How do I know I have figured out what I am doing? How do I get ready for the Bear Market?

I am remarkably lucky that despite all my fears that in a fairly short period of time I would run out of ideas for Blogs and get chronic Writer’s block, by some weird quirk I manage to continually trip over new ideas that I think would make interesting subjects to write about (so that keeps me enthused to actually write them !!) and enable me to get some valuable educational points across to Readers. These ideas just seem to emerge from nowhere for much of the time but in this case the subject came about from an idea thrown up by a question from Snailspup via Twitter (@Winterfell4x) - I was going on about what to do when bad times hit (I had been reading ‘Trade Like a Shark’ by Robbie Burns which is strong on this) and saying if you have a proven system that works over time then you should stick to your knitting etc. and not panic. 

Snailspup has been trading for about 5 years I recall but never been through a Bear Market so how can they know if their system works? I can’t recall the exact turn of the conversation but in essence this bit was asking if there was a way of measuring how reliable an Approach for engaging with the Stockmarkets was, and then there was a secondary part about how can you prepare for a Bear Market in advance?

I gave some sort of answer on the tweets but I decided it was an excellent subject for a Blog and therefore you are now able to read this !! It is clear there are 2 bits to this so I will break it down that way.

How do I know my Approach/System is robust?
Now I am starting to type this in Draft Form I realise this has some components as well - there are some more objective Numerical measures but there is also a qualitative / subjective element as well.

On the Numerical bits, my thinking is that over the last 5 years with the kind of Bullish Markets we have had, it should be possible to have made between about 5% and 30% each year for most of those years and perhaps to have had the odd year where your Portfolio went slightly Negative. Overall this should be a Compound Annual Growth Rate (CAGR) of probably between about 7% and 20% - if you have done these kinds of numbers CONSISTENTLY, then your Portfolio is probably in pretty decent shape and your Approach is clearly working.

If your Portfolio has wild swings from perhaps a gain of 60% in one year but then a Loss of 30% in another, then your Portfolio sounds extremely dangerous to me and if a Bear Market strikes, you will get decimated. There is without doubt some sort of link between the Rewards you make (your Annual Returns) and the Risk embedded within your Portfolio and this gets demonstrated by intense and extreme Volatility if you are taking on too much Risk.

In terms of the more subjective elements, if you have a Portfolio that is constructed of almost entirely AIM Junk Stocks like the usual Mining and Oil speculative trash, then you have a Portfolio which is a ticking Bomb and it will blow up on you at some point. By this I am not necessarily saying that all Oil and Gas AIM stuff is going to lose you money - BUT MOST OF IT WILL !! The only People who consistently make money in this garbage are probably Rampers and ‘Pumpers & Dumpers‘. If you must swim in these Shark-infested Waters then have a limit on your Portfolio with regards to how much you will ‘invest’ in such Stocks - perhaps a Maximum of 10% of your Portfolio Value is about right. Frankly, most people could make a lot more Money if they simply left this kind of stuff well alone (see the ‘WheelieBin’ page of my Website for a definition of the kind of Stocks which are likely to bring you Trouble).

If you want to muck about with the Junky AIM Stocks then your best approach is to become a ‘Trader’ and to regularly turn them over, selling into any Spikes up. This takes a lot of work but I know a few People who can do it very well. Simply ‘Buying and Holding’ this kind of rubbish will not work - 99% of these kinds of Stocks erode in value over time as Share Placings are issued and existing Shareholders get more and more diluted until there is nothing left.

Even if you avoid the Real AIM Trash but still hold a lot of Smaller Companies, then you probably have a High Risk Portfolio. It might work very well in the Good Times (and let’s face it, the Times have never been better than they have been for the last 9 Years or so) but when Liquidity dries up you will be in Big Trouble and your Portfolio will not have resilience. I myself do buy some pretty Small Stocks but I keep my Exposure to them very small and overall I hold a wide mix of different sized Stocks from all across the Indexes and I also Diversify across Sectors and different Strategies (such as Turnaround story, Income Stock, Growth Stock, Value Stock, Momentum Stock, etc. etc.). If you look at my ‘Portfolios’ Page you can see exactly which Stocks I am invested in and the proportions I have of each.

Another factor is the Number of Stocks you hold - if you have less than 10 Stocks you probably have a pretty Dangerous Portfolio - especially if they are all Small Companies. If you hold 16 to 18 you probably have the Minimum sensible Number and with that amount of Stocks you can diversify across Sectors, Sizes and Strategies etc. but as your total Portfolio Value grows you will probably find it is very hard to buy and sell stock - personally that gets on my t*ts so I prefer to hold loads of Stocks and to increase my Diversification as a result. In my ‘Main Trading ISA’ I aim for 40 Stocks (the Legendary ‘WD40’) and currently I have 41 but it is also worth remembering that I use Leverage via Mirrored Spreadbets across these Stocks so that is another reason why I keep my Risk as low as I possibly can but without destroying my Returns (too much Diversification can impact your Returns as you get nearer and nearer to copying the Market itself - but once you have a certain amount of Money you have little choice I find).

That takes care of what I see as ‘Stock-Specific Risk’ but the other Problem we face is that of ‘Market Risk’ and it is when the Market itself goes into a Major Bear Market Meltdown that the Bear Poo really whacks Goldilocks in the mush !!

Oh, before I move on, careful Research and ‘Trading Tricks’ like scaling in to a Position and scaling out of a Position can also help to reduce Stock Specific Risk and to boost your Returns as well. This matters especially when you hold a lot of Stocks like I tend to (see my ‘M3 Manifesto’ Page for more details on all this kind of stuff).

