Friday's drop was a fire drill to prepare us for a bigger pullback
On Friday, my Twitter feed was filled with horror stories of people losing millions in moments after the stock market fell and crypto nosedived late in the day.
Most of these losses were in futures contracts and leveraged trades that I never touch, but it was a reminder that understanding your own risks and how you deal with inevitable market downturns is important.
What was I thinking about on Friday?
Don’t Use Leverage
Investing horror stories always start and end with leverage.
If you’re investing in stocks, all the leverage you need is in the fact that we have unlimited potential long-term.
Repeat after me, “Don’t use leverage.”
Don’t Be Afraid to Take a Profit
Do you own a stock that’s up 500% this year?
It’s OK to take a profit!
I like to say that my biggest mistakes were selling stocks that kept going up, but the flip side of that is that we’re in this to make money, and if you’ve made money, it’s OK to take it. This is especially true if the stock now has a nosebleed valuation.
Insiders sell from time to time.
Long-term investors like Warren Buffett sell.
I over-index to not selling, but I do sell stocks, and it’s OK to take some chips off the table, especially in this market.
Understand the Market’s Risks
There’s always risk in the market.
That’s why we can make money as investors.
But understanding where the risk is and when it’s time to dial down the risk meter is important.
For a year, I’ve been talking about how I’m uncomfortable with the market’s valuation in many ways. The P/E multiple of the S&P 500 (shown below) has never been this high in a non-recessionary period.
There’s the AI bubble that could burst.
The economy could go into a recession.
Owning utility stocks today comes with a certain kind of risk, but owning AI stocks that are on fire comes with a different set of risks. Understand how those risks could become reality at a moment’s notice.
As for the Asymmetric Portfolio, I’m very exposed to the market’s overall risk, but I have very little in the AI bubble directly, and I’ve been adding more “value” stocks in overlooked portions of the market this year. I’m comfortable with those risks in a way I wouldn’t be comfortable standing in front of the AI train today.
Understand Your Goals
The beginning of the monthly email I send, laying out what I’m buying in the Asymmetric Portfolio, starts with the rules I’ve built the portfolio around. The reason I do that is to lay out how I’m building a portfolio over a long period of time.
I want to be fully invested because missing the biggest up days is more harmful to returns than avoiding a few down days.
I invest each month and increase my allocation in down markets, which allows me to be less concerned about valuation.
I try not to ever sell.
These are rules I put in place because the Asymmetric Portfolio has long-term goals, and I’m adding capital each month.
That’s what makes sense for me, and I’ve built the portfolio so you can have a view into how I’m building a portfolio over time. But it’s not the only way to build a portfolio, and you can take bits and pieces from me and others to make investments that are appropriate for you.
We all have different goals and different risk tolerances.
If you understand your goals and how they fit into the market’s risks and the risk of any individual stock, you’re set for success.
Prepare Emotionally and Financially For Stocks to Drop
Remember, the stock market goes up more than it goes down, but it will eventually drop 20%, 30%, or even more. And when that happens, we all need to be prepared to handle the downturn and be able to take clear-minded action to take advantage when everyone else is in panic mode.
I’ve learned that I’m more comfortable when the market is in a tailspin than I am when we’re hitting all-time highs. That emotional state may be very different from how you feel.
I’ve also put mechanisms in place to take advantage of large drawdowns when they occur. I have a buy list ready and a plan to double (or more) my investments when the market hits a 20% drawdown.
I’m ready when the pullback comes, and some of my comfort comes from my preparation, and some comes from having gone through it multiple times before.
Friday was a preview of a market panic, but it was a fire drill, not the real thing.
We don’t know when the real panic will hit, but history says we’ll have one again.
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