Investors can make a profit when the market drops.
Every trade has two sides, the buyer and the seller. They buyer thinks his investment has reached its peak and wants to get rid of it, and the seller believes the investment hasn’t yet reached its greatest value and is betting it will get stronger.
In order to profit from a drop in the market, you need to be confident in the future.
Two critical questions to ask before betting on the downside
Before you start trying to make money from a downturn in the market, ask yourself these two questions:
- Why do you believe the market will continue to drop?
- How long do you think it will tumble?
Sometimes people answer the first question, “Why do you believe the market will continue to drop?” with the over-simplified answer, “Because it’s so high already.” If that is your only reason to “short the market,” don’t. Based on that logic, you would have been shorting the market most of the time for the past 80 years. Yes, there would have been a few times (far and few in between) where you would have made money on crashes, but most of the time, since the market has been on an upward trajectory, you would have lost.
When people answer the second question, “For how long do you think it will tumble?” with the reply, “I don’t know when it will drop nor when it will recover; I just feel it’s going to drop soon,” they should also avoid betting on the downside. Here’s why…
Making a bet on a drop in the market requires knowing when to get in and get out of the position. Unlike investing in growth for the long term, where you can ride through the ups and downs, market pessimists don’t have that luxury. They need the market to dive, and then they need to close their position.
The easy tool for betting on a drop
Investors have placed trillions of dollars in “exchange traded funds” that closely track the returns of the market. If you think the market will drop, you can buy an “inverse” or “bear” index fund. These funds will go up when their related index goes down. Some people go for the extra return of funds that leverage the moves of the market. Those funds sometimes have the term “2X” or “3X” in their title. If you owned the 2X bear S&P 500 fund and the S&P 500 drops 2% one day, your investment will go up around 4% that same day. However, the opposite is also true, so be careful since “leverage” means you’re driving at full throttle and can lose money quickly.
Leveraged index funds normally reset on a daily basis, so the returns like the one described here only work when you look at them on a one-day basis. If you hold the fund for a week when the S&P dropped 10%, you may not actually make 20%. The prospectus of these funds describes why in more detail. These types of funds, though often used by regular investors, are really best suited for professional traders.
For folks who believe the market has peaked, rather than trying to earn extra rewards from the drop, sitting on the sidelines and keeping money in cash or other short-term programs may be the best choice. In most cases, they won’t be able to time the market well enough to profit continuously over the years, so caution makes sense. In fact, even if they believe the market will drop, it still might make sense to hold onto their growth investments and ride through the waves. Though past performance is no guarantee of future returns, investors who see themselves as long-term players will likely be satisfied with their results if they stay with the market over the years… and decades. But if you don’t have the tolerance for volatility, then stay away!
What Susan Polgar told me
Susan said that when chess players experience trouble in their match, they should try to make small, incremental improvements to their positions. The same applies to investors. Rather than trying to make a killing on a big short, if you believe the market is poised to tumble, see how you can make slight improvements in your pieces. Can you switch from individual stocks to mutual funds or index funds to diversify your risk? Can you look for companies with a strong history of dividend growth so you’ll have some income in the event that the market falls? Can you sell off loser positions and benefit from the tax loss? Can you just move to cash for a while?
If you have a particular strategy you like for dealing with a volatile market, send me a note at the “contact” tab of www.RichAsAKing.com.
Douglas Goldstein, co-author of Rich As A King: How the Wisdom of Chess Can Make You A Grandmaster of Investing, avid chess fan, international investment advisor and Certified Financial Planner (CFP®)
