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Reduce Investment Stress With A Volatility Plan

Iraq Is The Latest Volatility Catalyst

Iraq map

Financial markets tend to focus on one or two big stories, which is similar to patterns found in popular culture. The latest obsession is Iraq. From Reuters:

Iraq's most senior Shi'ite cleric urged his followers to take up arms to defend themselves against a relentless advance by Sunni militants, in a sharp escalation of a conflict which is threatening civil war and the potential break-up of the country.

Investors vs. Volatility

The longer you study markets and investor psychology, the more apparent it becomes that your investment approach should balance these two basic objectives:

  1. We need to leave our investments alone long enough to make money. All things being equal, we prefer to trade less, rather than more, frequently.
  2. When prudent, we need to adjust our portfolios to avoid the next inevitable bear market or financial crisis.

Without Volatility Investing Would Be Easy

If volatility was not part of the equation, we could all "stay the course" while capturing the S&P 500's 78% advance that occurred between early 1986 and late 1991.

SPX 1986 - 1991 Chart

Unfortunately, markets are not that easy. Capturing even a portion of the 78% gain was much more difficult in the real world, which is marked by regular ups and downs during any market advance.

SPX 1986 - 1991 Chart 2

The Answer Is Buy And Hold, Right?

Would a buy and hold investor have captured the 78% advance shown in the S&P 500 charts above? Yes, but there are two problems with that approach:

  1. Without some form of risk management, investor stress would have been extremely high during the 1987 crash. For most people, sleepless nights are something they prefer to avoid.
  2. A buy and hold investor has no game plan for the next bear market.

If you did not have money in the markets in 1987, you may say, "I would have been fine with a buy and hold strategy, even during the 1987 crash." That may be the case, but the vast majority of hard-working people have no desire to experience anything like the one day losses shown in the table below. Since it happened 26 years ago, many investors have lost perspective on the widespread financial damage that occurred on October 19, 1987. The S&P 500 dropped 20.47% on the day known as "Black Monday".

Before and After Black Monday

Buy And Hold Works Until It Doesn't

Our job in the markets is to develop a method or system to discern between "volatility to ignore" and "volatility to respect", a need that applies to daily, weekly, and monthly time frames. On a longer-term time horizon, the concept of volatility to ignore applies to the left side of the chart below (A). The concept of volatility to respect applies to the right side of the chart (B) since none of us want to "stay the course" during the next 50%-plus decline in stocks.

SPX 1997-2002 Chart

How Does All This Relate To 2014 And Iraq?

Iraq is a volatility-inducing event. Our job, even on shorter time frames is to discern between "leave stocks alone" volatility and "some incremental defensive action is prudent" volatility. Thursday's article outlined a hypothetical plan to manage volatility during the unrest in Iraq. Common methods to manage volatility are also covered in You Need A Plan For The Next Inevitable Bear Market.

The Term Airstrikes Is A Concern

We all know the current bull market is long in the tooth and has been helped just a tad by central banks. We also know Europe is still battling low inflation/deflation. The blurb below from The Wall Street Journal is another reason to use this weekend to provide some investment leadership for your portfolio:

President Barack Obama and his administration signaled they are preparing to re-engage militarily in Iraq, a remarkable U-turn for a president who campaigned in 2008 on ending the war there and has cited the removal of U.S. troops as one of his top successes.

The White House said Mr. Obama is weighing possible airstrikes to blunt the momentum of Sunni militants who have seized control of several major cities in recent days.

Can We Manage Volatility With Cash?

Chronic Underinvested Syndrome

Many investors are still understandably gun-shy about the financial markets and thus are sitting on large quantities of cash. Sitting on cash does eliminate risk, but staying underinvested for long periods of time can be very costly from an opportunity cost perspective. How costly? See the graphs and tables in this January analysis.

Execution Is Easier Said Than Done

Let's assume you have taken the time to build your own bear market exit strategy, which is an important step. The next challenge is avoiding the bear market pitfalls related to high stress, emotion, bias, ego, central banks, and poor execution.

Is There A Perfect Approach To Volatility?

No. All tactical approaches to volatility management, including moving averages, ratios, and indicators, have limitations. However, they all can add value and are light years ahead of a buy-hold-and-hope strategy. Since there is no magic moving average or economic indicator, building a risk management plan using numerous inputs provides a form of redundancy and improves your probability of investment success. To understand what we mean by indicator redundancy, this flow diagram shows the inputs from one of the submodels that feeds into our master market model; notice how multiple times frames are used as another way to diversify inputs.

2014: Even Some Of The Big Boys Are Struggling

Anyone who has worked on Wall Street or managed their own account will tell you that the financial markets are far from easy for anyone. It is difficult to muster the strength to study and improve your process when your confidence is low. If you have struggled in the markets, you are not alone in 2014. From Marketwatch:

Some of the biggest investors on Wall Street are losing money with wrong-way bets in markets around the globe, a surprising black eye amid a rise in stock and bond prices. Hedge-fund managers including Paul Tudor Jones, Louis Bacon and Alan Howard are among those who have misread broad economic and financial trends. Some have lost money as Japanese stocks fell, while others have been upended by the surprising resilience of U.S. bonds.

Investment Implications - Volatility To Ignore, So Far

As of midday Friday, the events in Iraq and the rise in oil prices have led to a volatility to ignore event. With about an hour to go in Friday's session, the S&P 500 was trading at 1,935, which is well above the "don't lose any sleep over Iraq" level of 1902 identified Thursday.

SPX Daily Chart

Experienced investors remember significant market volatility that occurred during unrest in Iraq in both 1990 and 2003, which means it is not safe to assume anything about what the future looks like. Sound implementation of a volatility plan requires staying in the now, a concept described in detail on January 9. Staying in the now allows us to observe with the flexibility needed to adjust to the real possibility of an Iraq-induced spike in stock market volatility. We made no allocation shifts between Monday and Thursday this week. Our allocations still consist of stocks (SPY), leading sectors (XLK), and bonds (TLT). The markets will guide us next week if we are willing to listen.


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