The Importance of Exit Points
(note: this article was originally published at indexuniverse.com on 2/3/10)
All of the hand-wringing, all of the second (and triple) guessing and heated debate typically reserved for position entry points and security selection would have us believe that disproportionate shares of return potentials and risk management levers therein reside. But for a significant portion of most people’s investment assets, attention to specification of position exits is at least as important.
Since the spring of 2007 we’ve seen markets express extremes of seemingly boundless euphoria and truly gut-wrenching, gutter-level despair. The ticket for investors to participate in and experience the depths of the negative side of that ride, in a truly up-close and personal way, has been simply to lack an exit strategy – to take to the road in a vehicle having no brakes, no doors, no windows. And many investors – if not most – did just that.
But “everybody” … the “experts” … they were nearly all saying (and are nearly all still saying) …
The shear weight of “buy”-oriented recommendations reflected in reporting, promotion and discussion on all media fronts and pushed by fund sponsor, fund research and brokerage marketing mills, all but buries relevant discussion and advice regarding exits and definitive measures to truly protect capital and to truly preserve wealth. Look to any of the media sources to which you regularly turn and judge for yourself the entry/exit coverage balance – or, rather, lack thereof.
Getting to the real sources of wealth destruction …
During the two most recent recessions, as well as during the intervening bubble-building years, how much personal wealth could most investors figure was destroyed, or even forsaken, on account of poor timing of position entries or poor security selection? How many tears were shed and shared at the water cooler on account of being one or two weeks, or one or two months “late” in establishing a position entry?
Consider, then, the absolutely mind-boggling expanses of wealth that were so thoroughly ravaged, so completely obliterated during the “train wreck” that commenced in May 2007 and hit bottom in March 2009 … simply for lack of a real and operable exit plan.
It was not market entries that, for far too many, killed the goose; that, for far too many, swept away the fruits of decades of personal sweat and labor. Rather, it was lack of exits. It was “cars without brakes”.
The bigger diversification picture: start with the forest before moving on to the trees
Most investors are quite familiar with the long-standing “street” mantra rightly touting the merits of the practice of diversification across holdings within a given investment strategy. As Harry Markowitz clearly illustrated many years ago, diversification across holdings within a given strategy can help moderate risk within that particular strategy.
Diversification among investment strategies having varied performance and risk attributes, likewise, can help reduce risk across an investor’s aggregate portfolio of assets. Few investors, though, are nearly so well-versed in diversification disciplines at the investment strategy level – that is, diversification across investment strategy approaches based on strategies’ market and risk participation characteristics.
For many investors, a single, stand-alone investment approach (especially one which carries truly open-ended downside risk) engenders far too much volatility, far too much poorly-compensated risk. And, of course, that simply isn’t good enough.
The bottom line: maintaining a favorable performance profile while limiting capital losses is the name of the game and is as important to aggressive investors as it is to conservative investors.
To illustrate this perspective, a diversified portfolio of strategies might include the following complementary components, in proportions suited to the investor’s risk appetite and in consideration of market participation and risk attributes of the particular strategies used:
Strategies imparting open-ended or uncapped risk to invested capital:
These buy-and-hold approaches take on either of two primary forms. A rather passive approach to management involves the periodic rebalancing of an asset allocation deployed utilizing index-based ETFs. Alternatively, capital can be committed to active money managers who exercise discretion on matters of asset allocation, entry/exit timing and security selection. Except where managers specify exit protocols, downside risk in these strategies is open-ended.
Strategies engendering conditional market participation, with explicit exit protocols to limit risk:
Strategies having explicit exit protocols seek to systematically limit participation in negative price trends – to cut losses short – thereby limiting downside risk to invested capital.
Strategies providing full principal protection:
Truly principal-protected “cash”-oriented strategies are comprised of short-term Treasury securities, FDIC-insured certificates of deposit or FDIC-insured money market funds (up to applicable coverage limits).
Diversification across investment strategies – that is, across the principal protection, conditional participation and open-ended participation spectrum – is where investors and advisors need to extend their thinking, their learning, and attention. It is here where the bulk of return and risk potentials is defined.
Orthodox “buy-and-hold” strategies … buy it and forget it?… Properly setting expectations …
Diversified buy-and-hold strategies, whether in the form of a “passive” ETF asset allocation or committing capital to an active money manager, tend to do well during periods of relative calm and positive price trends, including those punctuated by minor corrections.
But portfolios comprised of diversified buy-and-hold strategies alone, carrying open-ended downside risk, got pummeled from 4Q 2007 through 1Q 2009. And they suffered significantly in 2000-2002 as well.
Accordingly, investors using a buy-and-hold approach alone ought to expect to incur significant capital losses during market “corrections” as well as during stretches associated with deflationary and inflationary extremes – as we may have opportunity to witness in the years ahead. Investors need to treat with deep skepticism sweeping, generic assertions that buy-and-hold strategies out-perform historically or that, by extension, they surely must outperform in the future. The simple reality: buy-and-hold approaches outperform some strategies in some market environments.
From a purely risk-management perspective, the commitment of capital to active money managers is often approached in the same manner as capital deployed in buy-and-hold strategies utilizing passive, index-based instruments. That is, most investors simply do not explicitly and on an ongoing basis limit losses incurred by active managers in their employ. Downside risk is, accordingly, typically open-ended.
Moderation of concentrated exposure to strategies having open-ended downside risk via relatively irrevocably-invested capital (as is the case in truly orthodox buy-and-hold strategies, whether or not they involve active managers) is the key.
Open-ended downside risk to zero, whatever its form or source, must be coolly and plainly identified as such and, then, consciously and deliberately limited.
Play it again, Sam …
Lessons to be learned from the most recent financial crisis? Precisely the same lessons as from the preceding crisis, and the one before that, and the one before that …
Lesson 1: It is not market corrections and market crashes that kill investors. Rather, it is full participation in market corrections and market crashes that kills investors.
Lesson 2: With a bit of proper education, quite fortunately, the “participation” matter to a large degree becomes an object of choice. Unfortunately, it is not and cannot be a matter of choice to the uninformed (investor/advisor education is vitally important!).
Lesson 3: Aggressive and conservative investors alike need to limit capital destruction; properly-functioning brake systems are no less important to Formula I race cars than they are to family sedans.
Lesson 4: Strategy diversification is an important defining characteristic of a healthy total portfolio. This reality is overlooked, under-rated, misunderstood and regrettably under-appreciated by most investors.
Lesson 5: Market “corrections” are not historically infrequent events. Get used to it. Plan for it.
Putting brakes on the car …
We’ve written about tools, such as sell stops (here https://etfstore.com/etf-insights/stop-loss-and-sell-stop-limit-orders/ and here https://etfstore.com/etf-insights/protecting-recent-gains/) that can be employed to limit risk in a declining price environment. And we touched on a price trend perspective that can help to frame thinking regarding an exit strategy (here https://etfstore.com/etf-insights/where-theres-smoke-theres-usually-fire/).
Participating in markets with confidence?
- Consider having an exit strategy for a meaningful portion of your investment assets. Coolly, deliberately, consistently and mechanically cut losses short for those assets while letting winners run.
- If you’re not equipped or not inclined to go it alone, find an informed and capable advisor to assist you. And expect the advisor to also require that you learn and that you understand any strategy employed on your behalf.
- Lack of time is no excuse. If the fruits of decades of your labor are on the line and at risk, then make the time.
- Be aware that no well-reasoned investment strategy is beyond the comprehension of the average investor.
Be standing, financially-fit and winning during rounds 8, 9 and 10 of your 10-round lifetime investing bout. Make sure that you have working brakes on your car!