19, the S&P sold off 22% after a drop of 10% from the previous Wednesday. 7, 1987, the prime rate rose 50 basis points based on an evaluation of a strong economy. 5, 1987, the stock market started one of its major declines. Look at Figure 5, a history of the prime rate. Investment managers and investors may find it to be a better leading indicator than the fed funds rate. They do lower it, however, when they see a serious problem in the economy. They try not to change it often, and they resist lowering it because it lowers their income/profit margin. Wouldn’t it be nice if you could know when a prolonged drawdown will occur? In a way, the Federal Reserve and the banking sector do just that.īanks set their prime rate, the rate they will lend money to their most-favored customers, based on the fed funds rate. We seem to be able to deal with drawdowns that recover quickly, but the ones like those following the internet bubble of 2000 and the financial crisis of 2008 are best avoided. If you place it too close, you get stopped out on almost every trade. The closer you place your stop, the more often it is hit. Had you done that during the recent December 2018 sell-off of close to 20%, you might still be out of the market and missed the recovery-or been slow to re-enter and missed a good portion of gains. However, what happens is that you have a lot more losses of 10% when many of those stocks or ETFs turn around and make new highs. We know you can reduce the individual risk of a trade or position with a stop-loss of, say, 10%. We can follow a systematic strategy that includes a stop-loss or some other risk-moderating techniques that are intended to control the maximum drawdown. That action caused most investments to decline, even if they had nothing to do directly with the crisis. Investors exited the equity market and sold other assets to cover losses. In 2007–2009, as in other extreme periods, most asset classes reversed at the same time. Unfortunately, that works only when you don’t need it. Diversification means investing in assets that have different return and risk patterns. What can we do about the risk? The two most obvious ways to combat risk are diversification and selection. Figure 1 shows the AROR and the risk, measured as one standard deviation, for our sample investment selections. On the other hand, the calculation of returns is not a probability but rather the actual annualized return over the period from 2007. To be clear, one standard deviation means that there is a 16% chance that the risk will be larger than the calculated value, and the truth is that it will be much larger. To measure return and risk, financial analysts use the annualized rate of return (AROR) and define risk as one standard deviation of the daily returns. That period also spans one of the largest market sell-offs in the post-WW II era, an equally unprecedented bull market, and more volatile recent activity, making it a good data sample. 20, 2019, to allow for inclusion of all of the ETFs. We’ll look at the data from 2007 through Feb. dollar index (UUP), and the Goldman Sachs Commodity Index Trust (GSG). Social media basics for financial advisorsĪs our basis for comparison, we’ll use the SPDR S&P 500 ETF (SPY), high-grade corporate bonds (HYG), preferred stocks (PFF), a Vanguard bond fund (BND), municipal bonds (MUB), the U.S.
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