The Finance Professor
Seven Ways to Handle Market Stress
Scott Rothbort
08/16/07 - 01:19 PM EDT
The current market environment is fraught with volatility 
, anxiety and uncertainty. It is during times like these that an individual investor is likely to make wrong decisions or avoid taking the proper action. (The same is true for any time of personal stress.)
I often get calls from clients, family and friends asking me how to deal with times of market stress, so this installment of the Finance Professor will discuss seven ways in which you can cope with markets during times of volatility.
1. Get Rid of Leverage
I have talked about leverage before. Leverage is a wonderful thing when the markets are going your way. However, during periods of increased volatility and declining markets, leverage can work against you (see margin call ). When leverage turns from friend to foe, it can erode your portfolio much faster than if you did not employ leverage at all. So if you have any margin balances, to cure the negative effects of leverage, I suggest that you pay those balances down as soon as you can.
2. Identify Risk and Reduce It
If you have been following this column, then by now you should have a spreadsheet of your holdings (see "The Finance Professor: Manage Risk Like a Pro"). If you don't have that spreadsheet, now is the perfect time to put it together.
Now, here is what needs to be done with your spreadsheet:
First, take your holdings spreadsheet and identify your risk to the market (for example, the S&P 500), by ascertaining each individual position's beta . How? For each individual stock holding, multiply the holding size in shares by the stock price and then multiply that amount by the stock's beta.
Let's say that you own 1,000 shares of McDonald's (MCD Quote), which is selling at $50 with a beta of 1.68. While you own $50,000 of McDonald's, your market beta or risk is $84,000 (1,000 multiplied by $50 multiplied by 1.68).
of the portfolio.
A portfolio beta greater than 1 indicates that your portfolio will move at a rate greater than the overall market. For example, a portfolio beta of 1.2 means that your portfolio will move 1.2 times the market index , whether it moves up or down. We can see this as another form of leverage -- for $1 of investment, you are getting $1.2 of market moves. The higher the beta, the more risk you have. Reducing your portfolio's beta will help to alleviate risk in uncertain and volatile markets.
3. Know What to Sell
Not all market declines are the same. You need to understand what sectors or groups of stocks are under stress and are the "causal influence" on the market's decline and volatility. If you own these stocks, then they tend to be the weak link in your portfolio.
For example, right now (summer of 2007) we are in the midst of a financial-sector driven decline. So look first to the financials for sources of risk reduction. If the financials represent 20% of the S&P 500 (SPX Quote) then cut your financial stock weighting to less than 20% or even zero, if the pain is too much for you.
Down the road, when you experience another volatile market, what should you sell? There is no right answer, because in addition to no two markets being the same, no two investors are alike. However, here is a list of several professional rules of thumb:
- Sell losers rather than winners (see "Winners & Losers" ).
- Sell positions that you have "doubled down" on. (Doubling down is when you add significantly to a losing position when the stock has declined.)
- Eliminate high beta names and keep the less risky, low-beta holdings.
- Eliminate the marginal ("last in") or fringe position.
- Cut your portfolio down across all positions in a pro rata fashion, which means by a set percentage across the board.
, exceed returns for my targeted indices (stocks , bonds or a blend of both) and most of all, not lose any capital .
We will have many losing days, some "down" months and an occasional "off" year. What you need to do is keep focused on your long-term objectives while managing risk in the short term. Remember, had you bought the SPX on the day before the 1987 market crash, your cumulative return through the end of July 2007 without dividends would be 415%. That is even after giving up 20% on the first day after your investment.
5. Tune Out the Noise
When markets get volatile and investor stress levels rise, there is one thing that is certain: The media will parade out the doomsayers. This is Halloween time for the doom and gloom crowd. The noise coming out of financial television and radio is as deafening as the emergence of cicadas every 13 or 17 years. You need to learn to tune it out or turn it off. If you do not, you might be persuaded to take actions that would deviate from your normal investment philosophy and strategy. Remember that consistency is important in investing. Deviating from a disciplined plan because of media pressure could cause you to second guess yourself and result in disaster.
6. Seek Out the Counsel of Others
From 1950 through 2006, the S&P 500 average simple price return was 9.37%.
Also counting from 1950 to 2006, the S&P 500 has been down 15 of those years. During that time, we have had our share of selloffs, market corrections, mini-crashes, bubble bursts and a full-blown market crash.
) to get a history lesson and obtain advice on how to cope during market crises or dislocations.
7. Finally, Don't Make Hasty Decisions
Don't confuse risk management with the need to take rushed and severe action. Risk management is a thoughtful process that identifies risk and then develops a plan to take remedial action (if necessary). Bypassing the risk-management process and taking unprovoked action is poor overall investment management. In its simplest form, a move like that is panicking. And as Jim Cramer always says, "No one ever made a dime by panicking."