On Managing Risk during a Bear Market

Last Friday I played hooky; I took the day off from work to go snowboarding with my second daughter before she heads back to college, and we had a great time.

But the day could have been ruined before we even reached the mountain! And here's how. When we left home, the temperature was 40 degrees and the rain was coming down. As we drove north into New Hampshire, the temperature dropped steadily, and as it neared 32 degrees the rain became freezing rain and then eventually snow. The snow began to build up on the roadway, and before long ruts began to form, so that every deviation from the lane brought periods of substantially reduced traction.

The good news is that traffic was light, as is typical of the roads in central New Hampshire. The bad news is that most drivers took that as license to continue traveling at high speed, confident that their trusty vehicles would deliver them to their destinations.

Me, I started thinking about risk management.

I knew my tires had good tread and that my sedan's all-wheel drive system would provide traction to any wheel that could grip the road.

Trouble was, the road was becoming increasingly less grippy. So I eased off the gas a bit. Instead of being one of the fastest drivers on the road, I took it down to a normal speed. I took care to avoid situations where I'd need to use the brakes. And I was very careful to avoid abrupt lane changes.

Meanwhile vehicles continued to pass me. I wasn't happy about getting to the mountain later than I had planned on. But I occupied myself doing calculations in my head revising our estimated arrival time. I spent some time thinking about the weight shifts that come from driving uphill and downhill. And I reviewed physics terms like inertia, mass, angular momentum, and centrifugal force, not doing any calculations--my last physics course was a long time ago--but trying to understand the forces at work on my vehicle as we rolled along.

And then the flashing blue light appeared up ahead. A vehicle had slid off the road--a large SUV--and though it was still upright, it clearly needed a tow truck to be extricated from its position.

Ten minutes later we were off the highway and on to the secondary roads. Speeds lower still, maybe 40 mph. And very soon we came on another large SUV that had slid off the road and awaited a tow truck.

Now, it may have been coincidence, but my guess is that both these vehicles got in trouble because of their relatively high center of gravity, which magnifies the weight-shifting effects caused by braking or steering. The increase may only be 10% or 20%, or it may be more.

It depends on the vehicle, its speed, and the "severity" of the action that induces the weight shift. But the result in every case is reduced traction, and thus reduced ability to control the vehicle.

There's a fine line between control and loss of control and these vehicles clearly passed it.

But if they had managed their risk just a little better, by driving a little slower or braking a little less abruptly or steering a little more gradually, their day might have been as fun as mine.

Risk Management

Risk management, or course, applies equally well to investing.

When we're in a strong bull market, it's like driving down the highway on a clear summer day. Visibility is unlimited and your tires grip as well as they ever will. You can go pedal to the metal and rack up the miles - and the profits - quickly.
But a bear market, such as we're in today, is more like the weather I drove in Friday. It's far less tolerant of aggressive behavior. The effects of your mistakes are magnified. And if you make enough wrong decisions, it can ruin you.

The secret to surviving the bear market, of course, is adapting.

You slow down, pulling money out of aggressive growth stocks. You hold a lot of cash on the sidelines, waiting for the weather to improve. And you constantly take stock of your position, monitoring each holding in your portfolio to ensure that it's not putting your financial future at risk.

If you do choose to continue investing aggressively during the bear market, you'll risk less if you keep your investments smaller, if you focus on buying only after stocks that remain in uptrends have had normal corrections, and if you are ruthless about cutting losses short.

If you do, and if you're a little lucky, you may actually make money. More important, you'll come out of the bear market unscathed, and ready to participate in the next bull market.


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Today's investment idea comes from a recent issue of Cabot Top Ten Report.

But first, a few words about the market.

It stinks. It's unsupportive, unfriendly, and downright dangerous to your financial health. Unless you're an expert, the best place for your money now is a safe money market account.

On the other hand, the odds are we're closer to a bottom than the top. Why?

First, the bad news is well known. The recession word is everywhere, and the only question now is how much Ben Bernanke's Fed will cut interest rates when they meet next week.

Second, the indexes are down sharply. The Dow Industrials are off 15.3% from their October peak, while the Nasdaq has shed 18.1%. That seems like it might be nearly enough.

And third, investor confidence has pretty much disappeared. No longer are investors asking us what stocks to buy now. Instead, they're asking if they should continue to hold stocks in which they've lost money. (Generally, we say sell.)

Admittedly, the fact that we may be near a bottom does not mean that aggressive investors should resume buying; one of the difficulties at times like this is knowing what to buy ... knowing what the market will favor when the bull comes back into power.

MercadoLibre: The eBay of Latin America

One of the stocks we have high hopes for is MercadoLibre, which we like to call "the eBay of Latin America."

Here's what Mike Cintolo wrote about MercadoLibre a few weeks ago.

"The company began in Argentina in 1999, and has outlasted and outgrown its competition to emerge as the dominant site in South America. Brazil is the company's top market, supplying 43% of revenues, with Argentina and Mexico supplying smaller amounts. The company is still expanding, with moves into Central America markets, and an eBay-like integration of an electronic payment system is a plus. There's still lots of room for expansion into new markets and for higher online expansion into existing markets (Brazil has just 14% Internet penetration). Even today, revenue growth is accelerating! The potential for MercadoLibre is easy to see, and investors have been pushing the stock up fast. This makes it especially important to play any investment correctly."

I look at the chart and here's what I see.

MELI began trading last August at 18, and got as high as 40 on its second day of trading. In late November, it was still at 40, building a strong base. And in early December, it finally took off, running up to 81 by late December. But this year's downdraft has pulled the stock back down to its old support level. It closed last Friday at 47, and if the market performs as poorly as expected tomorrow, it's likely to fall through 40.

But I'll be watching how it performs relative to the market, and if it does find support, I'll continue to keep an eye on it as we wait for the broad market to regain its strength


Editor's Note

MercadoLibre may never be mentioned here again, but if you'd like weekly guidance on investing in the market's strongest stocks, as well as ongoing advice on when to buy, hold and sell those stocks, I suggest you try a no-risk trial subscription to Cabot Top Ten Report. To get started, simply click the link below.


Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory

Timothy Lutts can be found on Google Plus.

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