Market Crash Storm Watch Note 1 - Reducing Exposure and the Risk of Being Wrong re Timing

In my view, the market cycle is getting old.  The potential for a correction within the next year or two is significant - to the point where some prudent measures should be taken soon in order to prepare for the downturn.

With this in mind, I have started by reducing my exposure to equities in a significant way.

I take the "long view".  I have managed my affairs such that I have no debt and can live below my means if required.  As a result, I can forgo the "opportunity" to make further gains if the market increases over the next year or two.  In other words, I can afford to wait.  

In essence, my strategy is to minimize losses and yet, have some exposure to the opportunity for further gains (with the thought that they might offset, to some extent, losses when they do occur). 

A Few Givens

It is inevitable that a correction will take place.  (See previous posts.)

It is impossible to know when a market correction will occur.

It is impossible to know the extent and type of a market correction.

In light of this, what to do?  

I have experienced several corrections.  There were a few consequences:

• significant loss of money 
• reduction in the level of confidence in my ability and my faith in equities markets
• fear of investing at the end of the recession - the time when opportunities were ripe

The last two consequences are psychological.  Experience and reflection have taught me how to deal with them:

• to accept that losses are part of investing
• to realize that market cycles are normal
• to persevere through tough times

This time around, I will focus on the external - trying to minimize losses on equities due to downturns in the markets.  

The Impact of Losses

The implications of the following chart are clear:

• the need to cut losses early
• the difficulty in making gains to offset losses increases significantly with the extent of losses (which explains why so many people have yet to recover from major crashes in equities markets and the collapse of the housing bubble)

http://observationsandnotes.blogspot.ca/2011/02/importance-of-avoiding-large-losses.html

Reducing Exposure to Equities Markets

I have reduced the number of positions in my portfolios.  Characteristics of crew members who have been discharged include:

• high debt levels
• abnormally high P/E ratios
• sectors which are more prone to outsized losses during crashes
• complicated business models which are more prone to external shocks

In most instances, the reduction has been accomplished by eliminating entire holdings.  In a few, I have retained a reduced position. 

Crew members who are still on board have some of the following characteristics:

• robust financials
• leadership which has managed the company through at least one market cycle
• a market for products and services which is resilient during recessions 

The strategy is simple: easy to understand; easy to execute.  Above all, it provides resources to re-invest when market conditions improve.  Better to work from a base of strength than trying to recover painful losses.  It's better financially and far better mentally when one approaches life from the perspective of a hunter than that of a wounded warrior.  

Other Comments

• There is a variety of strategies which can be used to cope with volatility for one's portfolios.  I will use some of them.  Examples 
• Futures trading and the use of negative ETFs is also possible, but I find that timing is a real issue.  I generally have not done well with these instruments as they do not fit my style of investing.  
• There are real risks in trying to time the market.  However, it all depends on one's personal circumstances and outlook.  For example, if I have an alternative, I will not try to make a sailing passage when stormy weather is in the offing.  I've learned through my life on the water and in investing that it always makes better sense to select a protected mooring and be patient.  The experience of rescuing five people from a boat that foundered in a violent storm not more than 400 metres from our anchorage confirmed this belief.  Seeing the potential threat, we dropped the hook in a very protected spot and battened down the hatches.  Half a day later, the storm broke.  The winds of the microburst exceeded 80 kts sustained over a 20 minute period.  Coupled with higher gusts the force inclined the boat by 30 degrees at times during swirls.  As a result of our preparation, we emerged safe, exhilarated and positioned to rescue the crew of the sunken boat.