Lessons from Hedge Funds to Prepare for the Bears

Hedge Funds

We’re still waiting for the bear market that many have been predicting for a while to hit us. All-time highs aren’t it, but when this does finally come, we need to ask what we will do.

All three major U.S. stock market indexes hit all-time highs last week. While there is plenty of fear out there that a bear market may be right around the corner, we haven’t seen even a real hint of this in 2019, and are moving further and further away from these dreary prognostications as the year progresses.

Bull markets can last a very long time, and in theory can really go on forever, even though this has not ever happened. This would not be that hard to imagine though as long as we understand that it is the feeding of this bull by investors that sustains it.

If the economy keeps growing, and there is a strong tendency for this to happen, and people keep investing in stocks, then this growth can just keep propelling things forward indefinitely. If stock indexes really are driven by economic growth, as so many people assume, stocks should go up in a similar fashion as inflation, and inflation alone can drive this horse.

If we were down to just growth rates that mirror inflation or even GDP growth, it would be a pretty dull market indeed, as stocks would actually perform pretty similar to bonds, with returns in the 2-3% level to be expected going forward. We might as well be investing in bonds if this all were true, because stocks are simply a lot riskier, and we need to earn extra to make up for that.

The stock market is far more complicated than this though, and there are times where the economy is doing well but stocks can take a real tumble. Usually, it’s the economy slowing down a bit but still producing positive growth that these bear markets tend to occur more, and during these times we can see it lose half its value or more.

This is, of course, a huge over-reaction to these fairly minor changes in the economy, but the stock market over-reacts to everything, including positive things and even things remaining the same. This is not a negative thing, as it offers the possibility of a lot bigger returns than if you just owned a piece of a company’s profits with preferred shares, and the businesses themselves go public so they can cash in on this over-exuberance.

Dealing with Bear Markets Well Means Being Prepared for Them

We need to be prepared for when the tide turns though, and if we look at last year’s 20% dip, there really wasn’t anything out there that should have scared us anywhere near this much. Sure, higher interest rates may slow the economy and somewhat affects the profitability of the businesses that we own stock in, but we’re only talking rather small changes here and nothing even close to a company being worth 20% less.

We do follow the crowd though with stocks, and this is behind so many people investing in them, seeing the crowd driving up their prices and jumping on board to get a piece of this action. The same thing happens in the other direction, and as people get out of stocks, this causes even more people to follow this crowd and if the mob grows enough, this can see us go down a long way before they tire.

Many investors think and worry about bear markets quite a bit, but don’t really get beyond the worry and come up with a workable plan or even much of an idea about what they would do aside from hoping for it to stop and turn around.

If we are stuck in funds that can’t do anything but just hang on and pray when bear markets hit, that might be a plan but it really isn’t a very good one. Some investors might want to get out of their positions with these funds, at least taking a break during the periods of bad weather, but wanting this and knowing how to pull this off in a sensible way are two different things.

People put so much on the line with their investments but really tend to take a hands-off approach to them, letting others decide their fate. If you are in a fund that cannot do anything else, this isn’t exactly letting someone else protect you against such things.

More wealthy investors may invest in a hedge fund, who don’t operate under the same very restrictive rules and can do pretty much whatever they want with their funds under management, but many investors aren’t deemed to be accredited enough and are kept out. This really comes down to how much money they have, and somehow, regulators have decided that if we aren’t wealthy enough, we will pay the price of being limited to funds that don’t manage risk at all.

It’s not that easy to make sense out of how such rules could come to be, given that investors of any level of wealth can go and blow all their money off on things considerably riskier than hedge funds, buying a bunch of options for instance or leveraging their money enough with futures that a few bad trades can wipe them out.

It’s not that trading options or futures is a bad thing, although it can be if you don’t know what you are doing. There is no accrediting involved with these things though, you just need enough money to open an account, and you can then do whatever you want and be as unprepared and unskilled as you want to be.

Managing Our Investments Well Means Acting More Like Hedge Funds Do

If we want to manage our own investments though, and we don’t qualify to invest in hedge funds, we’re going to have to rely on our own skills. We don’t really need skills anywhere close to what professional traders have, and we really don’t need much beyond a little common sense to be able to pull this one off.

It’s actually better to run our own hedge fund style plan than let fund managers do it, if we are up to it that is, and it’s actually pretty easy to do better with our own then theirs. While mutual funds can be understood as all offense and no defense, hedge funds are allowed to play defense, but a lot of it consists of offsetting their risks.

If you have long positions and are worried about their turning against you, and you just can’t exit them at the drop of a hat, you will need to hedge them by taking positions that will benefit from a reversal. This involves their taking both long and short positions, but there’s a lot less need for us to do that because our hat comes off very easily.

We therefore really shouldn’t be doing things like buying put options or taking short positions in stocks or index futures, just as a manner of course, without any real indication of need. We can instead just go with the flow, and going with the flow is not only the best way but the only way that makes sense.

The lesson we can learn from hedge funds is that it is good to go with the flow, as hedge funds beat their mutual fund brothers generally in both bigger returns and less risk. This is the real lesson here, and one that anyone who thinks that it is useless to try to go with the flow needs to learn.

Beyond that, it simply becomes a matter of our determining where the flow is going. If it is pointed in a downward direction, it does not make sense for us to keep our bets that things will go up on the table, regardless of our time horizon. We instead need to be aware that this is all a game of probability, and while we have been able to make money by looking at the long-term probabilities while ignoring the short and medium turn ones, this is neither efficient nor even sensible.

The way to really prepare for a bear market just involves opening up our minds and looking to do what hedge funds do if this comes, which is to look to balance your assets more in the direction of the market. The only trick involved here is deciding on what the weather will be like, whether the sun is shining or it is raining, but this is not hard to do.

When it’s sunny, we generally need to bet on clear skies, but when it’s raining, instead of standing there and getting soaked and hoping it will end, we should actually be betting on the rain. The sun actually shines on any market condition, provided that we are on the right side of things, and bear markets can be both exciting and profitable if we are on the same team.

Investing is a real business, and we need to take a business person’s view of it, and not just be content with being led into big pens like sheep by those who want to manage our funds and want to continue to do so. You’ll never do well in business by hiding in the crowd, and we owe it to ourselves to at least be open to alternatives, even if this involves us breaking free from mutual funds and look to become more like those who prosper more by doing their own thing.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: [email protected]

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