Monday, August 20, 2012

Different Markets Require Different Strategies

My 13yr old son loves wearing shorts and a t shirt.  He loves this so much that he wears shorts no all year round, no matter how cold it is outside.  He does this for two reasons:

1. That is the style now
2. He is 13 and just doesn't know any better

He reminds me a lot of how individual investors behave.  They follow a traditional asset allocation/buy and hold approach regardless of what the market is doing.  This works fine in a bull market (just like wearing shorts and a t shirt is fine during the summer), along with any other strategy for that matter, but gets you crushed in a down market.

In reality there are three different types of markets, each requiring its own investment strategy:

1. So easy a caveman could do it market----these are the markets that go up in a straight line that even a caveman could make 20% (apologies to any cavemen reading this, if you can read that is).  1995-1999 would be a great example.  In this type of market anything that has you invested would work very well.  This could be asset allocation or a trend following tactical strategy.

2. Bear market----this is a market that goes down a lot.  2000-2002 and 2008 would be great examples.  Any strategy that has an investor fully invested would get crushed in this type of market.  This is just like my son wearing shorts in the dead of winter, he feels comfortable because everyone is doing it but he is freezing his butt off.  In this type of market the only strategy that works is being tactical as any good tactical strategy would have an investor in cash and/or bonds.

3. Risky market----This is usually a very volatile type of market that could produce some returns but is at great risk of becoming a bear market.  2011 and 2012 (so far) are good examples here.  The market has gotten some gains but the risk is still immense.  A fully invested strategy in this market could work out ok but the risk is not worth it.  This is like my son wearing shorts in the fall, if he gets a warm day he is ok but it could also get real cold.  Tactical is still the way to go in this market.  A good tactical strategy may trail a fully invested strategy if the market is going up in the face of great risk (albeit with much less volatility) but it will protect the investor  if the risky market turns into a bear market.

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