Pack Your Parachute Before You Jump

What can investors do now that will save them from watching their investment portfolios lose 40-50 percent of its value should the market tank again like it did in 2007-2008, or in 2000, or in 1998? According to Mebane Faber, portfolio manager at Manhattan Beach, California-based Cambria Investment Management, the key is to truly understand risk as it pertains to themselves. "People often say that they have a long-term time horizon or that they have a certain risk tolerance. But when it hits the fan, it turns out that they have a much shorter-term emotional tolerance for risk," he says.

Many who discover this about themselves are surprised because they’re used to taking risks in their businesses. Of course, the difference is that they understand their business, and are in charge. Not so when you turn your money over to an investment manager. "The risks are quite different," explains David Taggart, publisher of The MacroTrader.com newsletter (and my son). "Consequently, it’s very likely you don’t understand the risks you are undertaking when you invest. So, if you’re intent on managing risk in your investment portfolio, you must be really honest about what your tolerance for risk is."

That said, it’s very difficult for an investor to know how tolerant he is until he has lived through a downturn of the sort the markets have undergone in the last few years. That is, until he has actually watched his portfolio take a stomach-turning dive, the typical investor won’t know whether he can really "take a punch." Thus, to get their attention, Faber warns investors who simply index that they should be prepared to lose up to 90 percent of their money. "If you’re not prepared to do that," he says, "you should be looking to invest elsewhere or to employ strategies that will mitigate risk much better." What kind of risk, you ask? "The risk of permanent loss; the risk every investor should worry about," he continues. Here’s how to mitigate that risk.

Go Global

For Faber, the first step is to allocate your portfolio not just across U.S. stocks and bonds, but across foreign stocks and bonds, real estate – again, foreign and U.S. – commodities of all types and currencies. "Most investors don’t have much exposure to those areas," he says.

Though buying and holding a diversified portfolio of U.S. stocks and bonds has historically worked well in a bull market, such a limited strategy doesn’t work well in a bear market. Take 2008, for example. "At one point in 2008, you would have lost half of your money," Faber says. That’s a big hit, made even bigger when you realize that it will take a 100 percent return just to get back to even. "If you lose 75 percent, it takes a 300 percent return to recoup your loses," he continues. "Of course, on the flip side, if you just put all your money in T-bills or fixed income, you barely keep up with inflation, and you expose yourself to the risk that you may outlive your money."

Global macro – a hedge fund strategy where managers take long and short positions in any market or asset class based on macroeconomic principles – promises to deliver on both ends. According to Taggart, that investment approach has been the number one strategy over time because global macro as an asset class tends to shine in down markets (see figure 1). "If you think we’re going to have global turmoil on and off for the next ten years, throw some global macro into your portfolio," he says. "It’s a very good diversifier, a risk dampener if you will."

FIGURE 1

Traditional diversification – the 60/40 allocation between various classes of stocks and bonds – may work well in many markets, but when things go really bad, correlations go to one and everything drops like a rock. In other words, Taggart says, "real diversification is great, but quasi-diversification is garbage."

As proof of the pudding he’s peddling, Taggart points to the model portfolio he follows in his newsletter. Year to date, that portfolio has returned a positive .49 percent and suffered no more than a 2.27 percent drawdown (the peak-to-trough decline for a specific period, often used to quantify a portfolio’s risk). That’s no big deal, you say? Maybe so, until you compare that performance to the S&P 500, which has lost 4.23 percent over the same period. Worse, it has experienced drawdowns of as much as 17.9 percent. "Global macro does really well when markets tank and decent when they soar," Taggart claims.

Pretend You’re a Casino in Vegas

Think of diversification as compromise. Ideally, investors should always be leveraged and always be long. In an up market, the returns would be outstanding. But the downside is that you could be wrong. Proper diversification hedges that risk. The trick is to make the best compromise. Casinos know this. One or two tables work very well until the card counters show up. Add a lot of other tables, tables entertaining regular Joes who lose more than they win, and the casino will do just fine. "Likewise, the more different asset classes you are in, the better chance you have to weather a storm," Taggart says. "Real diversification is pursuing gains in many different places."

