The coronavirus correction in March took the stock prices of the S&P 500 companies down by 35%. Ouch! How did your portfolio do? As many of you know only too well, the damage isn't over. The S&P 500 remains 8% underwater.
The perennial argument is Buy and Hold vs. Timing the Market. The Buy and Hold camp tells us that it is impossible to sell at the highs and buy back at the lows. Perfect market timing is impossible, but open a price chart of the S&P 500 index. It was obvious to everyone by the last week in February that the market was in serious trouble. Depending on when you started closing positions that week, you would have limited your losses to something on the order of 10-12%.
But the Buy and Hold crowd rode the market down to the 35% low on March 23rd. And those portfolios have still not returned to positive territory. Many investors are afraid to see how badly they have been hurt and are just not opening their accounts. The Buy and Hold crowd became the Hiding Under the Bed crowd.
Some will argue this is a matter of risk. Conservative investors have been told that actively trading their stock portfolio is a high risk game. The results year to date in two of my trading services, each of which mirror my portfolios at Charles Schwab and E*Trade, serve as excellent real life examples.
The Conservative Income trading service mirrors the covered calls and cash secured naked puts in my E*Trade account. When used with solid blue chip stocks, these are widely regarded as the most conservative stock and option trading strategies available to the retail investor. When the market lost 35% in March, this service lost 10%. One month later, this portfolio had returned to break-even for the year. As of today, the year to date returns for investors in this portfolio is +13%, while the S&P 500 is still down 8%. This portfolio takes low risk positions and survived the correction very well. Taking more risk isn't necessary to protect your portfolio from corrections in the market.
Dr. Duke's Trading Group uses a variety of option spreads that incur moderate to high levels of risk. Our low point during the March correction was -36%, approximately the same as the overall market. But that is where the similarity ended. This portfolio had returned to break-even after six weeks. Year to date, our trading group has gained 132%. Members of this group are certainly taking more risk, but they survived the correction very well.
Whether an investor uses conservative, low risk trading strategies or chooses to incur higher levels of risk doesn't affect the trader's ability to survive a correction.
The difference is risk management.
Conservative trading strategies lead to a tighter spread of wins and losses, i.e., the standard deviation of the results is smaller. The average gains over time will be positive if trades are managed well. But these trades take less risk and therefore result in smaller net gains over time.
Trading strategies that incur higher risk lead to a wider spread of wins and losses, i.e., the standard deviation of the results is larger. But, again, the average gains over time will be positive if trades are managed well. One of the fundamental laws of finance tells us that the potential of higher gains is always accompanied by higher levels of risk. The higher returns of the trading group are an excellent illustration of that principle.
The crucial learning here is that the level of risk you take in your trading does not affect the ability of your portfolio to survive a correction. The ability to survive the correction is rooted in risk management:
• Choose trading strategies consistent with your risk profile.
• Learn as much as you can about the trades you choose to employ.
• Trade small. Trading small gives you the time to build experience without losing the farm.
• Develop and follow a trading system, i.e., a system of rules for entering, managing, and exiting each trade.
• Both greed and fear are dangerous emotions. Your trading system is the cure.
If you are tired of watching your portfolio swing back and forth in these volatile markets, check out the private coaching and group classes offered by Parkwood Capital. Subscribe to the Conservative Income service or Dr. Duke's Trading Group. If you aren't happy at the end of one month, we will refund your subscription.
Happy Independence Day!