At any given point in time, there is a myriad of potential causes for your investment account to get destroyed. This is no reason to seek shelter and reduce risk, however, as it is the very presence of risk that brings with it the potential for high returns. Investors frequently remain underexposed to market rallies, sometimes lasting years, because they do not have a system of identifying the true risks to their particular trading style and portfolio. Just as knowing the capabilities of your enemies will prepare you in battle, focusing on what may hurt your wealth is the best way to prepare and defend it.
The years 2007 through 2009 will stand in the memories of a generation of investors as proof that stocks can go down a lot further and for a lot longer than seems reasonable. The emotional scarring caused by these losses caused many market participants to sharply reduce their equity holdings in 2009 – after all, there’s nothing more humiliating than being burned twice by the same flame. In fact, stock funds have seen net outflows from retail investors so far in 2009, while bonds have seen net inflows – this is a clear sign of risk aversion. However, these same market participants had yet to formulate a plan to increase their risk exposure before a massive rally brought the market roaring higher off the bear market lows. Now, 2009 will also stand out as the year that proved that stocks can go up a lot more for a lot longer than seems reasonable.
Many market participants got caught flat-footed in the face of the now nine-month, 65%+ rally off the bear market lows because they have not properly assessed the inherent risks to their trading styles or portfolio. Right now, for example, there are plenty of people who have made some money back in 2009, but who are now selling or will sell at the first sign of trouble because they feel the market has simply gone up too much too quickly. While this may in fact prove to be true, they have failed to assess what this means for their holdings. Does it mean the market will go down 50%? 30% 5% Does it mean the market will go sideways for several months? How will this affect their positions?
Just as a bear in the woods must distinguish between the sound of shotgun versus a crash of lightning, stock market participants must distinguish what to fear and what not to fear. After all, if you recognize that the market is overbought and due for a rest or pullback, selling may not be a good idea, as the likelihood of just a mild, countertrend pullback may be quite high. Selling in such a situation would simply reduce your exposure during a healthy trend that is merely experiencing some consolidation, a pause of short duration – the risks of getting out too early cannot be understated, as a low-risk re-entry may never appear until the trend is over, and, as 2008 and 2009 have shown, you never know how long a trend will run.
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