The Rise & Fall of the World's Stock Markets
As happens from time to time, stock markets tumble (For example, read about Black Monday). Novice investors may expect markets to rise forever, but that is not reality. For your financial well being, it is mandatory that you, and all traders and investors, know how to operate when the stock market has a mind of its own.
The first rule is to be prepared. That is accomplished by having a written investment plan that describes the 'big picture.' Three popular plans are:
- Buy and hold. Remain 100% invested at all times. When it becomes time to add cash to your investment portfolio (monthly, quarterly, or annually) do so without fail.
- Allocate assets to more than one type of investment. A rising stock market will result in your having a relatively large portion of your assets in stock. That is the appropriate time to sell some stocks and re-balance your portfolio by investing the proceeds into other investment classes. (For most people, that means bonds, but other choices are available to the sophisticated investor. Warning: Do not diversify into asset classes that you do not understand.) NOTE: This is when greedy investors forget that asset allocation is the name of the game and refuse to sell stocks after a substantial rise.
Declining markets mean that stocks represent a smaller portion of your total assets and that is the time for investors to sell other assets and allocate the proceeds into stocks. NOTE: This is when fearful investors forget that asset allocation is the name of the game and refuse to buy stocks after a substantial decline.
Greed and fear can kill an investment portfolio. Avoid these emotional decisions by following a sound asset-allocation plan.
- Time the market. Buy more stock when you believe the market is moving higher. Sell some stock when you believe the market is headed lower. Despite an abundance of evidence that the vast majority of individual investors cannot outperform index funds, many waste time and money in an effort to do so.
Asset allocation is the most sophisticated of these plans, and has been shown to perform best over the longer term. However, this plan is not for everyone. If you do not understand other categories, then it is not a good idea to invest your money in something that is foreign to you.
Earning extra money by timing the market is truly very difficult. One major problem with market-timing strategies is that they are based on emotional, rather than logical, decisions. A few days of lower stock prices convinces too many people to dump their stocks. Similarly, a few days of higher prices convinces those same people to jump back into the market.
Brokers love that commission-generating behavior, but it is a money-losing proposition for investors.
I am not a fan of simple buy and hold methods, but they have worked well for decades. When buy and hold is combined with frequent portfolio analysis (do you really want to continue to own these stocks today), it is very effective.
Options can be used to reduce risk. For example:
- Replace long stock positions with in-the-money calls, thereby limiting losses to the cost of the calls -- while still earning big profits when markets surge.
- Writing covered calls to generate income during dull markets. This strategy produces winning trades more often than the buy and hold strategy, but it does limit profits -- and that is a negative for some investors.
- Write cash-secured puts as a method for accumulating stock in declining markets.
Whatever your investment choice, the prudent investor has a long-term plan and does not panic when the market behaves unexpectedly.