Observing what happened in the past 72 hours was very fascinating, to say the least. First, pretty much no one gave credit to Iran’s threats, then no one gave credit to US administration warnings and ultimately, when Iran pulled the trigger, everyone quickly dismissed the risk of a retaliatory strike from Israel.
What personally shocked me was even seeing some pretty respected and high-profile people calling this sequence of events bullish for the market in particular stocks. Clearly, very few did not fall into the “recency bias” trap. This bias is the tendency to assign a greater likelihood of an event happening in the future compared to another if the first event happened more recently than the other. In other words, since so far any military escalation turned out to be a “nothing burger” for markets, then the crowd is biased to expect even this new military escalation between Israel and Iran will have no impact on markets again.
On Sunday, many claimed to be right because the Tel Aviv stock exchange wasn’t bothered much by the weekend events and gingerly traded sideways for the whole day till it closed roughly unchanged.
Besides the fact that Israel for sure is going to retaliate against Iran, because failing to do so will significantly weaken their geopolitical strength and influence as I explained in this post (link), what was clear during the whole weekend is that almost everyone is long into the market (many with leverage) without any protection in place. As a consequence, all those people can hope for is another “nothing burger” without impacting the status quo of financial markets, particularly in the US and Europe.
Now, let’s assume things are different this time. Or perhaps we should say things will play out as they always did in the past in these kinds of situations. How would you manage your risk and in particular make sure any damage in your portfolio will be contained when markets resume their activity on Monday when you did not take any precaution beforehand?
1 – Don’t panic, if you do so rest assured your actions will result in greater damage than doing nothing.
2 – Don’t try to rush to make back your losses, in particular, do not fall into the trap of flipping your long positions into short ones.
3 – Have a good look at your investments and put them into 2 categories: those you really believe in and those you don’t have strong conviction about. You should cash out from any investment that falls into the second category, regardless of whether that happens at a profit or a loss. Why? Because these will surely be those you will have a harder time to stomach losses for in a market downturn and the longer you hold them just to wait for them to bounce back and sell at a lower loss, the greater the loss you will instead end up with.
4 – At this point have a look at your cash, your investments, and in particular at your leverage. If you have any leverage in place it is always better to take all that off ASAP when volatility starts to raise its head like it did last Friday for example. Remember, if you have leverage you will always have a chance to be wiped out while without leverage the chances of that to happen are statistically negligible.
5 – Arrived at this point you have to work to potentially go through a bear market that on average lasts between 6 and 12 months. What matters here is that you have enough cash, savings, and insurance to cover all that period even accounting for losing your full-time job income stream. Here is when the painful decision of cutting some investments you are attached to and strongly believe in comes. Beware, it is always better to do this early rather than waiting because of false hopes things can recover and turn out better than expected. If things go nuts in a few hours you can rest assured it is not going to end there. Furthermore, if you sell early your chances to take out enough cash and still maintain some investments in place is a far better position than risking to be forced to sell when prices and valuations will be depressed.
6 – Using derivatives is something I would not recommend in general if you did not have them in place before the events. Why? Because high volatility will translate into a far more expensive price, in particular, if what you are looking for is downside protection. Furthermore, derivatives are very sensitive to sharp swings and bear market rallies can be very powerful and knock out the hedges in place of investors not truly capable of managing them.
Summarizing all up, your goal will be to build enough financial cushion for tough times and significantly reduce the beta of your investments as quickly as possible if you feel you have what it takes to withstand a spike in volatility and potentially the bear market that follows.
Never forget that real life-changing wealth is always achieved by those people who have their bag full of cash when everyone is panic selling at depressed valuations. Trying to short the market or to trade a “real” market, not one that goes up every single day and only requires half of a brain to make (paper) money, in 9 cases out of 10 exposes to more damages than increasing the probability of potential gains. I know it is very difficult to resist the FOMO bug, in particular in a market where every risk event is quickly dismissed as a nothing burger, and central banks fill any crack with freshly printed liquidity. However, it has been proven time and time again that stock bubbles cannot be kept inflated forever since sooner or later the damages on the real economy will be too big to not have social (and consequently political) consequences so you better stop repeating to yourself “it is different this time” and make sure you pay attention to your risk from now on.