By Simon Baker, Guest Columnist
Conventional Wall Street wisdom states that a buy-and-hold approach to investing, along with diversification, is the best plan for protecting your portfolio.
This philosophy, typically perpetuated by the big fund houses of the world and your wire house broker, is supported by words of encouragement like "ride out the storm," a term that gained new resonance over the past weekend as the East Coast assiduously prepared for Hurricane Irene.
Looking back, it's clear that the ride out the storm philosophy is not only outdated, but dangerous and sometimes downright irresponsible.
For days, satellite images of a hurricane moving toward the eastern U.S. warned inhabitants in its potential path. As a result, millions of people were advised to evacuate their houses and protect their property. The recommendation, properly, was not to stay and ride out the storm.
Unfortunately, the stock market does not have a satellite system that can beam down images of future disruptions. However, there are a number of other indicators sending signals that tell of an increase in the risk in the market, warning investors to be prepared for potential losses.
At my firm, Baker Avenue Asset Management, for example, we use a combination of the volatility indicator, the VIX, combined with the moving averages of an index of more than 4,000 stocks to help up develop a risk/reward forecast of investing in equities versus evacuating and being in cash.
When the VIX started to spike back on June 13, it was warning us that dark clouds were gathering. This, combined with the moving average turning negative (or negative market momentum), made clear that the storm had now shifted direction and was moving our way. As a result we got out of equities and moved 100% into cash, avoiding the destruction of much of the downfall in July and August.
Back to Irene. By the time the storm reached New York, it had significantly calmed and did not pose the threat it did 24 hours earlier. Indeed, evacuation may have been an extreme measure, and, as it happened, was not necessary. However, that was for New York City. The storm did in fact inflict significant and very real damage on its way to the Northeast, knocking out power to millions, causing floods and property destruction that will total in the billions of dollars, and even leading to the loss of life.
The true force of a storm is never known before it arrives. Indicators for the stock market are no different: The dot.com selloff of the early 2000s and the financial crisis of 2008 were both preceded by our market sentiment indicators running negative and the VIX surging. That said, there are periods when storms pass right by and equities continue to rally.
So, should you sit tight and ride out the storm, hoping its devastating consequences go by? Or do you take the necessary precautions and head back when safety is a sure thing? As a family man, I, for one, am not willing to leave the well being of my loved ones in a hurricane's path.
Simon Baker is CEO of Baker Avenue Asset Management & Great Gable Partners. He maintains a blog on the market, and you can follow him on Twitter @CheekyTrader. Additionally, he has been a past guest on Breakout. You can see his most recent appearance by clicking here.