Dealing with Stock Market Risk

Essentially, there are two types of risk when owning stocks:

  • Individual stock risk—what happens to your portfolio when any one stock drops significantly in price, and
  • Market risk—what happens to your portfolio when the market as a whole falls.

“Diversification”—holding many different stocks instead of just a few—helps to mitigate individual stock risk, and as such, is a staple of prudent portfolio management. But it does nothing to offset market risk.

There are two basic approaches for dealing with market risk:

  • Static—you allocate your assets such that the percentage of stock holdings (i.e., the market risk you are willing to accept) is appropriate for you. This allocation is not influenced by market conditions; it reflects your financial wherewithal and risk tolerance. Such an allocation is generally slow to change.
  • Dynamic—you modify your stock market exposure as stock market conditions change.

The static approach is the easiest. It’s pretty much “set it and forget it”—you make a change only when there’s a change in your financial picture. This approach implies that you’re always in stocks, to the degree of your asset allocation.

Most investors who have watched their portfolios plummet during steep market declines will tell you that a static allocation is not enough. There are times to be in the stock market, and times to avoid it.

The dynamic approach can be implemented two ways:

  • Emotionally, or
  • Non-emotionally.

Since 1994, DALBAR’s Qualitative Analysis of Investor Behavior has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds over both short- and long-term time frames. The results consistently show that the average investor, by virtue of their emotional responses, earns much less than the mutual fund performance reports would suggest. DALBAR found that for the 20 years ending 2013, the average equity investor earned 5 percent per year while the S&P 500 returned 9.2 percent per year!

Non-emotional approaches use measurable data to trigger the changes in your portfolio’s stock percentage. Let me give you some examples, citing the indicators you might use to vary your market exposure:

  1. Economic     GDP growth, unemployment rate, CPI, LEI, etc.
  2. Fundamental  EPS, profit margins, dividend rates, etc.
  3. Valuation     P/E ratios, PEG ratios, P/E vs interest rates, etc.
  4. Momentum   Price vs moving averages, volume flows, etc.
  5. Behavioral    Congressional (sell when Congress is in session) or “Sell in May.”

In summary:

  • Diversification is good, but only deals with individual stock risk.
  • Static asset allocation, alone, will not protect your portfolio from a down market.
  • Employ dynamic, non-emotional triggers to reduce stock market exposure in falling markets.

Robert A. “Rocky” Mills is a financial advisor with the Global Wealth Management Division of Morgan Stanley in Westlake Village.  The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice.  The views expressed herein are those of the author and may not necessarily reflect the views 
of Morgan Stanley Smith Barney LLC, Member SIPC, or its affiliates.