Trading in a Bad Market

 | Aug 19, 2011 | 8:15 AM EDT
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"A champion is afraid of losing. Everyone else is afraid of winning."

--Billie Jean King

When it comes to dealing with a bad market, my guiding principle is it's more important not to lose money than it is to make money. My goal is to try to keep my portfolio as close to its highs as possible. That generally means getting out of the way of a downtrend and staying there until the smoke clears.

The primary reason for my approach is that I have found it so extremely unproductive to make up losses. If you lose 20% of your capital you need to produce a gain of 25% just to return to even, and it gets worse the more money you lose. If you are down 50%, you need to double your money to make up your losses.

That is a tremendous amount of work to produce no return, but folks set up that dynamic for themselves all the time by riding stocks down in a downtrending market. One of the big, and very questionable reasons, that investors do that is because they are more focused on relative returns than on absolute returns.

In the perverse world of money management, it is considered better to lose money and beat the indices than to make money and lag them. This thinking is a function of the idea that stocks are just another asset class and not the sole vehicle for managing wealth. As long as you allocate your assets properly to various asset classes the only important thing is that your stock-market returns beat the market. Your other asset classes will make up for it, so that is how modern money management has developed.

As an individual investor, I find it much more productive to focus solely on absolute returns and to forget how I perform relative to the indices. I want to make as much money as possible regardless of how the market acts. Ironically, this also turns out to be the best way to produce relative outperformance as well, because of how it helps to avoid the problem of having to make up losses in a bad market.

Another reason so many market players rack up sizable losses in a downtrending market is they focus way too much on trying to catch the bottom. This is one of my pet peeves about traditional Wall Street and market pundits. They focus endlessly on trying to predict when a bad market will turn back up and spend almost no time on ways to avoid losses.

I guarantee that you will hear dozens of market "experts" say today that the bottom is near and you should be buying. They may be right this time, but I bet these are the same folks who were saying the same thing last week, last month and last year. If you really listened to the advice of these folks, you would always be fully invested anyway, so you'd have no capital to put to work when in a free-fall like this. I strongly believe that the focus on bottom calling results in more market underperformance.

When I look at the market I see a very ugly collapse and, unlike the folks in the media, my first thought isn't "Is this the bottom?" but "How do I keep from losing money?"

The reasons behind this market collapse don't really matter. In fact, it can be better to simply respect the price action and stay out of the way rather than to look for fundamental justifications to hurry up and buy. The problem is that the sovereign debt issue in Europe is becoming worse and the economy in the U.S. is slowing far more than expected. A poor economy and too much debt aren't very supportive of stocks.

The bulls are hoping that the economic meeting at Jackson Hole, Wyo., in a week or so will produce an announcement of another round of quantitative easing, like it did last year. But there are plenty of skeptics, and many folks don't think it will help much at this point.

The open this morning is ugly enough that we may see some capitulation selling. I'm expecting bounce buyers to try early, but the key will be holding the early lows. We did not hold them yesterday and that kept the pressure on all day.

My focus is to have a shopping list but not do much until the price action improves. I'm more concerned about not losing money than I am about making it right now. When the market acts better I'll focus on good trades and, hopefully, by avoiding losses I'll be so far ahead of the game that I can take my time and be selective.

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