Click this link for access to a free Family Wealth Education Institute class on advanced estate planning and estate tax control/elimination personally taught by Dr. Camarda & “Super Board-Certified Tax Lawyer” John Crawford.
The global economic and investments collapse of 2008 changed the world for many investors, and the aftershocks of volatility and unstable markets continue to the present day. The markets remain extremely treacherous and may be facing the stiffest headwinds of our lifetime. Conserving, growing, and protecting our families’ wealth from numerous threats has never been more challenging. Maintaining the capital needed for a comfortable retirement lifestyle has become much harder since the Great Crash of 2008 and the market freefall of early May, 2010. Getting our portfolio planning just right has never been more critical. The more you understand the factors affecting your money, the smarter decisions you can make to protect your interests – and your future.
A Brief History of The 2008 Collapse
The crash of ’08, bottoming in March of 2009, was the major down leg (we hope) of a secular bear market begun in March of 2000. The popping of the equities asset bubble is widely attributed to the economic carnage stemming from the collapse of the massively-overvalued real estate markets, which had become widely speculative and overbought on the wind of very low interest rates and completely undisciplined loan underwriting – anyone, it seemed, could borrow any amount at near-zero rates with almost nothing down for any purpose connected with real estate, whether it seemed likely they could ever repay it, or not. There is, of course, much more to the story, but virtually all assets – stocks, bonds, loans, real estate, even commodities like gold and oil – joined together in one great re-pricing swoosh of the economic toilet. Stocks got clobbered because their values are a function of expected future profits, and with the world facing an economic black hole, it did not look like anyone would be making much money anytime soon.
The bottom for stocks (and many other assets) seemed to be found in March of 2009, and the markets have staged one of history’s greatest rallies in the year following, a rally in my opinion just begun, and which I think will persist many, many years, bringing great wealth to shrewd investors. Tentatively, investors have reluctantly regained faith in the market since then, faith that was sourly tested in May of 2010.
The Phantom Crash of May, 2010
The new bull market showed impressive strength in early 2010, thrusting fitfully higher through the first four months of the year. In April, after looking like it was taking a serious shot at DOW 12,000 (a pretty impressive run, as the March 2009 bottom was only a little more than one-half that), the market showed signs of being ready for a breather, or mild correction. Many technical indicators pointed that way, and onto this finicky stage came the Greek riots. Now, the social ills of the fiscally irresponsible Greek welfare state are an entirely different kettle of fish than any of the futures which seem possible for even socialist-yet-prosperous European countries like Germany, let alone the United States, yet footage of civil violence spurred by economic collapse are quite disturbing and were more than enough to spook investors and kick off a stock market selloff that was probably in the cards already anyway. What happened next was almost unbelievable, the stuff of science fiction stories. For reasons still far from clear as this is written, the vast, entwined, ungodly-complicated network of dispersed trading computers which are the reality of today’s stock market (no matter what you think from seeing broadcasts from the floor of the New York Stock Exchange on TV – the real market is in outer-cyberspace these days) malfunctioned, and began showing make-believe trading prices as low as $0.01for shares that never, ever got even close to those lows – not even in the same universe as those lows. The stock indexes that you see on TV – like the DOW – are really just ghostly reflections of the transaction prices these computers show, so the indexes themselves took a make-believe phantom dive based on absolute garbage data, scaring the be-Jesus out of an investing public, eyes-glued-to-tube, already pretty spooked by the Greek riots.
The Phantom Crash (the media is calling it the “Flash Crash”) was all over in 20 minutes – way down, then way up as the computers corrected – but the aftermath will be with us for a long time. Investor attitudes and behavioral biases changed fundamentally during the 2008 Crash, adopting a Depression pallor that will likely last for decades, and this recent event will only reinforce the shift.
So investors have become concerned with downside protection like possibly never before, and because of this we write this report for you. Whether or not actually using any of these techniques makes sense for you is a matter for deep discussion between you and your advisor. But here are the basics.
