To be a successful investor, you must control your risks. In this article, Paul Merriman discusses the two most fundamental ways to achieve that. 

One of the most important things investors have to do is limit their risks. There are various ways to do this, and because risk is emotional as well as quantitative, one size definitely doesn’t fit all.
     
Risk, of course, is the possibility that you will lose money that matters to you. The loss may be permanent or only temporary. It may be large or insignificant. It may be triggered by a general market meltdown or a single bad investment choice.

But one thing is certain: If you don’t manage your risks, they will manage you.

Perhaps the most fundamental way to reduce risk is to diversify into what are called non-correlated assets. That means you put your money into various investments that aren’t likely to all move up and down in sync.

I’ve written a lot about diversification, and getting that right is extremely important. This is true whether or not you use timing to reduce risk.   

However, even with the perfect balance of stock investments in large and small companies, growth and value companies, U.S. and international companies, there’s still the general risk of the stock market.

Over long periods of time, stocks lose money in about one-third of all 12-month periods. Sometimes the losses are short lived; sometimes they last a long time. But there are always losses.

To be a successful investor, you have to keep those losses small enough so they won’t cause you to abandon your long-term investment strategy.

I have spent many hours thinking about risk and reading about risk. I have talked to thousands of investors and dozens of experts about it. As far as I’ve been able to figure out, there are only two basic ways to reduce the risk of owning a stock portfolio.

One way is to own enough bond funds to reduce the portfolio’s fluctuations to acceptable levels. This works because bond funds move up and down in cycles that are different from those of stocks. And it works because bonds’ fluctuations are less severe than those of stocks.

Bonds, in other words, smooth out the ups and downs of stock market volatility.

The second way to reduce risk is to get out of the market when it’s going down. While this is supremely logical, it’s also supremely hard. Nobody has a crystal ball showing where the market is about to go.

This second risk reduction method is known as market timing, though it is more accurate to call it active risk management. In a nutshell, it consists of adopting some system for getting out of the market when there is more chance for loss than for gain – and getting back in when the chance for gain is greater.

This is easier said than done, and it’s a road full of chuckholes. But it’s possible, and for almost a quarter of a century I’ve been teaching people how to do it themselves – and I’ve been doing it successfully for clients since 1983.

The majority of investors – roughly seven of every eight – say they believe in buying and holding. Their behavior may indicate otherwise, but this is what they are comfortable with. For those investors, timing is not appropriate. They must control their risk levels by carefully considering how much of their portfolios to have in bond funds.

Many other investors aren’t willing to sit passively and watch their capital shrink during a market downturn. For them, some sort of active risk management is essential.

Most advisors and money managers offer only one of these risk-management solutions. But my commitment is to help investors who believe in timing as well as those who don’t. Our company manages hundreds of millions of dollars of buy-and-hold accounts and hundreds of millions of dollars of timed accounts.

This is not a conflict for me. I truly believe in timing. And I truly believe in buying and holding. What I don’t believe in is following either one of these approaches on the basis of emotions, judgment calls, predictions or other subjective factors. In my view, the way to be successful at risk management is to do it mechanically.

Buy-and-hold investors get in trouble when they don’t really buy and hold. They buy only when it’s comfortable; they sell when they’re scared. They think they will know when it’s time to get in. They think they will know when it’s time to get out. And mostly, they are wrong.

Timers get in trouble for the same reasons. They may adopt a system of timing only to abandon it when it “makes no sense” to follow a particular buy or sell signal. Buy-and-hold investors sometimes conclude that it “makes no sense” to hold assets that are falling in price.

So which is better, timing or buy-and-hold? The answer is different for every investor. Ultimately, it comes down to what you believe in and what you can live with.

If there were no emotions involved in investing, buy-and-hold would be a perfect approach. But that’s certainly not the case. Because investing involves risk and risk involves emotions, there’s simply no free lunch.

THE FRUSTRATIONS OF BUYING AND HOLDING

Buying and holding is boring. To many people who don’t want to pay much attention to their portfolios, that’s good. But to many others who like to tinker, fine-tune and second-guess, that’s a drawback.

Many retirees have portfolios equally split between equities and bonds (we call this a 50/50 portfolio). This keeps risk very moderate while still leaving plenty of room for long-term growth.

However, psychology is a frequent intruder. If the bond funds in a portfolio like that are up 5 percent and the equities are down 30 percent, an investor may focus exclusively on the equities. The overall portfolio may be down only 12.5 percent, but investors in that situation sometimes become obsessed with the loss in equities, feeling as if they have lost 30 percent of their money.

This type of emotional response sometimes makes it very hard to maintain their strategy. Imagine if you’re in that position after a year and it’s time to rebalance by selling bond funds and buying equity funds. How excited are you going to be about doing that?

A logical solution to that is timing. But that solution generates its own challenges.

THE FRUSTRATIONS OF TIMING

Because of the frustrations we just noted, many people like to have an exit strategy when things aren’t going well – or more accurately, when things aren’t going as those investors hoped or expected. Notice the strong emotional content of that last sentence.

Many investors’ informal approach to timing is 100 percent emotion-based. It’s what I call the “I can’t stand it any more” timing system. It’s a disastrous system. But if you want to follow it, here are the rules: When the market starts going down, do nothing. Keep hoping that things will turn around. If the market keeps going down, wait until you are really afraid and uncomfortable. Then, when you truly can’t stand to lose any more money, sell in a panic.

