THE SPECIFICS OF AVOIDING BIG LOSSES
Remember, there are only four possible outcomes for every investment—a big gain, a small gain, a small loss, and a big loss. We use an active investment discipline designed to realize big gains, small gains, and small losses.
Yes, small losses! We use small losses to keep them from turning into doozies that wreak havoc on portfolios.
Many in the mainstream financial media would rather you believe yourself to be powerless. Since you cannot predict the future, they say, then you should buy, hold, and hope that your entire nest egg survives a catastrophe.
Hold-n-hope is not a strategy. Granted, the direction of stock prices may be unknowable. Still, a person has the power to manage investment outcomes.
At Pacific Park Financial, if the risk-reward backdrop is favorable, we pursue financial goals with sensible allocations. If the risk-reward environment becomes unfavorable, we seek to protect client assets.
There are three environments that warrant shifts. They are:
1. Low Risk
2. Elevated Risk
3. High Risk
A Low Risk environment most often occurs at the early stages of a stock bull. Prices may be bargains relative to company profits, sales, book value and cash flow. Similarly, our technical indicators tend to signal a positive backdrop for acquiring assets.
In a Low Risk environment, portfolios often reflect the highest risk targets with little-to-no cash. For example, a moderate growth investor might expect a 70% stock/30% income target. Additionally, the stock portion might include a wide array of classifications (e.g., small-cap, mid-cap, domestic, international, emerging market, etc.), while the income component would cover multiple segments as well (e.g., investment grade, high-yield, convertibles, preferreds, foreign, domestic, short-term, long-term, etc.).
An Elevated Risk environment frequently occurs during the late stages of a stock market bull. Prices may be extremely expensive relative to company profits, sales, book value and cash flow. Similarly, our technical indicators may be signaling a mix of positives and negatives. Some indicators may even be flashing “warnings” or “sell signals.”
The process for downshifting in an Elevated Risk environment happens in two meaningful ways. One, we reduce the risk associated with the type of stock and the type of income. Rather than hold a variety of stock types (e.g., small-cap, mid-cap, domestic, international, emerging market, etc.), we move towards less volatile stock holdings, like large-cap domestic stocks. We also shore up the risk associated with the type of income, transitioning to the highest quality bonds.
Second, we reduce the overall risk exposure by raising some cash/cash equivalents. For instance, a moderate growth investor might have 50%-55% large cap stock exposure, 30%-35% high quality income exposure and 10%-20% in the safety of cash. Not only does the higher allocation to cash minimize volatility in the near-term, but it also represents a buying opportunity when returning to a Low Risk environment.
A High Risk environment typically involves the eventual arrival of a severe stock bear. Our technical indicators have already moved into a ‘sell’ mode.
To protect principal in a High Risk environment, we aim for a larger percentage of cash/cash equivalents. Additionally, we incorporate alternative assets, like those that make up our Multi-Asset Stock Hedge (MASH) Index.
For example, a moderate growth portfolio may have one half (35%) the ‘normal’ 70% target allocation to stock that might exist in a Low Risk environment. Also, we may utilize our MASH Index by incorporating a precious metal like gold, a currency like the Swiss Franc, as well as U.S. Treasury bonds.