedge for the “what if.”
Over the last few years, we saw much of the same euphoria, and the idea that nothing could stop the rally higher. And while we’re not saying we’ll see a near-term repeat of 1929, we are saying that very few of us are really well prepared for even the possibility.
In early February 2018 for example, the Dow slipped 2,000 points.
After a 10,750-point move higher in a year, fears of inflation began to appear. Now, there were fears that the Federal Reserve, now under Chairman Jerome Powell, could accelerate interest rate hikes and potentially slow our red-hot economy.
With a tighter job market, higher wage growth and the idea that tax cuts could accelerate growth, there are concerns of higher inflation, which could lead to higher interest rates. If, for example, inflation soared above 2% — which is a concern – the Fed would be forced to quickly accelerate hikes to tighten credit and stop inflation threats.
That concern fueled a good deal of the fear in the markets at the time.
Yet, many investors were never prepared for the potential “what if” factor.
So, how do you prepare for such a situation?
One thing I can tell you for certain is that it’s never a good idea to panic.
With recent market swings in both directions, there are four key pointers to follow.
Tip No. 1 – Never panic
If you panic, you sell. And if you sell, you miss the potential for the recovery rally.
We have to remember that markets are resilient and eventually recover, as they have historically. In fact, look back at the history of bad moves and you’ll see that each time they were followed by a recovery rally.
Days after the cowardly acts of September 11, 2001, the S&P 500 fell from highs of 1186 to less than 985 – a loss of 17%. By December, the S&P regained 1173.
On March 11, 2004, a commuter train bombing n Madrid left 191 people dead. Spain’s IBEX 35 fell from highs of 8204 to less than 7681 in a day.
By April, it regained highs of 8,478.
In 2008, markets sank from more than 10,000 to a low of 6,500 before the Fed stepped in, sending markets to all-time highs.
After the pathetic Boston Marathon bombing of 2013, the S&P 500 lost a bit more than 2% of its value. The market recovered that lost ground in two weeks.
We’ve seen similar resiliency in Mumbai train bombings, Tokyo subway attacks, the London bombings of July 7, 2005, and the USS Cole bombing, among others.
While none of us can accurately predict the severity of reaction to any events, history has proven that sell-offs have been consistently short-lived.
By removing the human emotion from a trade, the better your portfolio can perform.
Tip No. 2 – Consider buying the dip
Wait to see where the market begins to show signs of catching support and recovering. Also, be sure to wait for signs of a higher move to avoid buying into head fakes. We also have to remember that the U.S. economy is still strong. GDP growth, unemployment, consumer spending, and tax reform could fuel higher highs.
We can also spot dips using technical indicators such as the Bollinger Bands, Williams’ %R, MACD, and relative strength. In fact, shortly after the Dow plunged 2,000 points look at how these indicators alerted smart traders to the oversold opportunity.
Each indicator was deep in oversold territory at the time.
Tip No. 3 – Do nothing and wait for the storm to blow over.
It may take some time for investors and traders to feel confident in buying again. If you’re most comfortable waiting for the possibility of a resumed rally, do so. It’s your money. Take your time. But remember, markets are resilient and can snap back quickly, too, as we noted above.
Tip No. 4 — Always be hedged for the “what if?”
In early February 2018, the Dow Jones plummeted 2,000 points.
On top of that, analysts began to argue we could see a 10% correction, or a drop of 2,500 points, which should scare you. What should also scare you is if your portfolio isn’t hedged against the possibility of such a decline.
In fact, to be very honest with you, it’d be downright stupid not to protect your portfolio here. Granted, no one can time a potential correction. But we still prepare for it just in case. We also have to remember that bull markets are born in pessimism and end in euphoria, just as we saw in 1929 and 2008.
We must also remember that when analysts get far too bullish as they just were, it happens near market tops, not near market bottoms.
Consider that the next time you leave your portfolio unprotected.
Some of the best ways to hedge for market downside at any time is with these four opportunities.
- Consider moving some of your portfolio into cash
- Trade the potential for Volatility by buying Volatility Index (VIX) calls
- Buy a put option on the NASDAQ, the DIA or even the SPY
- We can even hedge our long positions with ETFs, as well, including the Pro Shares Short S&P 500 ETF (SH), the Pro Shares Ultra Short S&P 500 (SDS) and even the Pro Shares Short Russell 2000 (RWM).
It’s never safe to leave your money unprotected without a hedge.