(Other investors, by the way, will applaud your actions. You have just helped to make the assets you sold even cheaper and more of a bargain for others who are more level-headed.)

The other instructions for this awful timing system kick in when the market starts going back up: Don’t do anything. Wait for the market to be strong enough that you can “trust” it. Wait until you see lots and lots of other investors making buckets of money. When you simply can’t stand to be on the sidelines any longer, buy.

This emotion-based timing system guarantees a couple of things. First, you will be upset a fair amount of the time. Second, you will never come even close to buying low and selling high; you will more likely do the opposite. You will own equities when the market is going down, and you won’t own them when the market is going up.

I’m sure that you personally have never practiced any variation of the wretched strategy that I’ve just described. But I bet you know someone who has.

The only sensible way to do market timing, in my view, is to adopt a mechanical discipline that doesn’t require analysis, judgments, forecasts or predictions. A discipline that tells you exactly what to do and when to do it.

I have written extensively about timing systems elsewhere on FundAdvice.com. We offer five free timing systems in the Tools section of the site: one for bond funds and four for U.S. equity funds. For an explanation of our equity timing models, click here. For a brief description of our fixed-income timing model, click here. These signals are available via free email subscription.

The systems we use are all trend-following. That means they are based on events in the market that have already occurred. The systems generally issue buy signals after the market has risen a certain amount and sell signals after the market has fallen a certain amount. Hence these systems won’t ever get investors in at the bottom or out at the top.

They don’t have to do that in order to be effective in the long run. One difficulty with timing is that in the short run, it’s often “wrong.” About half of the individual trades result in short-term losses, though they are usually small ones because of the self-correcting nature of a trend-following timing system.

I often tell people that investors have a choice of making many small mistakes (with timing) or potentially making a single very big mistake (buying at the wrong time and then holding). I don’t mean to paint either of these approaches as negative; my point is that each one presents emotional challenges.

Another difficulty with timing is that it requires watching the market every business day. If you take that seriously, you can’t ever take a true vacation without your laptop at your side. (I know people who solve that problem by simply moving their money to cash when they won’t be available to make the daily calculations.) Timing also generates lots of transactions, with associated costs and tax consequences.

Like buying and holding, timing requires faith and persistence. Not everybody has what it takes to be a successful timer. For those people, there’s buy-and-hold.

Buying and holding a properly diversified portfolio works very, very well in the long run, and many people prefer it. It’s less demanding, less expensive and much more tax-efficient than timing.



EIGHTEEN DISMAL YEARS

In 1983, I began a company (now Merriman Berkman Next) managing money for individuals. My focus was on timing, and here’s why: From 1965 through 1982, the Standard & Poor's 500 Index had compounded at 6.3 percent. Adjusted for inflation, the rate was an annual loss of 0.3 percent.

This washed a lot of people out of the stock market, many of them for good. I had faith in the long-term upward bias of the market, but I knew that I didn’t have the stomach to take the risk of being in the market during a bear market like that of 1973 and 1974. (The S&P 500 Index lost 37.3 percent in those two years.) And if I didn’t have the stomach for it, how could I counsel my clients to be buy-and-hold investors?

I found a group of timing systems, similar to the four we now publish on our web site, that would provide a way for investors to participate in the stock market without that level of risk.

Since then, timing has invariably reduced the risk of investing. (Every day you are in cash is a day you are not exposed to the risk of market loss.) We believe that mechanical timing systems, such as those we use, can provide competitive returns when employed over an extended period of time.

I cannot of course tell you which approach will do better in the future, either long-term or short-term. I can tell you for sure that many investors who were heavily committed to equities in 1999 wished they had had a good exit strategy when the severe bear market of 2000-2002 came along.

In those three calendar years, the Standard & Poor's 500 Index lost a cumulative 37.7 percent – coincidentally almost exactly the same as the two-year cumulative loss in 1973 and 1974. But our four free timing models, when applied to the index, resulted in a gain of 0.7 percent.

Still, most of the money that’s invested for people and institutions is actively managed in some way, and that means it’s subject to some sort of timing. This may take the form of deciding which sectors to invest in and which to overweight and underweight (and changing those parameters from time to time as the economic outlook evolves). It may take the form of gradually moving some assets back and forth between equities and bonds (or equities and cash) as managers re-assess their view of the future.

But it’s timing, even if investors and managers call it buying and holding.

Critics of timing say it’s more risky than buying and holding. They said that in 1999; the Standard & Poor's 500 Index was all anybody needed. Then along came the awful bear market that lasted more than two years.

Those who used mechanical market timing got out before the worst of the damage. Those who truly followed buy-and-hold suffered big losses unless they were unusually well diversified. Those who thought they were buying and holding but were really timing didn’t know what to do; in many cases I know of, they lost a lot of money.

No matter what you do, if you invest money you will always run into frustrations. Your expectations won’t always be met.

At that point, in order to stay in the game you need an approach you believe in. That belief, and the trust and discipline it encourages, is more important than whether you buy and hold or use timing.

Many investors I know prefer to control risk with timing. Many others prefer a buy-and-hold approach. We teach both, we manage both and we believe in both.

In addition, many investors – I am one of them – believe in and use both buy-and-hold and market timing. I think this makes a lot of sense. If it’s done right, coupled with proper asset allocation, this dual approach might even be the ultimate investment combination.