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There is a more general question on preparation here, I am focused purely on investment.

There is the conventional wisdom of don't try to time the market, and while I can't find the quote at the moment there's a thought from Warren Buffet along the lines of "don't buy something you wouldn't want to own 20 years from now".

That being said, let us assume that in February 2020 a bubble will pop, and the ensuing recession will have similar market effects to the Great Recession (not focusing on the subprime mortgage aspect, just generally speaking). What from an investing perspective should I do today, September 2018, and for the next two years, to prepare for this? Assume I have a portfolio that is well balanced between domestic and international, stocks and bonds, not concentrated in one industry, etc.

I'm thinking about this in the sense of, pretending that its now March 2020 and the crash already happened, what did people who saw the warning signs of a crash two years prior but didn't know exactly when it would happen do to minimize their risk while still maintaining some level of gains do well? Not people who lucked out on big short positions, people who rebalanced and hedged in ways that greatly limited their exposure or even put them out on top. Examples of investors from the great recession are welcomed.

  • A big part of this question relies on (a) your level of conviction; (b) your tolerance of risk; and (c) the specificity of timeline. ie: do you believe that there will be a market crash at some point between today and 2020, with all days being equally likely vs a crash between Jan and Feb 2020? – Grade 'Eh' Bacon Sep 28 '18 at 19:44
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    There is no fool-proof plan for an unknown event. If you're wrong, you'll be worse off. You can lower your risk, but you sacrifice returns in the good years by doing so. – D Stanley Sep 28 '18 at 19:44
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    If you KNOW that in February 2020 the bubble will pop then it's an easy answer. Sell everything the month before and go short. – Bob Baerker Sep 28 '18 at 19:52
  • @DStanley this question is about minimizing risk while also maximizing gains. Of course the most risk-averse thing to do would be pull everything out and wait for the crash to reinvest, but the loss of gains would be staggering. Grade Eh and Bob bring up a good point with the timeline, I'll try and hash that out in the question – Gramatik Sep 28 '18 at 20:00
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    You can't minimizing risk while maximizing gains because risk and reward go hand in hand. If you are willing to make that trade off then you can hedge in a variety of ways. I just read your addendum edit. I got out of the way of the GFC in 12/07, selling off a large portion of what I owned and was net short for 18 months. It's a transition process as it unfolds not an all or nothing approach. I'll conjure up an answer when time permits later. We'' probably be banished to chat :->) – Bob Baerker Sep 28 '18 at 20:07
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Sorry in advance for the length of this but this is my big picture view of what you have asked about.

There are different approaches to protecting profits, reducing your losses, or profiting in a bear market.

Buy & hold types recommend diversification (sector, asset class, geographic, etc.). Equity diversification spreads losses across various sectors, hoping that some don't lose as much as others. With equity and geographic diversification, you will lose in a deep recession. You'll take the beating as you ride it out.

For the period of 1/01/08 to the end of the GFC on 3/09/09, the SPY lost 52%. The best performing SPDR sector was Consumer Staples, down 'only' 31%. Those losing more than 50% included Consumer Discretionary, Energy, Industrials, Materials, O&G Exploration, and Technology, with the winning entry being Financials, down 77%. Note that a drop of 50% requires a 100% recovery to break even (ignoring dividends).

Some recommend gold. Sometimes it correlates, sometimes not. It's iffy. For the past three recessions:

In 1990, it lost about 10% of its value.

In 2000, it did nothing.

In 2008 it dropped 30% before recovering and ending up 4% for the year.

Some recommend stop loss orders. That's fine in an orderly correction but in a volatile down market or a crash, you'll have no clue where your fill will be if price gaps through your stop loss price.

You could write covered calls but that only provides limited downside protection unless they are deep ITM. For ATM and OTM CCs, if your stock craters, you won't be able to continue doing so without locking in a loss. Writing deep ITM covered calls provides more protection but why would you? You would have little to no upside profit potential and they would be Unqualified which means that you would not be able to claim long-term gains if assigned and the underlying is called away. Caveat? Don't monkey with covered calls if you don't want to sell the stock.

You could buy protective puts but that has several issues. At the current level of implied volatility, ATM portfolio protection with SPY puts costs about 8 pct a year. Puts on individual stocks usually cost more. That's a lot of portfolio drag to overcome if the stock or stock market stagnates or only moves up modestly. You can reduce put protection cost if you use OTM puts but that adds a 'deductible' to the equation (loss from current price down to the put's strike price). If you buy protective puts and the market moves up, additional gains will not be protected.

If you are willing to make the trade off of giving away much of the upside potential gain, you can reduce/eliminate the cost of protective puts by collaring your long stock. For every 100 shares that you own, sell an out-of-the-money (OTM) call and use the proceeds to buy an OTM put. This defines a floor beneath which you cannot lose as well as a ceiling beyond which you will not profit. You can do it on individual stocks or globally with liquid SPY options.

Collars can be structured for no cost. If you want to skew the risk graph so that you have more upside potential than downside risk, the call will be further OTM (or the put closer to the money) and the collar will have a net cost. Skewing the collar in the opposite manner (the put is more OTM than the call is OTM) will result in a net credit but potential loss will be greater than the potential profit.

Pending dividends affect option premium, inflating put premium and deflating call premium. The larger the dividend, the more expensive a collar becomes.

If you do 1-3 month long stock collars and the stock appreciates toward the short call strike, With some cooperation from the underlying, you may be able to roll the collar up and/or out, protecting some of your additional capital gain. Wash, rinse, repeat. Caveat? Don't monkey with collars if you don't want to sell the stock.

To offset losses or profit during a recession, you need to own negative correlation positions:

1) But puts

2) Buy inverse ETFs

3) Short stocks, ETFs, futures

4) Run a long/short portfolio

The average Joe can take advantage of a bear market (not crash) and profit from it. Note that a crash and a bear market are different beasts. 1929 and 1987 were crashes. Unless you had some form of negative correlation protection in place prior to them, you paid the piper. Bear markets like 2000 and 2008 took 18 months to unfold and they offered lots of time to react and adjust if you weren't oblivious or afraid of being wrong.

Transitioning to cash or quality debt is something that any investor can achieve. Managing the downside requires more experience and effort. As the market drops, transition to more cash or fixed income and eventually add a small portion of negatively correlated positions. Let your portfolio’s declining value dictate the transition from long to short (and vice versa). React, don't predict.

  • Did one "pay the piper" during the crashes, even if they held on to their positions (sold nothing) long-term (up to and past recovery)? – horse hair Sep 30 '18 at 1:11
  • horse hair - Spare me the old argument of "I didn't lose money because I didn't sell." If the value of your investments drops 50%, it's an unrealized loss of 50%. It's still a loss. Rhetorical question? You're retired and you incur a 50% loss of portfolio value. Are you feeling good about that because you believe that it might come back to break even some day? – Bob Baerker Sep 30 '18 at 3:31
  • What if I'm 20 and have many years before retirement? Are the techniques you provided in your answer better than just leaving it where it's at, to recover after the crash? – horse hair Sep 30 '18 at 4:19
  • @horse hair - My suggestions addressed the OP's question of how to prepare a portfolio for a financial crisis. You are now asking whether it would be better for you over the the next 40 years to do nothing. Would you feel comfortable having an equity portfolio lose up to 50% of its value one or more times during the next 40 years or so? If that's OK with you then that's your path. I am not OK with it so in 2000 and 2008, I chose a different path and will continue to do so. I retired very early, keeping it is more important than making it. I like the latter but the former takes precedence. – Bob Baerker Sep 30 '18 at 12:37

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