How to protect your capital in a down market

How to protect your capital in a down market

Anyone can make money in a bull market, but the real challenge begins when things turn bearish, as we’ve seen following the peak in April last year.

The simple fact is, no one rings a bell to tell you when the market has peaked, nor do they ring it at the bottom. This you have to decide for yourself, and this requires knowledge.

“The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge”

 

— Stephen Hawking

It is interesting to me that many people think they have the knowledge to be good investors, yet so few do. Therefore, as Mr Hawking so eloquently says, they are living with an illusion. Sadly, this illusion is held by a majority, not a minority.

As the majority overestimate their level of knowledge when it comes to understanding the share market and investing, it’s no surprise that investors struggle with maintaining a consistently profitable portfolio. The reality is, anyone can have a portfolio that performs well, providing they are willing to learn how.

The first step is learning how not to drown – let me explain…

At Christmas, I was in Bali with some friends, and one person didn’t know how to swim – they could not even float. Being a former lifesaver, and someone who taught kids to swim when I was young, I offered to teach them how to stay afloat. This person expected me to teach them all of the strokes, however, I explained that the first lesson was about how not to drown. Why?

Quite simply, if you are in the water up to your neck and in a panic, you can’t breathe, so you won’t be thinking logically, nor will you listen to logic. After the first lesson, they became calm in the water, no matter the depth or situation. However, it was only once they knew how not to drown that they were able to start learning to swim.

The same is true for the share market. Once you learn how to protect your capital in a down market, you are learning how not to drown. At this point, your money is much safer and this allows you to enjoy more freedom and peace of mind, because no matter what occurs, you know you can handle it.

First and foremost, successful investing is not about how much money you make, it’s about how much you don't lose, and this is especially so in a bear market.

I find that most people are influenced by market myths and not facts, and so they drown when the water gets a little rough. Yet when confronted with a fact, instead of embracing it, and adjusting how they manage their portfolio, they stay fixed in old ways and follow the herd.

While space does not permit me to run through all the myths that influence investors, or even why they are myths, one myth I cover in my book is called 'dollar cost averaging', which quite simply does not work.

So why do investors stick with ineffective investment strategies?

Quite simply, it is fear of losing and making the wrong decision. Operating out of fear in a bear market results in no decisions being made or emotional ones being made instead, which often result in portfolio returns falling by 20 per cent or more. Learning not to drown in these conditions would save investors thousands and reduce stress.

Fact: The Australian share market falls every year by around eight per cent to 12 per cent over a few months, and every four to five years the fall is around 20 per cent or greater over approximately 10 to 14 months. Every 20 years the fall is greater.

So if you run a portfolio of shares, you need to accept this fact, and that doing nothing means your portfolio will fall every year, with some falls being much bigger than others. If you can accept these falls, and that bearish markets are part of normal market cycles, then you will have average returns and no stress.

If having shares fall into loss after you buy them, or on seeing your whole portfolio fall in value in a bearish market, stresses you out, then you have two choices:

1. Do not invest in shares

2. Learn how to properly manage your portfolio so you don’t drown!

I constantly talk to people who have chosen to go down the path of setting up their own SMSF. Quite often, the reasoning I get for setting it up is 'at least I can’t do any worse than the professionals' or 'I just want to control my own money'. Remember what Mr Hawkins said above. That’s all fine if you actually know what you are doing, however, if you do not know how to swim, then jumping off a cliff into the water isn’t smart.

There are two simple techniques anyone can use straight away to protect themselves in a bear market, and they are:

1. Use a stop loss

2. Use correct position sizing for your portfolio

A stop loss I use and teach investors is 15 per cent, meaning if a share falls by more than 15 per cent, then you sell. Correct position sizing requires you to only ever place eight per cent to 12 per cent of your total portfolio value in any one share you buy. Using both of these rules will ensure you only risk around two per cent of your capital in any company, which means you’ll stay afloat.

An example of why you need a stop loss is Telstra. In the 11 years between 1999 and 2010 it fell 72 per cent, while at the same time BHP rose over 800 per cent, CSL and COH over 700 per cent. There were many more shares rising while Telstra was falling, and therefore using a simply stop loss to exit Telstra would have enabled investors to go into other shares.

Sadly, most investors believe in myths and thus hold onto losing shares thinking 'it will come back to where it was' or 'I have not lost as I have not sold'…

I wonder what investors in Babcock and Brown, ABC centres and others that are no longer with us are thinking about those myths now?

Dale Gillham, chief analyst, Wealth Within

How to protect your capital in a down market
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