Understanding the Basics of Hedging and “Portfolio Insurance”
Hedging means no more than owning something that will maintain or go up in value if something else you own goes down. Fire insurance on your house is a simple xample. So long as your house does not burn, the insurance has no value, in fact costs money (as do all hedges in some form). If the house burns – going way down in value thereby – the insurance goes way up in value, to the limits of the claim. That’s really all there is to it. “Portfolio insurance” can mean many things, but typically involves the purchase of options, futures, or other derivatives that should move in a direction opposite to the risk being hedged. Like insurance, hedges can closely or only loosely track the downside we wish to protect against. A life insurance policy can cover death from any cause, or a cheaper policy may cover only accidents or airplane crashes. The death benefit amount may be enough to replace all future income, or only enough to dig a hole and buy a casket. Like insurance, the better the coverage, the higher the costs. In the investments world, perfect coverage – eliminating the possibility of any loss at any time for any reason – is so expensive it eliminates the possibility of any gain – the hedges pretty much wind up costing as much as all of the potential return from a risky investment. So most investors who use “portfolio insurance” choose to only partially hedge, just paying for enough protection to limit instead of eliminate losses.
How stop-loss orders can protect you if stock prices collapse
One of the most basic “downside protection” techniques for stocks is stop-loss orders. A stop loss order is one that becomes activated when the stock trades at a particular price lower than the price at the time the order is placed. This idea is that if the price falls to your maximum loss level, you have left “automatic” orders to sell the stock. A regular stop order becomes a market order when the stop level is hit, meaning the stock will sell at whatever the price happens to be when the order is activated, and not necessarily near the stop price – it could be lots lower. A stop-loss-limit order is activated at the stop price, but will only be executed if someone is willing to pay your limit price once that happens; if the stock is dropping rapidly, the stock may never get sold.
Using stops like this makes sense if you want put a “maximum pain” floor under your holdings, like 20% under your purchase price, “high water mark,” or other value parameter that you need to carefully decide on, and then regularly update. There is no cost to setting a stop limit order, except the commission you would have to pay if the trade goes off, so this is a very cost effective way to hedge a little and get some limited protection. Remember that there is no assurance that the stock will be sold – especially with a limit order – so if you want higher “quality” “insurance” and are willing to pay for it, consider buying put options, witch give you the right to sell at a predetermined price even if the stock goes worthless, as discussed in the section below.
Orders like these only work for securities that are actively traded all day, like individual stocks and ETF’s. You cannot use them for mutual funds, since they do not trade at all, really. Whenever you buy or sell a mutual fund, you get the price of the day, which is figured after the markets are closed, and they figure up the closing prices of all the underlying securities that make up the mutual fund. You always get the next price figured after you place your order. If you want to try to time the price of a mutual fund (usually a bad idea) you want to wait until near the very end of the trading day to get a sense of where the market will close, and ballpark it from there.
How to use put options as a last-resort if markets free-fall
Put options are easy to understand if you try just a little. A put gives you the right – but not the obligation – to sell your stock at a given price for a certain period of time, generally no longer than 9 months. You have to pay to get this right, and what you pay is called the “premium,” just like insurance. So this means for a limited period you can sell your stock at a given price if you want to, usually a price far lower than where the market is when you decide to sell, or “put” it to a buyer who was paid a premium to take on the risk of a falling stock price for you.
If own individual stocks and are concerned with being sure of getting out if the markets really tank, consider buying puts – one contract for each 100 shares – at a price lower than your stop limits. This lets you, relatively cheaply, have ultimate “get out” insurance if you need it, while still relying on free stop-loss-limit orders as your first line of defense. If it hits the fan and prices fall through your stops, the puts guarantee that you will get out at some pre-determined price you have had time to plan for. As you probably guessed, the higher the “strike” or exercise price of the put – the higher the price you get to force someone to buy for – the more you have to pay for the right. So you want to be careful to be sure you minimize your cost to maximize the downside protection you feel you need to buy with puts. Because the puts are only good for a limited time, you will have to keep buying the “insurance,” or “rolling” the options portfolios, and should develop a cost-effective plan to manage this, either with an advisor who knows what they are doing, or by developing the required knowledge on your own. This needs to be planned very carefully to make sure you both do not overpay, or find yourself without this protection when you might need it most.
