My friend was worried about a market crash. It was September 2021; his portfolio was already up more than 25% this year and the markets were roaring higher. Not just the stocks he owned but everything. And this included over valued junk companies with no profits, SPAC’s, crypto currencies.
He was worried about a market crash for good reasons:
- He wanted to protect his gains, already over 25%
- He was wondering how long this madness can go on
- He saw the US markets, already overvalued by every valuation ratio you choose to look at, hitting new highs every day
- The overvaluation and new all-time highs seem to be propping up everywhere with all assets
How to prepare for a crash
We talked at length on what to do.
We agreed his greatest risk and worry was a permanent loss of capital.
How to avoid permanent loss of capital?
Just what is “permanent loss of capital” and how can I avoid it you may be thinking.
A permanent loss of capital happens if any asset you hold falls in price and does not recover. It can also happen if an asset falls in price, and you sell before it can recover.
Permanent loss of speculative assets
For example, if you buy speculative assets with no underlying value. Tulip bulbs, crypto currencies, beanie babies, or loss-making start-ups (with no hope of a profit) for example. Because none of these things (we cannot really call them assets) have an underlying value their price is determined by the last buyer.
And a higher future price depends on a buyer willing paying more for these things in future. If the thing has no underlying real value, a profitable business, or a use as payment, for example then its value is unsure (it may even be zero) if the next buyer at a higher price does not show up.
Permanent loss of an overvalued asset
Permanent loss of capital when you hold an overvalued asset is best explained by an example.
Assume that a fair value for a growing large quality company is a price to earnings ratio (PE) of 20 and for a similar small company a PE of 12.
On 11 November 2021, the PE ratios of the largest US tech companies were:
- Facebook 25
- Apple 27
- Alphabet 28
- Netflix 63
- Amazon 69
- Microsoft 38
- Tesla 342 (just for info)
The average PE of the above companies is 42 (excluding Tesla). For these companies to trade at a PE of 20 from a PE of 42 they must fall 52% in price.
This is already bad, BUT remember they are not going to trade up to the PE of 42 that they reached before they crashed.
This means this loss is a permanent loss of capital.
Compare this to the newsletter
Compare this to an undervalued small company portfolio – the kind of companies you invest in with the Quant Value newsletter. The current PE of the newsletter’s portfolio is 10.
As I assumed above, a fair PE is for this type of companies is 12 it means the Newsletter’s portfolio is trading below fair value. (They are more undervalued, but I do not want to get into that here.)
This means if the market crashes the Newsletter’s portfolio will of course also decline, but when dust settles, and things return to normal, and these companies will trade at about their current value.
Thus, no permanent loss of capital.
The best way to hedge the risk of a market crash
After a LOT of research and calculations I have found that there is not really a cost effective way to actively hedge against a market crash or bear market.
The problem with hedges is they depend on you getting the timing right. And this depends on your opinion about when the market, even if it is overpriced, will crash. Taxes also don't help because you pay taxes on your hedges when you sell them, but have unrealised losses on your stocks.
Hedging is also very expensive. For example, a strategy that holds put options on the S&P 500 costs over 7% per year. If you hedge for two years your hedging ALONE will be over 14%.
Simply move to cash
The simplest and best way to hedge a market crash is to increase the cash part of your portfolio.
This is best shown through an example.
If you sold 30% of your portfolio you reduce your losses by 30%. If your portfolio is €100,000 and you sold €30,000 this means when the market falls 30% your loss will be 21% or €21,000 and not €30,000.
This is not rocket science you may be thinking, and you would be right.
This gives you three big advantages
BUT you have three big advantages when you sold 30% of your portfolio:
- You do not have the psychological loss. A 21% loss is less painful than 30%. This means you will be less risk averse and will have the courage to buy stocks again.
- You will be less likely to sell in panic because of the lower loss. This will keep you invested so that you can recover from the loss. Remember if you sell you have no way to recover a loss.
- You have the €30,000 in cash to invest into a lower and cheaper stock market. AND you do not have to sell stocks at a loss to get this cash. This is a big psychological advantage, as you know realising losses is hard to do because they hurt emotionally.
What to sell
What should you sell first you may be thinking?
What I did with my portfolio was sell investment already in a loss and stocks underperforming the market. Stocks with bad momentum in other words. I also sold about half of companies that have increased more than 70% in value since I bought them.
I did this until 30% of my portfolio was in cash.
What to do with the rest of your portfolio
With the rest of your portfolio, we suggest that you follow rules to keep losses low, the same rules we follow with the Quant Value investment newsletter.
Implement a stop-loss strategy
The first thing to do is implement a strict stop-loss strategy in your portfolio. This is how you do it in the newsletter:
- Implement a trailing stop-loss strategy where you calculate the losses from the maximum price the company reached since you bought it
- Only look to see if the stop-loss percentage has been exceeded on a monthly basis. If you look at it daily, you will trade too much and the costs will lower your returns. If you think markets are expensive look at your stop loss more often, weekly or even daily. Select what you are comfortable with.
- Sell your investment if at the evaluation date the trailing stop-loss level of 20% has been exceeded
- Measure the trailing stop-loss in the currency of the company’s primary listing. This means measure the stop-loss of a Swiss company in Swiss Francs (CHF) even if your portfolio currency is Euros or US Dollars
- See rule below, else reinvest the cash from the sale in the best idea that currently fits with your investment strategy. If you subscribe to the newsletter you would invest in the ideas you receive with the next newsletter
Stop buying when markets are falling
You know when markets fall, they all fall together – in more technical terms – they become correlated. This means, when markets are falling and you keep on buying, these investments will soon be sold because of the trailing stop loss system mentioned above.
This is definitely not what you want!
To solve this problem, we follow a simple rule (based on a LOT of solid research) - No new ideas are recommended when the markets are falling. This means we will only recommend new ideas if the moving average of the respective market index is above its 200-day simple moving average (SMA).
This is how it works:
- If the S&P500 index is above its 200-day SMA (and we can find good, undervalued companies) we will recommend investment ideas in North America.
- If the S&P500 index is below its 200-day moving average no North American companies will be recommended because it means the market is falling.
Summary and Conclusion
My friend sold his whole portfolio
So, what did my friend do to prepare for a market crash? He sold his complete portfolio to give him the freedom to think from an uninvested point of view. The portfolio was in a tax-free account which helped with the decision. He then increased his margin of safety and slowly started buying again.
Here is how you can you best prepare for a market crash:
- Know that you and I will NEVER get the timing of a crash right, so we have to prepare in advance
- Sell as much of your portfolio so that you feel comfortable
- Know that you will regret your decision to sell as the market goes higher
- Make sure that you cash is safe. Buy US T-Bills or similar low risk cash assets to make sure your cash safe irrespective of what happens to you bank or broker
- Change the cash percentage as the markets go even higher and get even more over-valued. Again, so that you are comfortable and can sleep well. There is no right answer here.
When will you start investing again?
To help you start investing again after a crash we suggest you prepare a list of companies you want to buy once the market falls.
Decide if you want to implement a trailing stop loss, and a rule to not buy if markets are falling, i.e. below their 200-day simple moving average as described above.
Prepare a strategy of how and when you will start investing again. This is important so that you do not become paralysed. This is what happened to me during the last two market crashes. I now have rules that at after a 20% fall I invest 10% in half positions. At a 30% fall I buy full positions for another 10% of my portfolio.
If you do want to hedge
If you do want to give hedging a try here are a few articles to help you: