When financial capital is hit, investors lose money. But when mental capital is hit, they lose their nerve and their capacity to be rational, which is sometimes even worse. LEVERAGE MAGNIFIES LOSES For unprepared investors, the real pain of a bear market is not just the potential for a 41% haircut from start to finish. It is also in the magnification of losses through leverage. Many investors use “leverage,” which essentially means adding borrowed money to their own capital in order to increase returns. (This isn’t an exotic concept. If your stock- trading account is qualified to use margin, as many are, that means you have the ability to buy $200 worth of stocks for every $100 in capital.) Leverage becomes very popular toward the end of a long bull market run. As investors grow more confident, their willingness to use leverage increases. The amount of optimism and leverage tends to peak even as the bull run reaches its climax. This magnifies the pain of the bear market that follows. This is why bear markets can extract a double or triple cost. Not only do they inflict harsh losses on a stock portfolio, they exact a psychological toll, and – especially when leverage is involved – they take away the capacity to generate returns in the next bull phase... which can then reinforce a sense of frustration and despair when investors realizes a new bull run has taken off without them! It’s a truly vicious cycle. That’s the bad news.
THE GOOD NEWS IS... By having a rational plan it’s possible to sidestep all of this – and to actually take advantage of the opportunities that bear markets create. When a bear market comes, the investor’s first job is to preserve financial capital. This means “avoid losing too much money.” Their second job is to preserve mental capital. This means “avoid losing your nerve.” As a side note, bear markets are where “buy- and-hold” strategies tend to fall apart because the buy-and-hold approach is just too costly, both financially and mentally, in the face of the brutal losses. Leverage becomes very popular toward the end of a long bull market run. As investors grow more confident, their willingness to use leverage increases. It’s one thing to be confident in buy-and- hold when the major stock indexes have been gently rising for years on end. But it’s another thing when the markets feel like a never- ending sea of red and have felt that way for six months or more. As it turns out, preserving financial capital and mental capital is a two-for-one deal. Investors can help preserve both by managing their risk, which means sizing positions properly and cutting off exposure to losses before they grow large.
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November 2018
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