Pay Attention to Trends

Markets are still trying to recover from the 2007-2008 crash. Many experts are worrying that the current bear market could rival the one in Japan that has lasted some 20 years. To protect his investors against that possibility, Faber employs a so-called "trend following" strategy. As markets decline, he scales out of stocks and into the relative safety of cash and fixed income securities. "When markets decline, volatility explodes," he explains. "That happens because investors use a different part of their brain when they’re losing money."

Think about it. When you’re making money in the markets, don’t your thoughts run to ski trips in Utah, that new Mercedes on the lot, or the condo in Florida? Now consider what happens to most investors when the market declines. They become fearful and uncertain. They don’t know what to do. They flee the markets, leaving a trail of red ink in their wake. "It’s actually physically painful," Faber claims. "People hate losing money at least twice as much as they enjoy making money."

Currently, Faber has allocated about 60 percent of his Global Tactical Asset Allocation (GTAA) portfolio to cash-type investments. He says that in 2008 when most markets were down 30 to 40 percent, his portfolio stayed roughly flat by paying attention to a long-term moving average (see figure 2). "So as prices are moving up, based on this very simple indicator, we tend to be invested," he explains. "And as prices come down, we tend to move to the safety of cash."

FIGURE 2

Buy Managed Futures

Keeping with his theme that real diversification means looking for returns in all the right places, Taggart argues that any well-diversified investment program should include managed futures – alternative investments managed by commodity trading advisors that take long and short positions in futures contracts and options on those contracts. Yes, they can be volatile by themselves, but as just one asset in a many asset investment portfolio, they help lower volatility and therefore risk. "Many studies show that they definitely dampen volatility," Taggart says. "I look at them in terms of how they affect drawdowns in a portfolio – the loss from your last peak to your new low. Managed futures tend to decrease the size of your drawdowns."

Managed futures allow you to be long and short in a variety of commodities and futures markets, across currencies, both precious and industrial metals, soybeans, wheat, oil and gas, as well as stock and fixed-income index futures. There’s even a futures market that allows investors to hedge out broad market risk in real estate, though you still can’t do that for a specific house. "Managed futures are among the first, easiest, and most researched ways to diversify your portfolio," Taggart says. "Some people may think futures are risky because their friend lost money in them. Based on that standard, buying a house is risky."

Grab (and hold on to) Your Parachute

 In the end, the best way to protect yourself in a volatile market is to get out of your way as an individual investor, Faber says. "Have a plan. Pack the parachute before you jump out of the plane." Whatever your plan, even if it’s simply buy and hold, make sure you understand and are comfortable with the risks involved. That starts with being completely honest with yourself about your tolerance for risk. Completely honest. "That way you’re not waking up in the middle of the night wondering, ‘what do I do tomorrow if the market is up or down 5 percent,’" Faber says.

Who Can You Turn To?

Managed futures, global macro, trend following. Are these tools you can safely handle by yourself? Neither Faber nor Taggart claims you can’t. They do say to think twice before you try. "Some may think, ‘okay, I ran my business well, so I can do this too,’" Taggart says. "Yes, you can – if you put the same time and effort into it that you put into your business."

If that describes you, go for it. If not, seek out an investment professional who understands these alternative approaches to investing. If credentials are important to you, look for people with a CFA (Charted Financial Analyst) or a CAIA (Chartered Alternative Investment Analyst) after their name. Bottom line, it costs to manage your risk. It costs even if you do it yourself. "Most of our clients understand that they could replicate what we do," Faber says, "but they pay us to do it for them because they either don’t trust themselves or think we add value." So, do you trust yourself enough to pack your own parachute?

 

 

 

Gregory Taggart is a financial writer who has written for Institutional Investor, Bloomberg, BankRate.com, Morgan Stanley, Schwab, and Fidelity, among others.