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  • Writer's pictureGeorge Kiraly

"Do Nothing" Doesn't Work

Some of the most extraordinary investment advice I've heard during the biggest stock market declines over the 25+ years I've been in the business is "we're going to do nothing" or "we're going to ride this out" or "we're going to stay the course". I understand that these strategies are fine for standard corrections that frequently occur in normal market conditions. But what about when corrections morph into big bear markets or even financial crises?

How did "we're going to ride this out" work during the brutal declines of 2001-2002 and 2008? How is it working out today? Maybe you have just a few bucks in an investment portfolio and these strategies work for you but what if you have a significant taxable and/or retirement portfolio? What if you can't wait years to recoup big losses? Our philosophy has always been "gain more by losing less". In a broader context, this amplifies the importance of risk management. As a portfolio manager, I'm often looking over my shoulder, and sleeping with one eye open, watching for risks that most investors assume aren't there. Mitigating losses is important to preserve the power of your portfolio and allow for maximum participation in future gains.

During a financial crisis, you must take action, especially early on, before things take a real turn for the worse. And this is a financial crisis, not a correction. Most investors are familiar with the term, correlation. It's an important concept. Correlation is a statistical measure that determines how assets move in relation to each other. A perfect positive correlation between two assets has a reading of +1. During a financial crisis, standard diversification doesn't work very well. All assets tend to have a correlation of +1, meaning everything goes down together, just like in 2008.

The problem is that during a financial crisis, market mechanisms sometimes don't function properly. Credit markets seize up. You can't invest as you normally would in an abnormal market. Assets become mispriced. Uncertainty and financial distress can lead to forced selling by institutional investors. There may be no buyers at all and prices fall vertically. Investor panic ensues and further exacerbates the situation.

A few weeks ago, the bond market wasn't functioning normally at all. It was broken – and it still isn't 100%. Most conservative bond funds fell -6% to -10% in a week's time. Many are still down -10% year-to-date. High yield bonds are down -16% to -20% since mid-February. The Fed is working to stabilize the bond market. Eventually, it will return to normal and things will calm down. We sold all of our bond funds in client portfolios where practicable weeks ago, side-stepping most of the carnage. We will eventually buy our funds back, as the bond market regains its equilibrium.

There is nowhere to hide during a financial crisis. Stocks fall, bonds fall, reits fall, gold and other precious metals fall, commodities fall, etc. – everything but cash and some non-traditional alternative assets, including hedge funds and certain derivatives. Some of the more common hedge fund strategies include equity long-short, distressed assets, arbitrage, and macro-trends. Derivatives such as inverse index ETFs and put options work in a protective capacity to offset the often significant losses that big declines cause. We have used a combination of these at various times over the years.

Why don't many investors make portfolio adjustments during a crisis? Part of the problem is that we have been conditioned over the last 50+ years to recite the mantra of something called Modern Portfolio Theory (MPT), developed by Harry Markowitz. It's a mathematical formulation of the concept of diversification in investing, with the aim of selecting investment assets that have collectively lower risk than any individual asset. It works – if you have an incredibly long time horizon and no emotions whatsoever. MPT doesn’t account for the fact that change is inevitable in our lives – nothing ever really stays the same. And even if it did, assuming everything will be fine twenty years down the road is really irrelevant if we're going to be miserable along the way.

The major shortcoming of MPT? It assumes stable correlations among assets. During a financial crisis, stability goes out the window.

Traditional MPT and its Efficient Frontier fails during crisis periods because asset classes become highly correlated – they move together. In the last financial crisis of 2008, for instance, many investors held assets that supposedly had low correlation, historically. Yet, when the markets crashed, those correlations went up sharply and all assets went down, together. For most investors, their diversified portfolios failed and large losses followed. The same thing is happening in today's markets. In the last three weeks, the DJIA crashed, losing almost -40% from peak to trough. Some sectors of the market actually lost more. If you hold a portfolio of stocks, you need them to produce a +66.67% gain going forward, to get back to even.

We've always recovered after big market declines and this time should be no different. The variable is no one knows how long it will take.

So, don't "do nothing". It won't work very well, unless you have an incredibly long time horizon and aren't bothered by the losses you see in your portfolio. By utilizing strategies that actively manage risk, you'll gain more by losing less, which will likely lead to superior investment results over the long run.


Disclosure: George Kiraly Jr., CFP®, MBA is the Founder & Chief Investment Officer of LodeStar Advisory Group, LLC, an independent Registered Investment Adviser located in Short Hills, New Jersey. George Kiraly, LodeStar Advisory Group, and/or its clients may hold positions in the ETFs, mutual funds and/or any investment asset mentioned above. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. The above commentary does not constitute individual investment advice. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.


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