Successful investors know managing risk is as important in good times as in bad.
Last week I heard a couple of unrelated items that brought to mind a good investment practice every investor should follow: risk management. However, as with many things in life, good practices often slip in importance when times are good.
It can be difficult to remember to protect ourselves when we’ve forgotten the pain that hardships, such as large portfolio losses and volatility, can bring. Unfortunately, investors who experience this type of “risk amnesia” may not be doing all they can to protect their wealth.
The calm before the storm?
The first item that came to my attention last week was the good economic news. With 3.9% unemployment and the addition of more than 200,000 nonfarm jobs last month, the U.S. economy is looking strong. Inflation remains quite low, as do interest rates, and all of this exists in the midst of new tariffs, the threat of a trade war, and countless other fears investors live with every day.
As impressed with the strength and resilience of the U.S. economy as I am, I cannot help but think back to prior times when the economy appeared to be this good. The two periods that quickly come to mind are 1999–2000 and 2006–2007. Both periods felt good at the time because, like now, the economy was growing in an apparently constructive manner and the stock market was rising.
Get protection in advance
The second item I heard was the story of how a gentleman’s very expensive collector car had been totaled in an accident. Fortunately, nobody was hurt, but his pride and joy (and prized asset) was a total loss. He went on to happily share that he was so pleased with the insurance coverage he had on his prized asset. It dawned on me then that he made the wise decision to take the action to manage the risk of owning such an asset by protecting it in advance of his potential need, while his asset was safely tucked away in the garage.
I am sure you can see where this line of thought is leading. The car investor was smart and purchased insurance on his asset while “all was good.” Stock and bond investors tend to get lulled into thinking that they have no need for risk management for their portfolio—especially when times are good. Jerry Wagner (the president of Flexible Plan Investments and this column’s regular author) and I have each been investing professionally for more than 40 years. Too often we have shared stories of those unfortunate enough to have their lives adversely altered by not protecting their portfolio assets with some sort of risk management … risk management that is available to all investors.
The cure for “risk amnesia”: Risk management
Successful investors are often successful because they deliberately and simultaneously engage in two activities:
- Dynamic, active pursuit of profit opportunities.
- Dynamic, active risk management.
The word “dynamic” refers to the many and adapting forms of profit pursuit and risk management.
These two activities seem like common sense—and they are. That is why they are routinely done by professional and institutional investors. They are not as commonly done by individual investors, but they can be done and should be done by them too.
Successful investors have learned that bad times often follow good. Yet, it is from the depths of those challenging times that the greatest investing opportunities arise. Take, for example, the following list of recent challenging market periods—just a few in which investors had opportunities to greatly benefit from employing dynamic risk management as an ever-present part of their portfolios:
- 1997 Asian financial crisis (-11% in three weeks).
- 1998: Russian financial crisis/long-term capital collapse (-19% in six weeks).
- 9/11/2001: Markets closed for five days with an ensuing market decrease of 12% in five days.
- 2001–2002: Bankruptcy of Enron, WorldCom, Conseco (-50% bear market).
- 2008–2009: Lehman Brothers, Washington Mutual, etc. (-50% bear market).
- 5/6/2010: “Flash crash”—$1 trillion in market value lost in 36 minutes.
It does not seem to matter on what decade we focus because the discussion with individual investors in good times has always been the same. It has always been around their perceived need (or lack thereof) for any activity associated with risk management, especially if there was any cost involved with such activity.
Remember, we are talking about a common-sense activity that is repeatedly perceived as important in times of market decline but too often seems unreasonable during “the good times.”
Successful investors know that actively seeking opportunities to make profits and to manage the risk associated with those profits is a full-time and all-of-the-time activity. That is what makes them successful.
The following illustration uses one of Flexible Plan’s Core Strategies (Evolution Plus – Balanced) as an example of how an active pursuit of profits with a built-in, ever-present, dynamic risk-management component can contribute to an investor’s long-term success. It is important to note that in the example illustrated below, both the dynamic and active profit pursuit and risk-management processes are working together at all times. At times, the profit-pursuit process dynamically and automatically takes the lead role, and at others, the risk-management process dynamically and automatically takes the lead role.
To address the concern of cost often raised by individual investors (but, interestingly, seldom by professional investors): All of the costs (and maximum costs at that) associated with the underlying investments and the profit-pursuit and risk-management processes are built into the results shown in the example.
Market and strategy update
What are we seeing through the view of the Flexible Plan “library of strategies”?
One of the many benefits of having such a large and diverse library of strategies is our ability to see through the objective view of the individual strategies what is going on in the many markets and asset classes in which we invest.
This past week our longer-term equity strategies remained invested, and those that could use leverage were doing so to some extent. For instance, our Market Leaders Sector Growth strategy was fully invested in sectors that reinforce the positive economic data recently reported.
Among our fixed-income strategies, Strategic High Yield Bond has been fully invested, reflecting the recent modest uptrend in high-yield-bond prices. Government Income Tactical had modest inverse exposure last week, reflecting the sideways trading range government bonds have been in for the past seven months. Our fixed-income strategies, in general, have recently favored high-yield bonds and domestic bonds with intermediate-term maturities. While the Fed has been raising interest rates this year, they have been doing so in a fairly well-orchestrated manner in line with their well-broadcast intentions.
Among alternatives, precious metals have gotten much of the publicity. The metals have been under selling pressure for some time. However, many of the alternative strategies we follow and employ have been on a move higher in the past two months. It is worth noting that when we speak of “alternatives” we frequently mention gold only because investors often think of it as the representative of the asset class. However, it frequently does not accurately reflect the conditions or trends all of the physical commodities and investment methodologies that make up the alternative asset class.
There will always be many profit and risk-management opportunities to pursue in our future. We are confident our dynamic and active approach will greatly aid in our efforts to be successful at both.
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. Inherent in any investment is the potential for loss as well as profit. A list of all recommendations made within the immediately preceding twelve months is available upon written request. Please read Flexible Plan Investments’ Brochure Form ADV Part 2A carefully before investing. View full disclosures.