The Playbook: Money Management-Defense

Part of the confusion now is that investors are trying to determine if what we are seeing is a normal pullback resulting from profit taking after our big run up or a change in market trend. Right now commentators are all over the board on what is happening. Of course there's almost nobody arguing that stocks could streak higher this summer so I'm reminded one of the first lessons I learned form the Consigliere-"stocks will do what they have to do to prove the most amount of people wrong". The most pain I think would be if the market were for some reason to suddenly melt up and tack on a quick 5-10% from current prices. I think many investors-particularly institutions aren't positioned for that.

I also don't find that the most likely scenario. I've mentioned why in earlier posts {although I think we are correctly positioned if it were to occur}. I like most others think stocks have to rest or retrace some of their recent gains. If this transpires we must employ defensive money management techniques. Correctly identifying the difference between a pullback and a change of trend means the difference of buying into the dips and profiting from a subsequent advance or being stuck in losing positions as the market grinds down.

Studying money flows into and out of stocks can help identify the difference. Unfortunately it is not a foolproof method and it is usually impossible to know what we are exactly facing until a pullback or trend change is well established. Therefore the key is to be disciplined in your money management approach. These are the defensive tactics of the Playbook. The first thing you have to do is to try and have an adequate understanding of each client's risk reward profile. Frankly some people tolerate risk and volatility better than others. After that, develop a disciplined money management approach based on what you know about that client. If the client's risk reward profile tolerates buying for short term opportunities you still need to have a line in the sand where you take losses just in case you are wrong.

There is no perfect system of money management. The key function of defensive money management in the Playbook is to give you a client centric plan for what you should do when the market moves against you. It does not mean a portfolio won't ever have losses. If constructed properly it should mean that a portfolio loses less when the market inevitably goes through a period of profit taking. This is very important now. Stocks have gone straight up from their lows and have now started to show signs of running out of gas. The best one can do is to try and control the risk in the client's portfolio based on their profiles. For us this has meant incrementally raising cash positions in appropriate accounts, identifying signals that might give us further clues as to the next leg in market direction and identifying levels where we might make additional sells for appropriate accounts.

No system of money management will completely protect a portfolio from a market declines. Short of a system that moves portfolios completely to cash, no system will completely protect a portfolio from a collapse like we experienced last fall. However, a proper system does allow you to control some of the risk in the portfolio. It may often mean you might sell something at the wrong time or watch something you sold move higher in the short term.

Selling is often less an issue with ETFs. With them you are buying a security based on an index and they are unlikely to move away from you on the upside so substantially that you can't think about finding a level to buy the security back. Investors are often reluctant to almost immediately repurchase a stock or ETF they just sold, but it can be a good strategy particularly if the market moves lower short term. Modern spreads and modern brokerage commissions which are a tenth of what they were even a few years ago make buying and selling not the cost prohibitive factor it once was.

Nobody knows for certain what the future holds. We can develop tactics based on experience and what we are seeing right now. But proper defensive tactic can give us a leg up. If deployed correctly they should mean that portfolios are positioned with adequate cash positions to be used if the market retreats to lower levels this summer. If the market instead moves higher then we will capture an adequate portion of the gains with the ETF positions we currently hold.