ETFs and Panic Avoidance

A couple of good articles from this week that I think are related. One is from the WSJ titled Even Pros Have Trouble With Buy And Hold and one from the FT titled Chinese fund fillip for oil and gold ETFs which is about the China’s SWF that is now using a lot of ETFs.

Or maybe I’m stretching but either way…

The WSJ article struggled to make its point and maybe I still have it wrong but it seemed to conclude that portfolio managers trade more frequently than they plan to because, like all people, that have emotions that they occasionally give into.

Much of what I write about is geared toward reducing or eliminating the role emotion plays in navigating the market. There is a difference here that is worth exploring. Emotion can come in the form of a complete meltdown where everything is sold in a panic after a big drop and of course this same sort of person might then realize they were wrong and buy back in after a big move up. People lose a lot of ground with that type of action.

Another emotional response I have mentioned quite a few times that is far less damaging is sacrificing one name to the market gods just to make yourself feel better during a market panic. Selling a holding that comprises 2-3% of the portfolio at the low would in hindsight turn out to be a bad trade but it is not ruinous behavior. The consequence of this small sacrifice is reasonably missing out on a couple of hundred basis points so with the rally from the March low it wouldn’t really matter whether you bounced 48% or 50%? However anyone riding the market all the way down fully invested who then panicked out completely in March has a big problem.

If the WSJ article even isolated anything interesting or is drawing the correct conclusion it is no doubt obvious the role narrow exposure ETFs can play in helping with this issue. Anyone reading this site for a while know I believe in using mostly individual stocks with a few ETFs but stocks require getting two big things correct; the theme and then the way you access the theme whereas with an ETF you need only be correct about the theme.

Recently I disclosed swapping out of Monsanto (MON) and into Market Vectors Agribusiness (MOO). MON started out as the correct stock in the correct theme and then became the wrong stock in the right theme. Picking the wrong stock now and then goes with the territory. If the wrong one is picked too frequently then maybe the strategy needs to change but picking the correct theme is easier, obviously, and realizing what other segments, if any, also benefit is easy as well. Note that this simply creates a tailwind not a guarantee of success.

A theme usually won’t implode unless there is widespread market panic, like a year ago, but a stock can implode at anytime. To the WSJ article when a stock implodes there then is extra work to try to assess whether the stock pick was really an incorrect one or not and after a big drop in that stock the process might be clouded enough by emotion to influence the incorrect action. Under normal market conditions an ETF is likely to be down less than possibly gone-bad stock pick and up less than a home-run stock pick so either way there is less chance of emotion clouding judgment. We are collectively probably wired to better handle a narrow based fund dropping 15% than a stock dropping 25% (obvious statement).

I can appreciate that this entire post may be obvious but if you have been a broad based index investor and are starting to think, as I have for years, that success in the next decade will require going narrower but you do not want to make the leap to individual stocks then ETFs are probably your best shot and the above, obvious or not, might be the right mindset to have.

About Roger Nusbaum 169 Articles

Roger Nusbaum is an Arizona-based financial advisor who builds and manages client portfolios using a mix of individual stocks and ETFs. Roger writes a popular blog, which focuses on risk management, foreign stocks, exchange traded funds, options etc.

Roger has been recognized by many in the investment management industry for his expertise in portfolio management. Roger has been regularly interviewed by the financial press, trade journals, and television news shows. He has also had numerous technical articles published and has been quoted in a number of professional trade journals, newspapers, and consumer finance magazines. He appears frequently on CNBC Asia as a market commentator.

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