FMD Capital Management

3 Reasons Bulls Take On Too Much Risk

Written by David Fabian, February 25th, 2014

A few weeks ago I wrote an editorial on the three reasons that bears never prosper.    The thesis behind this argument was that a one-sided view of the market can be dangerous to your wealth, especially when coupled with a lack of investment discipline.  In response to some of the feedback that was generated from that piece, I felt it was a prudent idea to look at the other side of the coin and analyze the short comings of bullish investors as well.

If you ever need a dose of bullish optimism in your day, you can always turn on CNBC which has a never ending parade of sunshine and lollipops for investors.  Whether it is secret value opportunities or hot momentum stocks, they are all strategically designed to get your dollars flowing in one direction.  These bulls don’t often offer up any words of caution, but are instead pounding the table to get you to put money to work in the market regardless of the timing or your unique situation.

1. The News Is Always Best At The Top

With the SPDR S&P 500 ETF (SPY) hitting new all-time highs this week, the enthusiasm for risk taking has never been higher.  News stories about momentum stocks like Tesla Motors (TSLA) breaking above $200 and Facebook (FB) acquiring messaging service WhatsApp for $19 billion are continuing to stoke the flames of technological innovation and corporate strength in the marketplace.

These feel good stories spark a rising tide of equity prices that lifts all boats in the harbor.  However, it is precisely these moments of excess that often lead to swift corrections or changes in market tenor that can catch the bulls off guard.  News is often times the most bullish at market tops and most bearish at market bottoms.  After all, if everyone is bullish and invested in the market, who is left to push it higher?

The psychological nature of the markets makes this a counterintuitive indicator, however it should give you pause to put new money to work when all seems rosy.

2. Markets Take The Stairs Up And The Elevator Down

One of the things that is hardest to remember at the top of the market is how easily gains can be wiped out.  Stocks can grind higher for weeks and months at a time and then suddenly have the rug pulled out from under them when you least expect it.  A quick look back at the summer of 2011 can shed some context on this phenomenon, as SPY lost 16.58% of its value (on a closing basis) in just 12 trading sessions.

Aggressive investors or those with long-term time horizons can often times handle that kind of volatility and are suited to make up the losses through time or trading strategies.  However, those that are in retirement or don’t have the stomach for large price fluctuations should be mindful of the downside risk.

By my count, SPY has now been above its 200-day moving average for 15 consecutive months now.  Everyone is a bull when the markets are rising for long periods of time and the gains come easy.  However, your resilience will be tested when volatility returns with a vengeance.

3. Big Losses Are Difficult To Recover From

In investing there are four certain outcomes: (1) a big gain, (2) a small gain, (3) a small loss, and (4) a big loss. Three of these outcomes are acceptable. Everyone can agree that a big or small gain is going to move the needle forward on your portfolio and even a small loss won’t derail you from reaching your goals. However, the big loss is the one cardinal sin that will haunt your dreams and hinder your performance.

The worst part about a big loss is how much harder it is to recover from. Remember that based on the rules of compounding, a 25% loss requires a 33% gain to get back to break even. A 50% loss requires a 100% gain to get back to break even. If you hang on to an investment with a loss of more than 25% and it continues to underperform, that money is just dead. It is not contributing to the long-term success of your portfolio and acts like a boat anchor attached to your money.

If 2008 taught us anything, it’s that there is no such thing as a safe stock and that big losses are difficult to recover from.  That is why I always employ a stop loss or sell discipline on my invested positions to guard against the potential for a protracted decline.  It’s not a perfect system, but it allows me to sleep well at night knowing that I have a limited amount of downside exposure.

The Bottom Line

Bulls often times have it easier than bears because despite every correction, recession, or depression the stock market has been resilient enough to march its way higher.  Not every investment survives these cycles, but the system as a whole has been one that creates wealth for the majority of its participants.

I don’t align myself with either the bull or bear camp exclusively.  Instead, I focus on building balanced strategies that take into account both sides of the trade and consider both the upside potential and downside risks.  That way I am prepared for either outcome and can shape the holdings in my portfolio to align with the current market environment.

The drawback to this philosophy is that I lose out on some upside in raging bull markets, but by the same token I do not undertake the same perils during bear markets either.  I try to keep some cash on hand to take advantage of strategic opportunities when they present themselves as well.  This allows me the flexibility to add to holdings that I feel are represent a unique value or reduce exposure to investments that hit my upside targets.

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