Safely Investing for the Long Term
Avoid Panic When Markets Decline
When markets decline, and especially when the decline is deep enough to frighten a substantial number of investors, put options become much-desired commodities and prices soar. This price change comes from an increase in the implied volatility.
The conservative, well-prepared, investor understands risk management and has some method in place that cushions his/her net worth against a stock market debacle.
Those investors never panic and buy/sell decisions are made on their merits, and never out of fear. When they want to own put options -- or adopt a different portfolio management technique -- they already own them as part of their ongoing strategy. There is no need to pay up for options just because unprepared investors (and speculators) drive prices higher.
Michael Batnick at The Irrelevant Investor describes how long-term investing is supposed to work:
I absolutely believe that stocks are the best game in town. I don’t think there is a better way for the average investor to grow their wealth. However, this is called investing and the price of admission is gut wrenching drawdowns and sometimes years and years with nothing to show for it. If you can accept that this is the way things work, you can be an enormously successful investor.
The majority of investors tend to remain 100% bullish at all times.
That investment philosophy can be successful for people who understand how the market works. Such investors invest in risk management ideas that limit the size of any drawdown (i.e., they do not lose so much money that they feel a need to sell everything in a panic). This allows them to remain invested and to participate in all bullish markets.
But there is no guarantee that the future will resemble the past, and you do not want to be one of those people who make rash decisions out of fear. When (not if) a steep decline does occur, you can rest easy because you know that all losses are limited and within your comfort zone.
As we all know, selling at the market's low point is very unrewarding. It wipes out years (decades?) of growth.The truth is that we never know when the bottom is nigh, but we do understand when the money lost has reached a level that is far beyond our comfort zones. That is what causes panic and the dumping of investments. Sure, dumping preserves what remains of their savings -- and such preservation is never a bad idea. However, some preparation can prevent you from ever finding yourself in a very painful situation.
This is not to suggest that you buy so much insurance that 100% of your assets are protected because that cannot be accomplished at a reasonable cost. Nor am I telling you that you will always know when the market is about to decline. However, there are some option strategies that you can adopt -- on an ongoing basis -- so that you can withstand the stock market's declines with a minimum of pain.
Bearish vs. Bullish
History tells us that investing with a bullish bias has been the right thing to do.
Collected data tells us that when individual investors try to time the market, it is a losing proposition for the vast majority.
- The ideas discussed here are targeted to investors who are willing to take out an insurance policy - and accept the fact that they will earn modestly less money when markets are rising -to be certain that large losses are avoided. It is your individual comfort zone and tolerance for risk that determines just how much you are willing to lose when the markets turn bad. And we do know that bear markets are a fact of life.
Typical bearish strategies that can be used for portfolio protection:
- Dump your stocks and replace them by owning high-Delta (~80) call options. One option for every 100 shares. If you do not own stocks in 100-share increments, then consider:
- Own out-of-the-money index put options, but buy them when no one else wants them. That is when implied volatility is low.
- Buy OTM put spreads. This costs far less but comes with only limited protection.
- Write covered calls on your existing stocks. Again, this is a limited protection plan.