Mthe arches go up the stairs and down the elevator. And who doesn’t want to take advantage of these quick movements? When you see volatility ETFs like UVXY go up 38% in one day and 71% in less than two weeks, it’s hard not to feel left out.
But believe me: betting on market declines is a dangerous business. Instead, I want to help you find a strategy to capitalize on market declines based on your specific needs and investing style. In my previous article, I explained how often pullbacks occur. Large withdrawals of 5% or more occur about once a year. Corrections of 10% or more occur once every three years or so. Bear markets of 20% or more occur about once a decade.
You should therefore use this strategy sparingly. Let’s start with a general overview of how it works.
Traditionally, investors split their money between stocks and bonds, usually something like 60/4%, respectively. This advice no longer applies. Right now, bonds and debt products are at their highest for years, and in many cases never! While they can provide short-term relief if the market falls, the long-term downside risk is too great to ignore.
That’s why I want to think of a portfolio in terms of stocks and cash only, leaving bonds out entirely. Therefore, if we ignore bonds, we must either go for cash or wait for any decline in the market, whether short-lived like that caused by COVID-19 or prolonged like that caused by the Great Recession.
However, for people who depend on their investments for a living, both of these options can be a problem. The S&P 500 took almost six years to recover from the stock market crash that began in November 2007. So how do you deal with this problem? We want to make sure we have purchasing power in our portfolio, either by keeping part of our portfolio in cash (up to 25%) or by contributing regularly.
It may sound like a lot. When the markets go down, we want to use the withdrawals to deploy more of our capital at lower prices. Based on history, we know that market declines of over 40% occur once every 25 years or so, while market declines of 20% or more occur a little less than once. every eight years. We also know that while the market can take more than five years to recover from these major crashes, it can recover from these small bear market downturns in just over a year. So we can aim to deploy this excess cash during withdrawals to help supplement our overall returns.
What to do according to your situation
Here’s how it might play out: Suppose I decide I’m ready to retire.
- I have $ 1 million in my wallet.
- 75% of my portfolio is invested and 25% is in cash.
- The stock market is earning around 10% per year on average (1991-2020).
Now if the market goes down 20%, with only 75% of my money in stocks, I take a hit of $ 150,000. But since I have 25% of my portfolio in cash, I have the opportunity to reduce my average cost of investing and increase my earning potential by deploying some of my cash to replace what I lost during that the shares are âfor saleâ. Getting back what I lost means I should actually earn 25% on my money (as opposed to the 20% I lost).
Note: Here is the calculation. If I invested $ 750,000 and lose 20%, I have $ 600,000 left. Coming back to my initial $ 750,000 would require a 25% gain. Corn, because I reinvested what I lost with cash on hand, a 25% gain will bring my investments to $ 937,500. With the money on hand, this brings my total account value to $ 1,037,500, allowing me to recover from the loss more quickly.
Let’s see how this changes depending on the different types of investors.
Conservative – Investors who are primarily interested in capital preservation.
The scenario listed above is how a cautious investor would approach market declines. If you are living off your investments, it is important to establish a stock-to-cash ratio that gives you enough money to pay for your living expenses. As a conservative investor, you are only looking to work with broad market index ETFs like SPY. You want to keep things simple and easy to measure.
Moderate – Investors who are willing to accept risk but don’t want to experience excessive volatility in their portfolios.
Most investors fall into this category. The difference between moderate and conservative investors is that moderate investors aren’t as concerned with preserving capital. Like conservative investors, moderate investors want a significant amount of cash to deploy. Now, instead of limiting yourself to SPY, you can look at sector ETFs or individual stocks. Typically, you want to look for areas of the market with relative strength – places that outperform others.
For example, during the COVID-19 recession, large-cap tech came first and outperformed overall. During the Great Recession, finances took years to recover. You don’t have to dig deep into a list of actions to find that work. If large cap technology is your choice, you can use the QQQ and XLK ETFs or be more specific with the SMH Semiconductor ETF. Ideally, you want to look to companies that generate profits and are not valued against the profits for years to come (like most EV companies are).
A great way to determine which sectors are performing best is to use market health metrics and analysis like those found in TradeSmith Finance. These can let you know which industries are outperforming the rest and will be the first to recover.
Speculative – Investors who are not afraid of losing money or incurring large losses.
Risk and reward go hand in hand. When you enter speculative companies, you have to be prepared to lose what you invest. So, using the same setup as the other two styles, speculative investors look for high growth stocks, usually in booming sectors. For this, we mainly rely on technical analysis, momentum and scenarios. However, our goal is to get some of the massive stock movement, not all of it.
Think SunPower (SPWR), which posted gains of over 1,000% from the March 2020 low of $ 2.94. The incredible momentum of this action was echoed by TradeSmith Finance when we triggered an entry into the green zone on August 27 at $ 11.05. The stock finally came to a halt at $ 23.61 on May 4, 2021, for a total gain of 113.7%.
This is only a fraction of the total possible winnings. But guess what? The S&P 500 only returned 19.5% during this period. This is the kind of return speculative investors can aim for during major stock market crashes.
Many of us will fall for more than one type of investment. Just because a person lives on his investment income does not mean that he will not have $ 100 to invest in a speculative investment. However, if you have to choose, choose caution over risk. Based on what I have talked about here, what type of investor do you consider yourself to be? Send me your thoughts here. I love knowing more about my readers because it helps me create content that is valuable to you.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.