Sooner or later stocks, bonds or both will be affected by market conditions. And while the “buy and hold” strategy followed by most investment managers and financial advisors may have paid off in recent years, you’re taking a big risk if you think it’s going to continue for years to come.
As we’ve previously noted, the current bull market is one of the longest in history, thanks to manipulation by the Federal Reserve Board. This year alone, the stock market had already set records 40 times as of Sept. 18.
Maybe the bull market will endure and stock prices will continue to set new records, but do you really want to take that chance with your life’s savings?
Active investment management may be the right antidote. As active investment managers seek to manage risk and limit losses, they are particular effective during volatile markets.
“Buy and hold” investment managers typically hold onto assets even when they’re losing money, assuming that diversification will mitigate risk.
Diversification may not help moving forward, though, as the Fed has announced that it plans to begin reducing its $4.5 trillion bond portfolio. While it is doing so cautiously, the reduction is likely to increase interest rates, and could affect both stock and bond markets.
The Fed’s quantitative easing program and easy money policy resulted in both stock and bond prices increasing for more than seven years. Conversely, what if a change in direction by the Fed has a negative impact on both markets?
We’re not expecting stock prices to plummet like they did in 2007 and 2008, but it’s best to be prepared. At that time, the prevailing advice among “buy and hold” managers was to stay put.
Those who did paid the consequences. Some have still not recovered. Remember that when your portfolio loses value, the stock market will recover before you will, because your portfolio will be smaller, which results in less of an impact if prices recover.
Assume your $1,000,000 portfolio is all in an index fund that is correlated to market performance. Your portfolio loses 50% of its value when the market drops by 50%, so it’s worth $500,000. When the market gains 50%, though, your portfolio is worth only $750,000 ($500,000 + (50% x $500,000)). This example is for illustration purposes only.
How Active Management Works
“There are two ways to mitigate risk,” Steven Williamson, a member of the National Association of Active Investment Managers, told CNBC. “The active manager moves funds as needed to limit losses by strategy, and the [passive] asset-allocation [proponents] who buy and hold, assuming that one asset class rises when another one goes down.”
If, as “buy and hold” managers often point out, you can’t time the market, how do you, as an investment manager, know when it’s time to sell?
Technical analysis. Active investment managers may follow many different strategies, but they typically take technical analysis into account. Technical research can help predict market performance. When technical analysis shows that stock prices are likely to drop, active managers can use that information to take action, such as lowering the equity allocation in client portfolios.
Stop-loss alerts. Active managers use sophisticated technology and economic data to identity the impact of economic and financial variables, such as corporate profits, interest rates, inflation and unemployment. Using proprietary models based on these factors, active investment managers can determine whether investors should be heavily invested in the market – or whether they should temporarily pull money out.
Models are not foolproof, of course. You may miss days when the market makes significant gains, but it is even more important to miss days when the market suffers significant losses.
Models used by active investment managers generate “alerts” that tell them when it is time to buy specific assets and “stops” that tell them when it is time to sell. A stop loss point is established whenever a new investment is made. If the investment appreciates in value, the stop is moved up to protect the gain. If the investment declines in value past the stop-loss point, the investment is automatically sold.
Active management does not prevent loses. Loses are a fact of life, no matter what investment strategy is used. However, the use of stops alone can prevent major, portfolio-draining losses, such as those experienced by investors in the financial crisis of 2007 and 2008.
Price targets. Price targets can also help determine when an investment should be sold. Price targets for a stock are calculated through a thorough analysis, including a review of its trading history, its price-to-earnings ratio and many other factors. If a security increases in value and reaches an expected target, the active manager sells all or a portion of shares in the stock, guaranteeing the gain.
Hedging. Hedging is used to reduce the risk that an investment will decrease in value by investing in an offsetting position in a related security, such as an options contract. An options contract obligates the buyer to purchase the stock or other asset at a predetermined price at a future date.
Investment managers may also hedge by investing in securities that have a negative correlation to each other. For example, stock prices typically increase when the economy is improving, while gold prices typically increase when the economy is performing poorly. Investing in both can help to mitigate risk.
While past performance does not guarantee future results, these tools historically have helped investors significantly reduce investment risk and increase long-term gains.