How To Handle Risk, With The S&P 500 (SPY) At All-Time Highs

From David Fabian: It’s easy to get sucked into the tunnel vision of an easy market. Trends are strong, liquidity is abundant, credit markets are cheerful, and volatility is low.

This is when it becomes easy to get complacent. To trick yourself into believing the recent past will extend indefinitely into the future. It’s a mental trap that even the most tenured investors find themselves falling into over various cycles.

What becomes more and more uncertain during these prolonged trends is when the correction will ultimately come and how deep it will go. There is no way of knowing in advance the when or where, and worrying about the “why” is equally futile.

The most important consideration is to appreciate the counter-intuitive nature of the markets and to prepare in advance for how you will deal with a future corrective event. The answer is not always as simple as you think it might be.

For some, the first impulse is to mirror the recent past and salivate over the opportunity to buy the next 5%-10% dip with as much vigor as possible. Latching on to top-performing stocks or sizing up existing positions in anticipation of another leg higher. The real worry will set in if that same pattern doesn’t play out in a quick fashion.

Others may opt to employ stop losses or similar risk management techniques to guard against a pernicious drop. Those tools are useful in that they frame your capital at risk and allow you to sidestep a large decline. However, they also put you on the back-foot if the market immediately snaps back higher or you find yourself with a large chunk of your exposure removed with no game plan to put it back to work.

There are also those who will try to preemptively time these drops by dumping stock exposure or loading up on hedges (gold, bonds, cash, shorts, etc.) to game the market. When used in small measures, this technique can help offset some risk and allow you to still participate in the existing trend. However, when taken too far, it places you out of step with the market and creates a myriad of conflicting signals that you must now manage to unknown effect.

Lastly, there will be those who simply choose to acknowledge the risk of any future corrections and ride through these dips with grim determination. Those with the psychological tenacity to leave their portfolio alone will likely be rewarded over the long-term with this method.

Nevertheless, history has shown that most won’t have the fortitude to carry through the darkest days. Even though they started out on this course with good intentions, they may ultimately capitulate at the worst possible moment.

I don’t have the answer to what the best strategy will be or how it should be implemented. There are pros and cons to each of these endeavors and unforeseen pitfalls that come up even when you think you have it planned to the max. My advice is to simply stick with a disciplined approach at all costs.

The use of minimum and maximum exposure limits, definable core holdings, or even breaking accounts out between “trading” and “long-term” money may help in these endeavors. That way you create pools of investment assets with strategic intent as a preparation for the next correction or bear market. For example, you may want to designate a 401(k) that you are contributing to monthly as your “dollar cost averaging” money, while you take a more proactive approach with other IRA or taxable accounts to mitigate downside risk.

Planning in advance of these fearful moments and being self-aware of your strengths or weaknesses is a huge advantage that most won’t take the time to endure. It will allow you to make sound investment decisions when it seems like the world is so uncertain.

That alone is a tremendous edge that can be leveraged to compound your wealth over the course of your lifetime.

The SPDR S&P 500 ETF Trust (NYSE:SPY) fell $0.15 (-0.06%) in premarket trading Tuesday. Year-to-date, SPY has gained 8.13%, versus a % rise in the benchmark S&P 500 index during the same period.

SPY currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 109 ETFs in the Large Cap Blend ETFs category.

This article is brought to you courtesy of FMD Capital.