Protecting capital in a market downturn

Business Times

16-05-2025

ONE of the most common mistakes made by retail investors is the failure to protect their capital in a market downturn.
They tend to hold on to their stocks in a market downturn, thinking that it is just a correction and hence that the market will rebound.
Many financial advisers have also advised investors to stay invested during a market slump as volatility is usually just noise. They point out that investors tend to sell out during market lows and fail to get back to the market just when it recovers.
Retail investors also tend to buy on dips, especially blue chips, as their stock prices have taken a tumble in a market downturn.
Investors reckon that the so-called fundamentals remain intact and stock valuation has since become cheaper. It is the time for bargain hunting as there is potentially a huge upside.
Cheap stock valuation is an important consideration in investment decisions. However, it can also be a value trap. It won't help investors much on market timing such as when to buy and sell stocks.
BT in your inbox
Start and end each day with the latest news stories and analyses delivered straight to your inbox.
Sign Up
Sign Up
Admittedly, it is unclear though if an initial market downturn is just a temporary selloff or the start of a prolonged and severe bear market.
More often than not, investors only recognise it belatedly when a downturn turns out to be a bear market. By then, it would be too late as they get caught in deep losses.
In my opinion, investors need to know when to be on the offensive and when to be defensive. One way of doing so is by using the 'trend following' approach.
Great investors or traders such as Paul Tudor Jones and George Soros are trend followers. They use the 'trend following' approach to profit from a rising market and to protect their capital in a falling one.
Jones has, for instance, advocated a 200-day moving average as a trend following indicator.
The American hedge fund billionaire was interviewed by motivational speaker and coach Tony Robbins, for his book, Money: Master the Game (2014), where Jones shared his investing strategies.
Said Jones in the book: 'I teach an undergrad class at the University of Virginia, and I tell my students: 'I'm going to save you from going to business school. Here, you're getting a hundred-grand class, and I'm going to give it to you in two thoughts, okay? You don't need to go to business school; you've only got to remember two things. The first is, you always want to be with whatever the predominant trend is.''
Jones continued: 'My metric for everything I look at is the 200-day moving average of closing prices. I've seen too many things go to zero – stocks and commodities. The whole trick of investing is: How do I keep from losing everything? If you use the 200-day moving average rule, then you get out. You play defence, and you get out.'
He then offered a set of principles to guide retail investors : 'I get very nervous about the retail investors, the average investor, because it's really, really hard. If this was easy, if there was one formula, one way to do it, we'd all be zillionaires. One principle for sure would be to get out of anything that falls below the 200-day moving average. Investing with five-to-one focus (asymmetric risk/reward) and discipline would be another.'
For those who are inclined towards numbers, here are the hard figures on 200-day moving averages.
According to Ritholtz Capital Management, the average one-year return is 10.6 per cent when the S&P 500 is above its 200-day moving average, and 6.9 per cent when it is below its 200-day moving average, based on data from 1990 to 2022.
As for market volatility, the annualised standard deviation for the S&P 500 is 12.6 per cent when the S&P 500 index is above the 200-day moving average, and 24.5 per cent when it is below that benchmark. Standard deviation here measures how much a set of data deviates from the standard or average.
In short, historical evidence shows that a market which is above its 200-day moving average tends to see higher returns and lower volatility, and a market that is below its 200-day moving average tends to see lower returns and higher volatility.
Experts and analysts like to point out, however, that if investors miss the 10 best days in stocks, their returns can be severely affected. Thus, market timing, such as the 'trend following' approach with 200-day moving averages, will not work well.
Studies, however, show that a majority of both best and worst days happen when the market is below the 200-day moving average. As such, returns from 'trend following' can be superior to returns from buy-and-hold in the long term as investors tend to miss both the ten best and worst days.
What about some false signals? Sometimes, a stock or index falls below its 200-day moving but a few days later, it then rises above its 200-day moving average. Investors then find themselves caught in whipsaws, which in turn would affect their stock performance.
Here are some thoughts on ways to mitigate whipsaws. One way is to use a monthly closing price. If by the end of the month, a stock's or index's monthly closing price is still below its 10-month moving average, investors should probably be the defensive. Though a 10-month moving average helps to cancel out noise if compared to a 200-day moving average, it is less sensitive in a volatile market.
Another way is based on the notion that an index – say, Nasdaq 100 or NDX Index – tends to deliver subpar returns after a phenomenal run.
The NDX Index was above its 200-day moving average from Mar 13, 2023, to Mar 5, 2025 – a total of 497 trading days. This is the second-longest stretch of time above the moving average since 1990. The return for the current stretch is about 70 per cent – the third-highest return since 1990. The best return was 179 per cent from October 1998 to May 2000, and the second-best was 83 per cent from April 2020 to January 2022. All ended badly subsequently. How will the current stretch turn out?
It should be noted that 'trend following' approach does not purport to help investors sell at the market top or buy at the market bottom. This is because when an uptrend or a downtrend is confirmed, it could already be quite lagging. As a result, investors might miss some significant gains at the major turning points.
George Soros has come up with some tricks to tackle this challenge.
As he put it: 'Most of the time I am a trend follower, but all the time I am aware that I am a member of the herd, and I am on the lookout for inflection points… I watch out for tell-tale signs that a trend may be exhausted. Then I disengage from the herd and look for a different investment thesis. Or, if I think the trend has been carried to excess, I may probe going against it.'
The writer is a private investor. He was previously a researcher at an international business school in Europe and an Asia-Pacific director at multinational corporations.