Don’t Get So Defensive!

The current market environment has investors spooked and everyone says we're in for more. To heck with fundamentally sound principles! Scary things are happening today, so let's batten down the hatches, dust off our "Options Investing for Dummies" books, and implement those defensive tactics that sound really cool and make us feel smart to talk about at cocktail parties.

Or—let's not.

Many make the mistake of discounting how big the decision is to "get out" of the market. Realize this is a major allocation change and there are implications—transaction costs, tax considerations and opportunity cost are but a few. However, if implemented properly with sound justification, a defensive strategy can have a significantly positive impact on a portfolio's long-term success.

Let's first review some unrealistic expectations—like trying to time short-term market tops and bottoms. It's unrealistic to predict investor psychology with any accuracy. Therefore, it stands to reason that timing market corrections—up or down—is unrealistic as their triggering is purely psychological and their movements are sharp and fast.

If it were possible to time corrections, I wouldn't be writing this—I'd be traveling the world living off my obnoxious wealth created from market timing. And so would everyone else. Alas, corrections are short-lived, psychologically driven phenomena and darn near impossible to time. So, for the long-term investor it makes sense to let corrections come and go while remaining vigilant, and instead focus on identifying and avoiding fundamentally driven bear markets—which last longer and are more destructive to a portfolio.

If long-term investors knew that once the market got wobbly it would be short-lived, most would let the turbulence pass without taking action. However, since most folks mistake corrections for bears or are simply spooked by any sharp downside, they often take immediate action. Ill-timed defensive tactics not only cost money to implement, they ensure an investor won't participate fully in the correction's rebound, which can take place at any time and be just as quick as the downdraft was. This is why it's so important to know the fundamental difference between a bear and a correction.

A bear market is a broad market decline of more than 20% that lasts for a significant period. Corrections usually fall into the range of 10%-20% down from the peak and often have scary stories most people believe which later appear silly. The Asian Contagion of 1997, the Russian Ruble Crisis of 1998 and the Y2K scare of 1999 are all classic corrections that come to mind. Back then, folks questioned the bull market right up until they believed it would never fall again. Of course, by that time the bear was upon us and the masses were euphoric.

I've been fooled by both bull market corrections and bear market corrections in my life. I've been taken to school more than I'd like to admit. But if I've learned anything, it's that successful long-term growth strategies are fundamentally based, and a realistic defensive strategy must also account for the surrounding fundamentals. A bear market doesn't materialize because technical charts reverse down or mass psychology says it should. A bear market materializes because of fundamental economic shifts and an investing community that hasn't fully appreciated them.

Investors don't fear corrections (at least they shouldn't); they fear bear markets. Most simply mistake one for the other. Proactive, fundamentally-based defensive strategies implemented during true bear markets can provide the benefits many long-term investors seek. Conversely, willy-nilly reactionary defensive tactics initiated whenever the market hiccups usually end up causing frustration and lost opportunity in the long run.

Of course, many will disagree, believing they can time the short moves and make a killing. And maybe a few can. Who knows? But over time, the vast majority of those folks will likely be the ones scratching their heads as they chase the market up and down, wondering why they aren't getting the results they seek. Maybe they deserve what they get.

Oh, sorry—I didn't mean to get so defensive.