Buy and Hold is too blunt a strategy in volatile markets

Knowing when 'enough is enough'

Investors who bought into the Japanese equity index on 29 December 1989, more than 30 years ago, are still trading at a 15.5% loss versus current levels.

This fact is a stark reminder that the success of the popular passive buy-and-hold approach is predicated on the initial price paid.  This, by definition, and depending on who you talk to, requires a degree of skill and a dose of luck.

One of the most important lessons for retail investors to draw from the current environment is that their portfolio has many gears, and that the passive buy and hold strategy is not suited to volatile markets. Capital preservation, taking profits and proactive risk management take on a new and historically underappreciated importance. Many providers of investment services do not offer retail investors the tools that can help them navigate this volatile environment and deliver returns. Wealth and asset managers have in general missed an opportunity to provide this access and education. Buy and hold is too blunt a strategy and should be enhanced with a selection of precision or targeted strategies.

To put the recent market volatility into context: between 01 January and 01 June 2020 we have seen 17 instances of 3% (positive or negative) moves on the FTSE 100. Compare this to the entire 2018 and 2019 period, where there were only two similar moves on the FTSE. (Source Saxo Strategy Department and Bloomberg).

For retail investors looking to implement precision or targeted trading strategies, there are two essential features they require: “stop loss” orders and “take profit” orders. Put another way, they need the ability to predefine how much they are prepared to lose and how much do they want to gain, and ensure automatic execution when those thresholds are hit.

Stop losses and taking profits are key features of portfolio risk management. They add structure and direction to the portfolio as opposed to the monetary value going up and down at the whim of the market. In a volatile market, it is prudent to take planned profits and protect the portfolio from large falls.

To take an example, we will assume that an investor is prepared to lose 6% of the total portfolio and would be happy to make a 20% return. Once this is decided, a stop loss or portfolio shield trade of 6% would be placed on the portfolio. This means that if the overall portfolio falls 6% from the ‘purchase price’, the portfolio is sold and the cash is held. Stop loss orders can also be placed at the individual instrument level if this is preferred. This strategy protects capital and avoids a significant move down in the portfolio. It is also automatic and removes the emotion from what is a difficult decision, probably made worse by negative financial commentary and falling share prices.

Take profit orders, in general, are placed at the individual instrument level. In this case, individual instruments or positions would be sold once they had appreciated 20% above the purchase price. It is worth noting that stop loss and take profit trades can also be placed as and when new positions are added to the portfolio. In some cases, these levels can be triggered outside the target percentages if the market ‘gaps up or down’ on market opening, e.g. when a share price or the price of other financial instruments is higher or lower on market open than it closed the day before.

In my conversations with retail investors, I am further perplexed at misconceptions around market liquidity and how long does it take to add to or reduce a position in a portfolio. Almost all retail portfolios can be liquidated immediately unless they are made up of highly illiquid instruments. This appears to have been poorly explained.

Wealth and asset managers should be able to provide the ability to place stop loss and take profit orders, and if they are not, it is important that retail investors question this. Is it because their preference is to keep their clients fully invested come what may, because this is where their model is most effective or fee maximization is achieved; or is it because they have not invested appropriately in the requisite technology to enable that level of automation? Retail investors should create a catalyst for change by demanding from their wealth and asset managers access to all the instruments and tools that would allow them to make better investment decisions and generate returns.

Stop losses and take profits, or knowing when to say ‘stop’ or ‘enough is enough’ are empowering and sensible measures. A good practice in general and particularly important in a volatile market. They provide an effective way to help preserve capital or to lock in profit, allowing investors the opportunity to regroup their thoughts, review the situation and the overall strategy, or to put it another way - to live to fight another day. Volatile markets require dynamic and prudent risk management strategies and your wealth or asset manager should provide them. If not, it may be time to put a stop loss order on your relationship with them.