Alternative Ways to Participate in the Stock Market

There are more mutual funds available today than there are stocks, and a tremendous industry surrounding them that provides research, facilitates meetings, sells software, hosts seminars, employs spokesmodels, and in general focuses on picking and buying the right stocks. The fundamental assumption is that the stock market goes up over time and will reward long-term investors with a return that will meet their financial goals. But this view has not always been the case. Prior to 1980, the stock market was considered by many to be too risky for retirement savings, and this didn't really change until the creation of 401(k) plans in 1981 and the subsequent explosion of mutual funds. Investors in the 80s and 90s then experienced a market that delivered an average annual return of 13% or more, and throwing darts at the business section of the local newspaper was as good a technique as any for picking stocks. The predominant strategy that came out of this time was to buy stocks or mutual funds, and hang on through the dips. Any other strategy in the 80s and 90s ultimately resulted in lower returns.

If you believe strongly that the stock market will always go higher and will do so within your investment timeframe, then a "buy stocks and hold on" strategy is consistent with your beliefs, but that's not the only strategy available. If you have doubts about what stocks will do over the next 10 years or so (as I do), then it would be prudent to understand the other methods that are available for being involved in the stock market. The stock market has been volatile but ultimately flat for about 13 years at the time of this writing, so we've already lost more than a decade of the 10% annual returns the stock market is supposed to provide, and from all indications it would seem that volatility will be around for a long time. With interest rates at all-time lows, bonds and bond funds are not the safe havens they used to be, so I still think stocks are the best vehicle for achieving inflation-beating returns. However, making money in stocks is going to take a little more work than simply buying stocks and hanging on for the ride.

Making Money When Stocks Go Down

If you firmly believe that the global economy is in a death spiral and you're ready to buy bottled water and find a cave to live in, then shorting stocks is the most consistent strategy with your belief system. Shorting a stock involves selling a stock you don't own (i.e. borrowing it from your broker for a while), with the intent of purchasing it back later at a lower price. If you're right, this strategy can make you look brilliant at dinner parties because you will be making money while everyone else is losing money. However, if you're wrong, you will need to diligently avoid any financial conversations. Investment advisors who aren't afraid of risking other people's money will sometimes feel so strongly about the direction of the market that they will make a big bet on the short side of the market. Those who are successful end up with their own radio shows. Those who are a little off on their timing end up with clients who are losing money while everyone else is making money. In a short amount of time, these advisors are asking "would you like fries with that."

Limiting Losses

Warren Buffett's famous rules of investing are "Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1." Accepting unlimited losses in the hope that stocks will come back violates both of these rules. As a general rule, limiting losses requires giving up some amount of upside potential. One way to accomplish this is to insure your stocks using Put options. Put options establish an absolute floor on potential losses at the expense of the premium paid for the options. Although there are several techniques that can help recover some or all of the cost of the "Put insurance," if the stock price does not fall before the option expires, the cost of the Put option is lost. This is similar to losing the premium on your homeowner's insurance if your house doesn't burn down. Most people have accepted the tradeoff and are not disappointed when they don't end up using their fire insurance. The belief that is consistent with a "limited loss" strategy is that stocks will go up, but that large losses are unacceptable.

Direction-Neutral Strategy (Exploiting Stock Volatility)

The final method I'll cover is for investors more interested in meeting financial goals than in keeping up with the market. Similar to a Limited Loss strategy, a Direction-Neutral strategy (or, more accurately, delta-neutral) involves giving up a little more upside potential in return for an equal chance to profit when a stock moves down. This strategy profits from stock volatility in either direction instead of only when a stock goes up. From a very high level, think of this strategic objective as capturing some of the upside when a stock goes up (say, 5% if a stock goes up 10%), and capturing some more upside when a stock goes down (another 2.5% if the stock pulls back 5%). With this technique, the risk is no longer that a stock price might drop, but rather that a stock price stays the same with very little volatility.

Since Direction-Neutral is probably less familiar to most people than other strategies, it merits a little more detail. It should be noted that "Direction-Neutral", or "delta neutral," is different than the typical strategy used in a long-short or market-neutral mutual fund. The typical fund categorized as long-short or market-neutral uses a combination of owning stocks that are expected to go up and shorting stocks that are expected to go down. The problem is that this raises the possibility of being wrong on both sides. A delta neutral position uses a combination of stocks and options so that the only amount of capital at risk is the cost of the options. If the stock price does not move, the value of the options will gradually decay similar to the Limited Loss strategy. So the trick is to pick a stock that moves. Microsoft is probably not a good candidate for a delta neutral strategy, but Google or Apple would be. Similarly, Johnson & Johnson is probably not a good healthcare holding, but a volatile biotech stock would be interesting. In general, it is easier to pick a stock that has a good chance of price movement in the future (just look at the last several earnings cycles) than trying to pick a stock that will consistently go up in the future.

Another requirement for a successful direction-neutral strategy is the ability to lock in gains and readjust the position. If the stock price moves up or down after a neutral position is established, the position is no longer neutral. If the position has met a performance goal, or if the underlying stock shows signs that it may be done moving, it is important to lock in the gain and readjust the position back to neutral. This requires work that goes well beyond buying a stock and chanting "I will not sell, I will not sell,... " Diligently watching the performance of direction-neutral positions and managing them appropriately allows profits to be captured on moves in one direction and additional profits if the stock bounces are pulls back.

Summary

Below is a summary of the four basic techniques for investing in stocks, along with the belief about the stock market that would be consistent with each technique.

Technique:Buy stocks (or mutual funds) and hold on.

Primary Risk:Stocks may go down

Belief: "Stocks will go up fast enough to meet my financial goals regardless of short-term losses."

Technique:Short stocks (or buy inverse funds or bear market funds)

Primary Risk:Stocks may go up

Belief:"Global conditions are deteriorating and the market is in trouble."

Technique:Limit Losses

Primary Risk:Stocks go down or stay the same, but risk is limited

Belief:"I think stocks will go up over time, but I can't or won't accept large losses."

Technique:Direction-Neutral

Primary Risk:Lack of volatility

Belief:"I'm not sure which direction stocks will go, but I'm pretty sure they'll go somewhere."