Investing: Understanding a Sideways Market
Many investors think about market direction in simple terms: up or down. However, there is actually a third market direction that we should be looking at when analyzing the activity of our investments.
My wife and I spent a recent Saturday evening with some of her friends - twin sisters. They locked themselves out of their car. We’ve all done it before. Unfortunately, solving this problem is not as easy as it used to be because of the rate of car theft.
There are better security features in car designs. You can't use a coat hanger anymore. Faced with a situation that has changed, it's necessary to adapt and approach the problem with new ideas. There is a deeper lesson here. It's a principle that can be applied to many other areas of life. You can’t face new and different realities without adjusting your approach and expect the results to be just the same as before. (For more, see: The Stock Cycle: What Goes Up Must Come Down.)
A Third Market Direction
Most people are familiar with the terms bull market and bear market. When stock prices are trending up we say, “The bulls are in control.” When stock prices are moving down we say, “The bears are in control."
Even people who don’t know much about the stock market at all understand at least this basic fact - that the market goes up and down as stock prices rise and fall, respectively. And we recognize that you can make good profits if you are able to buy low (when the market goes down), and sell high (when the market goes back up again). There are also strategies that investors can employ to see gains in a downward market.
However, that’s not the end of the story. There’s actually a third market direction. I will often draw two arrows on my office whiteboard: one up and one down. But then I will draw a third arrow pointing out to the right. The third direction that the market can move is sideways. A sideways market occurs when price activity is oscillating in a relatively narrow range without breaking out to form a distinct trend up or down. The market chart just looks flat.
Portfolios Have Been Constructed to Capitalize on One Market Direction
It’s important to understand because traditionally, portfolios have been constructed to capitalize on only one market direction: upward. This has trained people to assume that the market has to be going up in order for a portfolio to perform and realize gains. That’s the scenario we’re most familiar with planning for. (For related reading, see: Finding Value in a Sideways Market.)
But here’s a fresh perspective. The economic downturn of 2008 was the catalyst for new research that called into question the wisdom of this single-focus approach. The reality is that the market constantly moves in three directions, rather than one. So why not prepare for growth in any environment? Instead of speculating with a single approach, take a holistic approach that incorporates three different types of investment strategies:
- Passive management strategies: perform best in upward markets.
- Active management strategies: perform best in sideways markets.
- Non-market related strategies: perform best in downward markets.
Employing a model that blends all three in this way increases your prospects of long-term success.
The takeaway question is this: can you say that your current portfolio is prepared for all three of these market situations? If not, it may be wise to discuss with a professional who can help you make the necessary adjustments to your portfolio. (For more from this author, see: The Key to Understanding Financial Risk Management.)