Correction Continues – The Value of Risk Management

Despite the recent rally, the correction continues. While wanting to “buy the dip” is tempting, there has been enough technical damage to warrant remaining cautious in the near term.

As we have discussed, managing risk requires discipline and the emotional ability to navigate more volatile markets until a more straightforward path for risk-taking emerges. The problem with this statement is that it often immediately gets translated to mean “being entirely out of equities,” which is the act of “market timing.”

That is not what we mean by risk management. Repeated studies have evidenced that the problem with market timing is that individuals cannot successfully replicate the profitable timing of the buys and sells. However, individuals can increase and reduce exposure to risk during periods of higher volatility.

This is because the most significant drawdowns tend to occur during periods of increased price volatility. As this correction continues, volatility remains relatively subdued. However, if the economy slips into a recession or some other event disrupts forward earnings expectations, there is undoubtedly a risk of a further increase.

As noted in this past weekend’s #BullBearReport, remaining unemotional during volatile markets is challenging. While “buy and hold” works as a strategy during a rising bull market, it often fails during a bear market for two simple reasons: Psychology and Destruction of Capital.

This is also why Darbar’s investor research annually shows that individuals always underperform the benchmark index over time by allowing “behaviors” to interfere with their investment discipline. Psychology is why “buy and hold” strategies often fail at the “first contact with the enemy.”

As is always the case, investors regularly suffer from the “buy high/sell low” syndrome.

Actual Versus Promised

Even if an individual successfully rides market volatility, the destruction of capital can have devastating consequences on financial goals. As shown below, an investor who expected a 7% “compounded rate of return” over a lifetime, as promised by “buy and hold” strategies, fell short of financial goals. This is because losing a significant chunk of capital and then getting back to even destroys the compounded return premise.

Such is why “risk management” is key for investors, especially those who employ “buy and hold” strategies.

A Simple Method

Let me repeat, I do not endorse “market timing.” Market timing is specifically being “all-in” or “all-out” of the market at any given time. The problem with market timing is consistency.

You cannot effectively time the market over the long term. Being all in or out of the market will eventually put you on the wrong side of the “trade,” which leads to a host of other problems.

However, no great investors in history have employed “buy and hold” as an investment strategy. Even the great Warren Buffett occasionally sells investments. True investors buy when they see the value and sell when value no longer exists.

While many sophisticated methods of handling risk within a portfolio exist, even a simplistic price analysis method, such as a moving average crossover, can be a viable tool to control risk. Will such a method always be right? No. However, will such a method keep you from losing large amounts of capital? Absolutely.

The chart below shows a simple analysis of the market versus a 40-week and a 200-week moving average from 2000 to the present. It is fairly evident that the 40-week moving average supports the market during bullish trends and provides resistance during bearish ones.

Furthermore, when the 40-week moving average crosses below the 200-week moving average, that has occurred during more protracted bear markets. Corrections below the 40-week moving average that remain above the 200-week moving average tend to be short-lived events.

This data allows us to establish a very simplistic trading rule to manage portfolio correction risk.

• When the market is above the 40-week moving average, the portfolio is allocated 100% to equity risk.
• When the market is below the 40-week moving average, the portfolio is only 50% allocation to equity risk.

Why Not Zero

Why not reduce equity risk to ZERO? Because now we are market timing and managing risk. The problem with being at zero exposure is the lost of appreciation in the markets before the correction is deemed technically over. Furthermore, psychologically, it isn’t easy to move from zero to 100% equity exposure during corrective periods. Maintaining some equity risk allows portfolios to continue to grow while mitigating severe damage to capital.

The chart shows the difference in nominal portfolio returns from 2000 to the present based on a $100 investment.

Let me restate that this is just a hypothetical example to explain the value of risk management. Improving returns over time does not require sophisticated techniques; an unemotional approach is all that is required.

The Correction Continues – Risk Management Is Needed

As the current correction continues, the market has violated the 40-week moving average. This has only happened a handful of times since 2008, namely during:

• The Euro crisis in 2012
• Brexit in 2015
• The Fed Taper Tantrum in 2018
• COVID in 2020
• Russia/Ukraine War in 2022
• And currently.

Each one of those corrections ended without a confirmed violation below the 200-week moving average, but each lasted a few months before the bull market returned. As the correction continues, the violation of the 40-week moving average puts us in the position of needing reduced equity risk in portfolios until we begin to see more bullish price action take shape.

Conclusion

Will portfolio performance lag when the market begins to recover? Yes. But as shown above, the long-term results of avoiding periods of severe capital loss will outweigh missed short-term gains.

“Anyone who followed the numbers would have avoided the disaster of the 1929 crash, the 1970s or the past lost decade on Wall Street. Why didn’t more people do so? Doubtless, they all had their reasons. But I wonder how many stayed fully invested because their brokers told them ‘You can’t time the market.”‘ – Brett Arends

There is little point in trying to catch each twist and turn of the market. But that also doesn’t mean you must be passive and let it wash all over you. It may not be possible to “time” the market, but it is possible to reach intelligent conclusions about whether the market offers good value for investors.

Providing risk management to portfolios over time has a clear advantage. The problem, as I have discussed many times previously, is that most individuals cannot manage their own money because of “short-termism.”

Despite their inherent belief that they are long-term investors, they are consistently swept up in the market’s short-term movements. Of course, with the media and Wall Street pushing the “you are missing it” mantra as the market rises, who can blame the average investor for “panic” buying market tops, and selling out at market bottoms?

Yet, despite two significant bear market declines, it never ceases to amaze me that investors still believe they can invest their savings into a risk-based market, without suffering the eventual consequences of risk itself.

Despite being an unrealistic objective, this “fantasy” leads to excessive portfolio speculation, ultimately resulting in catastrophic losses. Aligning expectations with reality is the key to building a successful portfolio. Implementing a strong investment discipline and applying risk management is what leads to the achievement of those expectations.

“It does mean you that you shouldn’t let scare stories dominate your approach to investing. Don’t let yourself be bullied. Least of all by someone who isn’t telling you the full story.” – Brett Arends

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Lance Roberts is a Chief Portfolio Strategist/Economist for RIA Advisors. He is also the host of “The Lance Roberts Podcast” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, Linked-In and YouTube.