Investing makes for one fantastic spectator sport. After this past week’s rising volatility, no doubt many investors are wishing they had taken some money off the table while things were quiet.
Yet investing, when done properly, is a much better participatory sport.
There’s nothing quite like taking some capital, moving it into your new favorite stock, and feeling overjoyed as it rallies. But it’s not that simple. It requires the patience and determination to deal with short-term market uncertainty.
That’s why many investors employ a strategy you may have heard of: passive investing. It simply means buying the entire market via an index fund, and having no strong opinion either way. The market’s return becomes your return (after a tiny sliver of fees is taken out).
That’s definitely a great way to invest if you don’t have the time to find great opportunities. If you use a tax-deferred account as well, like a 401(k) plan or an IRA, the tax benefits mean you’ll fare even better than the market over time.
The upside is you’re invested in the entire market. The downside is that you’re invested in the entire market. If some individual names do great, that’ll factor into your returns. If some companies go bankrupt, you’ll feel the pain, although it’ll be a small sting.
While that’s a good strategy—and one that I employ in tax-advantaged accounts—it doesn’t account for the fact that with discipline, you can do better than the market.
In fact, when it comes down to it, there’s no real way to invest while being passive about it. Even if your only choice is to buy shares in an index fund or stay in cash, you still have to make the decision. If you decide to avoid investing more because the market crashes, you’ll miss out on the next upswing. On the plus side, cash loses its value to inflation gradually over time, not immediately.
Likewise, index investors putting money to work on a regular basis are likely to be buying at short-term tops at times.
In today’s world, the push for automation in everything from the products we buy to the cars we own has reached into the world of passive investing as well. Using strategies like stop losses, for instance can save you some gains now, but at the expense of greater profits later.
For example, say that you bought shares of Procter and Gamble (PG) back in 2003. Your approach was to buy and hold—and passively manage risk with a 20% trailing stop.
Seems like the best of both worlds, doesn’t it? There’s the potential for capital gains, a moderate and growing dividend on the way up. You also have stop-loss that rises with the stock to ensure that, after the price goes up at least 20%, you’ll lock in some gains.
This approach would have worked pretty well on a venerable consumer-staple play like P&G, whose low Beta of .53 meant that it should have only moved half as much as the markets. But then the 2008 wipeout happened.
On September 12th, 2008, the share price was $73.15. Less than 2 months later, on October 27th, the share price was at $57.27. That’s a 22% dip that would have gotten our theoretical investment stopped out at $58.86.
To be fair, the passive investor would have probably been grateful, considering the state of the market at the time. But with the stop loss, that was it. They were out of the trade. There was no automated way to tell our passive investor to get back into the trade. They would have gotten back to breakeven—and even to a profit—had they just had the patience to sit through the crash!
And if they did get back into the trade, they would have gotten stopped out again 2015 as shares took another steep dive in 2015.
In the case of small cap stocks, which are the nursery for the next generation of mega-cap stocks, a periodic 20% correction is pretty commonplace, only to bounce to new highs that reward more patient investors. That’s something investors should expect in the space of a year. But for blue-chip stocks, it’s more infrequent, but it’s not impossible.
Could you have taken this passive approach while investing in small caps like Berkshire Hathaway (BRK-B) in the 1960’s or Wal-Mart (WMT) in the 1970’s and still hold million-dollar positions in those blue-chips today? Nope, you would have been wiped out ages ago, a victim of your own passive investment style.
Heck, you might have even sold at a loss!
There’s no ideal way to deal with this rising automation. It’s programmed by the same people that make mistakes with their own money. Programmed trades likely made the 1987 crash bigger than it needed to be to bring valuations back in line. Ditto with the tech crash and housing bubble.
The important thing is to keep an eye on what you own. And rather than look at a loss as a potential sale, first think about whether or not it’s an opportunity to buy more. Buying stocks in early 2009 was like buying filet mignon and lobster for $3 a pound at the store.
It’s a rare opportunity, and one that doesn’t last forever.
The market closed down in August and had a major decline last week. We could be in for some more turbulence. If you employ automation strategies like stop losses, it’s time to rethink whether they’re proving you with value, or hobbling your long-term returns. It’s also a good time to think about what you want to own next. Create a watch list of stocks you’d like to own at a price you think is fair.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and is managing editor of Financial Intelligence Report. To read more of his work, GO HERE NOW.
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