What happens when you stretch a rubber band? You pick up a rubber band lying in its normal state, and when you stretch it you can feel the resistance and feel that the rubber band wants to return to its normal state.
When the stock market gets stretched too far, it wants to return to its normal state also, and this is easily seen through statistics and the bell curve. The least desirable means for the market to return to a normal state is through a pullback in prices. Several market indicators are telling us that the stock market is stretched. The S&P 500 and the Dow Jones are at all-time highs. Just yesterday, I noticed that an indicator that measures participation in the market is at an all-time high also. Just when the market will pull back is unknown, and that unknown is what makes things interesting and difficult.
One school of thought to deal with a situation like this is to simply buy and hold. In fact, the mutual fund industry has promoted the buy-and-hold methodology for decades. It’s in their best interest. This methodology says that we should simply hold on when the market goes down because it will always come back. When there is time for the market to come back, as in the case of a very young person, this strategy can work well in the long term. But if you are in retirement or near retirement, it’s a much different story because the market may not come back in the time that you need your money. Another proven problem with this methodology is in regards to significant pullbacks. Since the year 2000, we have seen the stock market experience two major declines of 50% or more. Many, many people who were in retirement or near retirement during those downturns were devastated.
A much different school of thought to deal with an over-stretched market is to not hold onto weak positions when the market declines beyond a certain point. The thought here is that if the position was weak when the market was heading up, it may be weaker when the market declines. Setting stop loss points is another way to deal with a declining market. One should have a plan for what to do if things go according to plan, and a plan for what to do if things do not..
No matter what risk management strategy we employ, averting losses can give us comfort and greater peace-of-mind. Now is a time to be observant and aware of what the market is doing. As Yogi Berra taught us, you can observe a lot just by watching.
The information in this post is not a recommendation or advice. You should consult a qualified advisor prior to making any changes.