As a coordinated strategy with stop orders, you might consider setting stop limit orders at something like 15-20% less than your target value – a loss of 15-20% off that – and puts 5-10% lower still, to set guaranteed maximum loss levels at no more than 20-30% lower than your trigger points. A strategy like this should be both extremely cost effective and give you reasonable “worst case” downside protection. Or you may not what to tolerate this much potential loss, choose to pay more for
“better” puts, and set your stops higher, even though you would take more risk of missing profits from a market bounce this way. What constitutes a “worst case” to hedge against is really a matter of personal choice. Please note that you are free to select any triggerpoints you please for stops and puts, but also note the double dangers of setting your “bottoms” too high: not only does the cost of the put insurance go up the higher you set them, but also do the odds of your stops causing the sale of your stock prematurely, thus missing the upside if stocks recover. This is the dark side of any imperfect hedge: you sell at the wrong time, and wind up out of the market, missing significant gains, if your strategy turns out wrong. You are able to control the downside and set a floor on losses, but only at the risk of miscalculating and setting a ceiling on profits. There is no free lunch. If you take the time to mathematically construct the perfect hedge, you will find that your maximum upside is not much different from short-term money market rates, a dismal prospect. If you choose to eliminate all risk, you eliminate any real gain.
Most who choose to do this will prefer inexpensive, imperfect hedges against Armageddon scenarios. This can be done with any sort of portfolio, even those comprised of mutual funds, against which no stop limit orders can be written, as discussed above. To do this, simply buy puts on index ETF’s which emulate whatever portfolio you want to protect. You will have to do a bit of math to determine how best to do this, and how closely you care to hedge your particular portfolio. But you can assemble meaningful protection from only a few or even only one index, even if they only roughly correlate to your actual holdings. For instance, if you have a portfolio of 10% small caps, 60% large caps, and 20% foreign, you can still get meaningful – though quite imperfect – downside protection from puts against ETF’s comprised by S&P 500 holdings – large cap US stocks – since there is usually a good bit of correlation between stocks of all stripes, especially on the downside.
Is “asset allocation” obsolete? What to do about pretty pie charts and Modern Portfolio Theory…
That “correlation” word brings us to that bugaboo of the modern investing age, the Nobel Prize-winning “Modern Portfolio Theory,” popularly known as “buy and hold” “asset allocation,” poster child of the pie graph, and widely disparaged since the Great Crash of 2008 as no longer working, because “this time it’s really different…” The basic premise of this theory is that if you get the right proportions of the right pieces of different kinds of investments that tend to move in different cycles – that don’t, in most periods, all go down at the same time – you can get some of the risk to damp out without sacrificing profits. During most periods, this has tended to be true, and probably still will for a long, long time – that’s why it won a Nobel Prize. It does not, and does not purport to, eliminate risk or offer protection from highly-correlated-panic-driven Black Swan events like 2008, when everything came crashing down, no matter what it was, whether there was good reason to, or not. Panics are like that, being supremely irrational events. The short of it is that Modern Portfolio Theory tends to work much better over longer periods, when its casino-like math has time to work the odds. If you have a well-constructed “pie-chart” portfolio that is both properly balanced from an investment-mix perspective AND fits your investment horizon cash flow goals, you are probably better off muddling through with it. This is very key to the success of the strategy! Pie-chart advisors are a dime a dozen, and finding those who effectively practice this is like looking for a needle in a haystack…but they are out there, and you may be better off keeping or finding one (documented performance track records are really helpful here) than trying to practice the hedge techniques described in this report. The downside protection strategies described in the preceding sections can and will work if you learn enough and take the time to faithfully execute and update your strategies, but besides the work involved, they come with risks of their own. This is true whether you try to go it alone, or find an advisor to help with it.
