Stock investors got a dose of harsh reality this past week when the major U.S. market indexes declined and took many of the favorite stocks with them, including the so-called Generals: Facebook
; Walt Disney
The three-day selloff was a stark reminder that stocks are not bulletproof. One catalyst in this case was U.S. inflation spiking to a 13-year peak. Institutional investors do not take kindly to inflation and they sold.
Then stocks rebounded over the week’s final two trading sessions, recovering much of the earlier losses and bringing the major indexes above their 50-day moving averages.
Keep in mind the main goal of investors and traders is to reduce or limit risk. The second goal is to make profits. After a wild week and an unstable market, here are a six ways to make sure your investment portfolio is positioned appropriately to the market’s moves:
1. If indexes fall below their moving averages, take action: Traders and investors alike should watch moving averages, especially the 50-, 100-, and 200-day. When the indexes were sliding a few days ago, the S&P 500
for example, did not break its 50-day moving average at 4050. If it had, and had stayed below the average, that would have been a strong sell signal. Now from a technical standpoint the S&P 500 must remain above 4,125 for the bulls to keep control.
Whenever the major indexes fall below their 50-day moving average (red flag), the 100-day (big trouble), or the 200-day (welcome to the bear market), and stay below, smart investors consider cutting some of their long positions. The last thing you want is to be caught off guard. Here are moving averages for the main U.S. indexes as of May 14:
Dow Jones Industrial Average
: 33,442 (50-day); 32,195 (100-day) and 30,292 (200-day).
S&P 500: 4,063 (50-day); 3,941 (100-day) and 3,701 (200-day).
: 13,539 (50-day); 13,438 (100-day) and 12,479 (200-day).
2. Stick to your investment plan: If you don’t already have an investment or trading plan, make one. Evaluate what you own, cut losers that have little chance of rebounding and make sure your assets are diversified.
Create a plan based on facts, not emotion. If you do not have a plan, then you are susceptible to giving into fear and selling when the market plunges, or buying in a panic when the market rallies. Investing or trading based on emotion is a loser’s game.
Another reason for having a plan is to be prepared for a worst-case scenario. Your plan is like an insurance policy and should be reviewed annually at least.
3. Dollar-cost-average into index funds: If you are a long-term investor or a trader, consider dollar-cost-averaging a preset amount every month into a low-cost index fund, such as a basic S&P 500 index fund.
This way, you are buying at lower prices when the market slumps and at higher prices when the market rallies. If you are a trader, you should also use this strategy. Why? Because the key to success in trading, investing and in life is diversification.
4. Diversify: Three rules for investors and traders: sell losers; reduce or manage risk and diversify your investments.
Diversification simply means not putting all of your eggs in one basket. Have a core mix of stocks and bonds and a portion in alternative investments. Sell covered calls (more on this later). Own real estate. And be sure to keep a healthy amount of cash for emergencies — and for bargain-hunting in market declines. By diversifying, you can survive the market’s pullbacks or even a bear market.
5. Buy the big dips: Investors who missed out on the rally are waiting for the indexes to decline significantly so they can buy stocks cheaper. The market is an auction, and right now it trades near all-time highs.
Trying to time the market by buying the dip is not easy because you never know how low stocks or indexes can go. If you do, do not buy on the way down (trying to catch a falling knife is dangerous). Confirmation that the market has stopped its fall will be made when prices go sideways for a while.
6. Sell covered-call options: One of the least-risky option strategies is to “rent” your stocks to option speculators. With this strategy, you sell “covered-call” options on stocks you own. You receive premium for renting your stocks, but in exchange you give up control temporarily of when the stock is sold. This isn’t a strategy to use when the market or your stocks are volatile (like now). It is worth exploring during flat or moderately bullish market environments.
What to do now
Was this most recent market selloff just a three-day blip or a sign worse days ahead? If you are a trader, you will take advantage of increased volatility to try to make daily or weekly profits. But for most investors, the answer is elementary: reduce risk by increasing cash. This bull market is showing signs of slowing, especially since many of the strongest stocks are faltering.
Often, these one-or-two-day selloffs have been a gift to buy-the-dip investors, but this is also a dangerous maneuver to adopt should a sharp downdraft or freefall materialize. One of these days the market will plunge, and keep plunging — catching buy-the-dip investors off guard. That’s when you will be glad you have a plan, a diversified portfolio and plenty of cash.
Michael Sincere (michaelsincere.com) is the author of “Understanding Options,” “Understanding Stocks,” and his latest, “Make Money Trading Options,” which introduces simple option strategies to beginners.