Most Popular ArticlesBy Roger J. Schreiner
December 29, 2009
The idea that a 40% or 50% loss can be considered “good” makes no sense to me. The fact that it does make sense to the mainstream investment community is mind-boggling. A loss of that magnitude would be a disaster to every investor I know. This kind of loss puts the investor in a hole so deep that it can take a decade or more to recover.
It is important to appreciate the fact that diversification does an excellent job reducing company risk and sector risk. The risk of holding a diversified sector fund is significantly less than the risk of holding stock in an individual company. Likewise, a mutual fund representing the broader stock market is far less risky than a fund focused on a single industry sector. When it comes to managing market risk, however, diversification falls painfully short.
When there is a systemic problem affecting the entire market—the recent global financial crisis is a perfect example—diversification can be worthless. It’s like bringing a knife to a gun fight.
No place to hide
In any discussion about the financial crisis and its affect on investors, you can be sure that someone will lament, “Everyone got killed. There was no place to hide.” What they really should be saying is, “My investment process was inadequate. I had no place to hide because I was not prepared for this kind of systemic risk.”
There were places to hide during the crisis. Cash performed well and so did bonds. Investment techniques such as hedging and shorting also helped investors. Gold and other precious metals, while not completely immune, performed well during the fourth quarter of 2008 and first quarter of 2009 as stocks fell another 30%.
Students of market history understood the potential for systemic failure. They know that financial crises happen. Markets have crashed before and that they will crash again (no matter what politicians say). Such is the nature of cycles.
Successful investors understand cycles and plan for unknown and unexpected events, while average investors suffer from average thinking and crowd behavior. Average investors were not prepared for the recent financial crisis, and they will be ill prepared for the next one. It makes sense that they think there was no place to hide. Successful investors, on the other hand, may not have foreseen the crisis, but they were prepared for it. Their investment process included cash, alternatives and crisis-avoidance techniques. Their planning was grounded in economic and market history.
Limiting exposure to manage systemic risk
Assume that you and I are both above-average drivers and we want to see who’s more likely to crash first. All things equal, it’s a coin flip. But what if I had to drive my car for twelve hours, while you only had to drive yours for eight hours each day? Which one of us is more likely to crash? I am, of course.
The stock market is no different. The more time one is invested, the more likely they are to experience a crash. The biggest factor in determining investment risk is exposure. Avoid exposure and you avoid most of the risk. Avoid most of the risk and you avoid most of the potential for loss.
Mutual fund managers are right about one thing: Risk management is handled at the portfolio level, not the fund level. It is the responsibility of the investor and their advisor to select when to expose themselves to risk and how much of their portfolio to shield from it.
Roger Schreiner is the founder and CEO of Schreiner Capital Management, Inc. (SCM), an SEC-registered investment advisor located in Exton, Pennsylvania. SCM is a third party investment manager and sponsors the Select Advisors Wrap Program, an investment platform that provides active investment solutions for Advisors and their clients.
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