New Rules for a New Market

02/04/2010 11:17 am EST


Ken Kam

CEO, Marketocracy, Inc.

Ken Kam and Mark Taguchi of Marketocracy SWAN Advisory Service say that after years of unusual market volatility, investors have to be nimble and adapt to change.

Until 15 years ago, the Standard & Poor’s 500 index grew steadily, averaging about 10% a year with not that much volatility. In that kind of market, it made sense to buy the whole market and stay fully invested all the time, through thick and thin, over the long term.

The problem is that for the past 15 years, the market has not followed the script. Instead of steady growth, we’ve seen huge run-ups followed by devastating crashes. During the last decade, the S&P 500 has suffered drops of 46% and 56%, and it can happen again. This kind of volatility overwhelms most other factors and cannot be diversified away. If you cannot afford a big loss like this, you need more protection against market or systemic risk.

Investors lost much of their life savings during the financial crisis when the global stock market lost $33.3 trillion (according to the World Federation of Exchanges), or over 50% of its value.

[So, here are some] new rules of investing:

• You need to protect yourself from the next system-wide crisis. The government will not protect you. Wall Street won’t protect you. Diversification won’t protect you. There are going to be times when you will want to be less than 100% invested, and even times when you will want to hedge against the market.

•  The most important decisions investors need to make are judgment calls. Make sure that you have confidence in the judgment of the person making these decisions for your portfolio. This is true whether you are making these decisions for yourself, you have an advisor, or you are relying on a fund manager.

• Make course corrections. No matter what decisions you make now, the market changes rapidly and we need to make course corrections as news comes out that clears up uncertainties and shows us where the opportunities are. If you are not on course, don’t wait long to change course.

Holding cash preserves investing power for when there are opportunities and can provide protection. Over the last six and a half years the SWAN Team has ranged from 4% to 45% in cash and has averaged a cash position of 16%, so the current 15% is just below average.

Currently, they have positioned the [stock] portfolio where they think they have the best shot at delivering returns: health care, materials, and energy while maintaining limited exposure across other sectors.

Do we need insurance? Yes. Over the last 15 years, the Federal Reserve and government policies have made the market much more volatile. This is the systemic risk that you cannot diversify away from, and it is BIG. You can lose half your money, so the market impact overshadows most other factors and more predictable economic forces don’t drive it. It is driven by people, and they can make mistakes.

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