What can we do to prepare for a Bear Market in advance?
Although the chunk of Text I bashed out above is really classified by myself as ‘Stock-Specific Risk’, in reality if you follow the kind of Approach that I do of having a lot of Stocks and Diversifying in many ways, then it will actually put you in pretty good Shape to take on a Bear Market spanking - however, it only REDUCES the brutal mauling that the Bear gives you and you need to do other stuff as well.

Regular Readers will know that I am utterly obsessed (to the point of it being very unhealthy !!) with the concept of Hedging my Portfolio using Short Spreadbets on Major Indexes like the S&P500 and the FTSE100. This is something that Robbie Burns (The Naked Trader) does and needless to say he is a complete genius at it but I have found in practice that it is not easy to do. During the Collapse of 2008/9 during the Credit Crunch, I used Shorting quite a bit and it most definitely helped although my hope is that next time the Bear properly comes for his Honey I am ready to really kick him hard in the Fruit & Nuts……

During the Credit Crunch I Shorted some individual Banks with mixed results but I also Shorted the Banking Sector and the Retail Sector and that worked very well - although I did not do it in large enough size really. However, this taught me some valuable techniques and most importantly it made me appreciate the Power of Shorting Indexes when the Bear turns up on my doorstep with his Claws fully extended.

Anyway, I could go on and on about this but there is little point as I am currently in the process of writing another Blog which is specifically dedicated to my latest iteration of my ‘Approach to Index Trades’ where I will be defining in precise detail exactly how I go about Trading the Indexes and of course this means by Shorting as well as by ‘going Long’ (is that ‘Longing’?) and the Shorting is the key to dealing with Bear Markets. That Blog should appear in the next month or so and will probably comprise of 3 Parts. In the meantime, if you keep an eye on my ‘Trades’ page and if you read my Weekend Charts Blogs, then they will tell you a lot about the Index Trades I am doing and you should be able to figure out a lot about my ‘System’ simply from reading these (NOTE: Since writing that paragraph my ‘Index Trading System’ Blogs have been published and there is a link at the bottom of this Blog).

So, getting back on the subject of this particular Blog, before we get to a Proper Bear Market, there will probably be lots of opportunities to practice Shorting the Indexes and getting ready for ‘The Big One’. For example, just in February we had some big falls on the Markets and if you look on my ‘Trades’ page then you will see that I Shorted the S&P500 and did quite well on it - although as it turns out I wish I had Shorted the FTSE100 but that is another story……

But the point is that we get loads of these kinds of pretty severe Pullbacks and they are a superb opportunity to try Shorting and to see how it works. Start off doing it in small size and gradually learn what works for you and how comfortable you are with it. An important lesson I have learnt in recent years is not to aim for a ‘Perfect’ Hedge (this is where your Gains on the Index Shorts exactly match your Losses on your Portfolio of Stocks) but to try to REDUCE the impact of the Falls and to make some Money on the way down and then when the Markets turn up again, you go Long on an Index to catch yet more Gains on the way up).

I tend to use Spreadbets to Hedge my Portfolio but you can also use a clever ETF (Exchange Traded Fund) called XUKS which you buy and sell like a Normal Share and it gains in Value as the FTSE100 falls and you lose Value if the FTSE100 rises - it seems weird but once you have used it you will probably figure out what it is doing. There are some other Leveraged ones like SUK2 but personally I don’t like these because they tend to ‘Track’ badly and only work properly if the Market falls in a straight line down - if it chops about from one Day to the Next then you will find it does not pay you back the Value you were expecting. Anyway, Spreadbets are better (and you can use CFDs - Contracts for Difference although these are taxable which is why I prefer Spreadbets which are Tax-free).

Conclusion
So, in summary, what I am saying here is that when the Markets are ‘easy’ and kind to you, you need to be formulating a Plan for what you should do when a Proper Bear hits and practicing this Plan when we get the usual hefty Pullbacks from time to time. Reading my Weekend Charts Blogs will help you a lot with this.

So I am saying that you should be prepared in advance and I find that Shorting is a big help in getting your Psychology right for the Bear Markets - having a short is a great distraction because I find that my Mental Focus turns to this when the Markets are tanking - and I worry much less about my normal Stock Portfolio. Obviously the Psychological Aspects of a Bear Market are very important to get on top of and by doing the kind of things I have described in this Blog, you will feel much better during the next Bear Market Collapse because you will have thought about things in advance and will be ready and waiting.

I hope that all makes some sort of sense,

Regards, WD.


Related Blogs:
Here is the ‘Sell the Spike’ one for making Money out of AIM garbage:

http://wheeliedealer.weebly.com/blog/sell-the-spike-aka-dont-buy-the-placing-hype-spike

These ‘Pin the Tail on the Monkey’ ones are about different ‘Trading Tricks‘ you can deploy:

http://wheeliedealer.weebly.com/blog/pin-the-tail-on-the-monkey-musings-on-portfolio-management-part-1-of-2

http://wheeliedealer.weebly.com/blog/pin-the-tail-on-the-monkey-musings-on-portfolio-management-part-2-of-2

This Bear Market Blog should give more info on dealing with tough Market conditions:

http://wheeliedealer.weebly.com/blog/taming-the-bear-how-i-handle-nasty-markets

And here is ‘Wheelie’s New Improved Index Trading System’ - this is the Final Part but there are links in it to the other bits down at the bottom:

http://wheeliedealer.weebly.com/blog/wheelies-new-improved-index-trading-system-part-3-of-44826674