Sunday, September 13, 2015

What Should I Do With My Failing Investments?

A Stock Twits reader asks a difficult question:  "Much of my retirement is in PG stock.  Any idea when this slow bleed will stop?  What can I expect in short term?"

There are many possible answers to this; let's start with the most basic.  If you're asking a similar question following a market decline, you've made a cardinal error.  A sizable proportion of your retirement funds should be concentrated in no single stock, even if it's a solid, dividend paying company that you've researched well.  If you look at how those stocks traded during the bear moves of 2001-2003, 2008, and 2011, for example, you'll find stomach-wrenching drawdowns.  When it's your future financial security at risk, it's difficult to tolerate those drawdowns.  That increases the odds that you'll bail out at the worst possible times.

Diversification is not only important in investing; it's important as a life principle. Although there is no lack of chest-beating quotes about the virtues of concentrating your bets, the psychological reality is that we can best take aggressive bets when a host of other bets are working for us.  I can take risks in my career because I have steady payouts from my relationships, investments, and intellectual pursuits.  When you go all in and place a large proportion of your funds in one stock, with all its gap risks and market sensitivity, you end up in an unwanted psychological version of Russian roulette.

So what about that PG stock?  No one has a crystal ball into the future, short term or otherwise.  All we can do is lay out probabilistic scenarios and effectively prepare for each of these.     

If you study sharp bear declines where volatility has expanded and breadth has blown out to the downside, the most common pattern is that momentum lows--points at which the peak number of stocks registering new lows on the year--are typically followed by tests of those lows and often by further price lows.  That bottoming process can take quite a few months, as in 2002-2003 and 2008-2009, as well as in shorter declines in 1998, 2010, and 2011.  In other words, the "slow bleed" typically occurs over a period greater than a few weeks.  A stock like PG, that receives considerable institutional flows, is unlikely to buck the trend of the major indices.

Even if our base case is that the lows of August 24th represent a momentum low in stocks (2906 stocks made fresh three-month lows vs. highs across all exchanges; 800 stocks made new 52-week lows), we have to assign some probability to the scenario in which this is the start of an ongoing bear market, not the end of a short, sharp correction a la 1998.  In the bear markets that began in 2000 and 2007-2008, those seeming momentum declines were followed by bounces--and then further waterfalls.  All it takes is a policy error or geopolitical event--a failure to bail out Lehman; a World Trade Center attack--to turn a stiff correction into a full-blown bear market.  The possibility of policy errors abound in the current environment, from destabilizing actions in China to premature monetary tightening in developed markets.

PG lost close to half its value over the course of the bear markets of 2000-2003 and 2007-2009.  It's already lost about 30% from its recent highs.  It's not inconceivable that it could lose further value.  As an investor, I need to turn that worst case scenario into a survivable event.  I would do that by buying insurance, either with a portfolio hedge in the form of an offsetting short position or in the form of an options position.  As I've shared with readers before, I missed the market bottom in 1987 by only a day or two.  The problem is that the market plunged well over 20% during that time.  Had my stock portfolio not been protected by out of the money put options, I would have been decimated.  The hope with hedges is that you never need them, just as you hope you never need to make a claim on your homeowner's insurance.  Having the insurance in place, however, helps you sleep at night.

But having hedges in place helps in another big way.  The 1987-1988 period represented great longer-term investment opportunity.  Similarly, 2003, 2009, and 2011 were great times to buy stocks after those high volatility declines.  With world central banks continuing to pursue low interest rate policies and our own rate path likely to be mild, stable companies with attractive yields should be attractive longer-term investments.  You always want to be in a mindset where you have free cash to invest.  Bear markets offer the greatest risk, but also substantial rewards.  If your portfolio--and your life--are sufficiently diversified and hedged, you can treat periods of threat as future periods of opportunity. When experiencing a slow bleed, a tourniquet buys you time for a transfusion.

Further Reading:  Managing Your Money and Your Life