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“The market’s up”, “The market’s down”, “The economy is rebounding”, “Brace for inflation, deflation, stagflation, etc.”. So much advice, so little of it agrees. Regardless of which direction the markets are heading, it's always important to keep a strict investment strategy to protect portfolios from markets, whichever way they go.

Preserving Capital Money Management Bull market investments Bear market investments

While reading advice, determine who will benefit most from the advice and proceed cautiously.

Analysts often offer advice to benefit their larger clients.  If a client has a large holding which they’d like to sell, an analyst could release recommendations that could inflate the price enabling their client to sell out at a good price.  Unfortunately the smaller investors are used to inflate the price and then are caught when the price tumbles as the large client sells his holdings.

Mutual Fund Advisors usually work for the mutual fund company.  It’s not likely they’ll recommend selling out of a fund and moving to a safer cash position during turbulent times.  They are salesman for their funds.  They’ll suggest that diversification is your best defense in a Bear Market.  How convenient for them that the advice offered is to buy more of their funds instead of selling them to wait for better investment opportunities. 

Investing in difficult markets is an experience all of us have been through during the last 3 years.  Most are realizing that a bear market (down trend) is much less forgiving to investment mistakes than a bull market (Up Trend).  A bull market puts time on the investor’s side.  If a mistake is made, usually time will bring the investment back to the purchase level to minimize losses.  A bear market will deplete entire portfolios while people, “wait for the rebound”.  Rules about safe investing don’t change from one market to the next, but bull markets will produce careless investors that ignore rules during the good times then get quick lessons when a market turns bearish.  The rules that follow are written from a stock investment perspective but should be followed by those investing in Mutual Funds and Retirement plans.

Preserving capital or money management is key to growing and protecting a portfolio through different markets.  Money is made with correct investments and lost with incorrect ones.  It’s impossible to continually make correct investment choices so it’s important to limit the amounts that are lost with wrong choices and survive to make better ones.  Discipline is key during investing.  Each investment should be looked at separately and planned accordingly.  An investment plan would include the following:

In a bull market, the entry price is a low price in the chart pattern to buy the investment.  The exit price is the high price to take profits.  One of the most important money management tools is a stop loss.  Investing will get emotional.  Investors in a losing position will find numerous ways to justify keeping their investment.  This thought process all too often causes bad investment decisions.  In order to prevent such emotional decisions a stop loss is used to make automatic decisions that emotions can’t influence.  Think of a stop loss as the maximum loss, whatever happens.  At a certain price an investor has to admit they were wrong.  A stop loss helps the investor admit they were wrong so they can sell to protect their capital.  Remember, if all the money is lost, there can’t be another attempt.  A stop loss gets investors out with cash left over so they can try again.

To set a stop loss, determine a risk vs. reward ratio.  A 3 to 1 ratio offers 3 chances to get the investment correct.  If the investor is trying for a 100% reward on the investment, they shouldn’t risk more than 33%.  That means the stop loss is a price not more than 33% below the purchase price.  If the entry price was $100 and the exit price is $200, the stop loss price is $66.   If the price falls to $66, sell without question and reinvest the $66 somwhere else or at another time.

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A stop loss example is shown in the chart to the left.  The chart compares buy and hold Investing with the safer stop loss type of investing.  The dark blue (Buy & Hold) curve represents riding a stock price for a time period.  In this example, the stock price fell from $100 to $50 then recovered to the original $100.  

This curve is representative of many current investors.  They justify their position in a stock with statements like, “It’s not a loss since I didn’t sell” or “It’ll come back again.”  Both may be true, but the investment violated even the simplest of plans.  The original plan was to, “make money.”  The stock falling to $50 changes that plan to, “making money back.”

The pink (30% Stop & Buy) curve shows how the stop loss forces a sell.  In this example the stop loss is 30%.  As previously mentioned, if the stock price drops 30%, sell.  This example shows selling the stock at $70.  Continuing on, the stock fell to $50 before it turned around.  Since you still have $70 cash, you can reinvest in the stock during the recovery.

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This second chart assumes the same stock performance and strategy but shows the return on investments when using a stop loss.  The dark blue curve shows the percentage return for a buy & hold strategy.  The stock dipped 50% then recovered for a 0% return.

The pink (30% Stop & Buy) curve represents the return when a stop loss is used.  In the example the stop loss remains at 30%.  As previously mentioned, if the stock price drops 30% ($70), sell.  Continuing on, the stock fell to $50 before it turned around.  Since you still have $70 cash, you can reinvest in the stock.  This example assumes missing the bottom and buying back conservatively during the recovery ($60).

The original benefit of a stop loss was to preserve capital or not lose the entire investment.  Looking at the pink (30% Stop & Buy) curve, there is an added attraction.  Notice that instead of breaking even at $100 there was actually a profit.  The return was 17% from the time of investment vs. the 0% from a typical buy & hold strategy. This is due to selling the stock at $70 and buying it back at $60 which yields more shares than the orignal investment.

Money Management is important in any market.  Using an investment plan and stop loss strategy offers protection in both up and down trending markets.  They should be used in any type of investment whether it’s a stock, bond, mutual fund or retirement plan.

The following definitions explain how investments should be made depending on the market trend.  If you do not feel comfortable investing in a certain way or in a certain type of fund, wait for the market to trend in the direction you’re more comfortable with.  Do not fight the trend.

Bull Market Investing (Buying Long)

The trend of a Bull market is up so the risk vs. reward for buying Long is in the investor’s favor.  Continually look for the stongest sectors and buy the strongest stocks in these sectors. Even the weaker stocks will rise in a bull market which helps limit risk when the stock picked turns out to be less profitable than expected.  Low volume retracements should be viewed as buying opportunities and profits should be taken as volume drops off at high levels.

Bear Market Investing (Selling Short)

Selling Short is an investment strategy many investors don’t understand.  The simplest explanation is predicting a stock will fall instead of rise.  Instead of buying the stock, you’re selling the stock first.  Since you don’t own the stock, the shares you are selling are borrowed.  The stock falls and you then Buy to Cover or buyback the borrowed shares at a lower price.  The profit is the difference between the Sell Short price and the Buy to Cover price.  The trend of a Bear market is down so the risk vs. reward for selling Short is in the investor’s favor.  Continually look for the weakest sectors and sell short the weakest stocks in these weak sectors. Even the stonger stocks will fall in a bear market which helps limit risk when the stock picked turns out to be less profitable than expected.  Low volume highs should be viewed as short selling opportunities and profits should be taken as volume drops off at low levels.