Why “equity index” annuities offer false hope and guaranteed underperformance
Many investors would just throw up their hands, and stick their money in the bank, or in guaranteed government bonds. The danger, of course, is that even before taxes they don’t yield much, and can actually lose you money after inflation. Many feel that inflation will be fierce in the twenty-teens, and “money in the bank” could be a recipe for steep, guaranteed losses. This is also true for interest-paying “fixed annuities,” and other products of this ilk.
The lure of “equity index” annuities is that they promise a guaranteed return of principle, some guaranteed minimum interest rate, as well as the chance for that interest rate to go up if the stock market goes up. The marketing material and the salespeople paint an even rosier picture, sometimes even spinning these products as if they offered all the guarantees of FDIC CD’s and all the upside of unbridled bull markets. Again, of course, there is no free lunch. The reality is that these life insurance company products restrict your access to principle with penalties and other costs – sometimes colossal penalties and very long lock-up periods – and usually offer only mediocre interest rates and very limited participation in stock market gains. The basic process is this: they take your investment, and put it into something safe like interest-paying bonds, give you a part of this interest, keep part of it as their profit, and use the other part of the interest to buy call options on stock market indexes, a way to bet on market increases. If they call options “hit” you get a piece of the profit, and they get some, except that your profit is limited to the “participation” rate, but their profit – which is created by the options bought with the interest on your money – is unlimited. The annuity contract smoke and mirrors are quite a bit more complicated than this, especially when we consider how the sales commissions (sometimes unconscionably high) and surrender charges, all manner of riders, and the rest of the jumble fits in, but this is the basic premise. If the concept of “in the bank” guarantees and a shot at stock market upside appeals to you, you can easily cut out the middleman and buy index calls yourself or with an advisor. You will be much farther ahead, and not have to sacrifice access to principal to fund sometimes-ungodly sales commissions.
Stacking the odds – how history tells us to maximize returns and minimize risk
In the end, there is no best way to achieve high returns. The basic principal that taking risk increases potential returns is unfailingly true, but most people who invest usually wind up taking far more risk than is necessary or even known by them, predictably lose money, and think all investing must be unacceptably risky. The reality is that their risk is poorly controlled by them (or their advisors), and that they would have made far more with less risk. The truth is, returns go predictably up with just a little more risk, but most investors take on so much risk that the odds of payoff become so remote that they mostly lose.
So controlling rather than avoiding risk is really the key to investment success.
The first section of this report discussed controlling downside risk with stop-loss limit orders and put options. This technique will work if you both work it and know what you are doing, but also assumes you know when to get back in after a tumble so as not to miss out on rebounding prices. Most investors miserably at this, often staying in cash long after the bull returns, and giving up unforgivable upside while they wait to “make sure” the market is “safe” again.
Modern Portfolio Theory is yet another way to control risk, one pretty well proven over decades of data, despite the current knee-jerk fashion to throw it out based on the monkey wrench of a single-year’s data, a single year in which a once-in-a-century perfect storm for the markets occurred. This “asset allocation” approach is still probably the best way for most investors to control risk and target acceptable returns over the timeframes that are meaningful for them. It ain’t sexy, but it is proven to enhance the probability that our outcome will be successful. For most of us, this is the best way to “stack the odds,” so long as you find an effective practitioner of this somewhat rarified art.
What the technical indicators are predicting for the market this year, and down the road
Technical analysis – the use of charts and trading activity data to predict future market behavior – has a rather checkered reputation as an oracle of future prices, and some even revile it as snake-oil sorcery. As a CFA®, I was grounded in fundamental analysis, which instead uses hard business data about profits and growth to assess value. Still, I have come to respect technical analysis as probably the best way to forecast what people – irrational, incompletely informed, emotionally-driven people who actually make up the market by deciding what prices they are willing to buy and sell at – will do in the market, imperfect as such forecasts must be. In that vein, here is what the charts are whispering to me, as the clouds swirl across the May, 2010 full moon, and my crystal ball quickens to the pulse of the conjured animal spirits.