How To Invest in a Bear Market

First and foremost, you need to know that we are in a Bear Market right now. The media likes to claim that a Bear Market is a 20% decline in stocks. This is foolish. The difference between a 19.5% and 21.2% decline in stocks is irrelevant. No one sees his or her portfolio decline by 19% and thinks “well at least it isn’t a Bear Market!” So, what is a Bear Market, really? 

A Bear Market is a prolonged period of “risk off.” It is a time in which stocks trend DOWN. During Bear Markets, you need to “sell the rip” or bounce rather than “buy the dip.” Bear Markets are extremely difficult to trade. There is a reason we use the metaphor of a “bear” to describe them. When a bear attacks, it savages everything around it. Bear Markets are similar. 

They induce the maximum amount of pain on the maximum number of investors. This is why I urged clients to go 85% to cash as soon as it was clear that the multi-month consolidation in stocks had ended in a breakdown. By quick way of review… Throughout most of 2022 thus far, the major indices were trading in wide ranges. They were 4,200 to 4,600 on the S&P 500 (chart below)… 

During this time, we were waiting for a breakout to determine whether stocks were in a correction within the context of a larger bull market… or if we were in a legitimate Bear Market. In late April/ early May the breakout hit… and it was DOWN. This was the signal that we are in a Bear Market. Again, that is when why I urged clients to go to cash (how much is up to each individual, but I recommended 85% cash). 

Why? The average bear market is 19 months long and sees stocks lose 30% of their value. Once you are certain a bear market has hit, the trend is DOWN. However, things are in fact worse than this. 

During a normal Bear Market, bonds are a safe haven. Put another way, during normal Bear Markets, when stocks take it on the chin, bonds rally. This is why Modern Portfolio Theory suggests you should have a sizable chunk of your portfolio in bonds as well as stocks. The most common example is the 60/40 rule: you should have 60% of your portfolio in stocks and 40% in bonds. 

As you age, Modern Portfolio Theory suggests moving more and more into bonds until eventually your portfolio breakdown is 20/80: 20% stocks and 80% bonds. During this current Bear Market, bonds are NOT a safe haven. In fact, they’re selling off just as badly as stocks! in 2022 both stocks and bonds (all flavours) bothe declined rapidly. This is why in this high inflationary environment I go for ZERO allocation to bonds.

Put simply, this Bear Market is VERY different from the last few in that there are NO safe havens. This was an Everything Bubble… and right now EVERYTHING is selling off. Because of this, I want to urge you that During This Bear Market Your #1 Position Should Be… CASH. During this Bear Market, your largest position should be in cash. Write this on a post-it. Put it next to your computer. Do NOT forget this no matter what the circumstances. DO NOT get persuaded by ANYONE to think otherwise. 

There will be countless situations in which you begin to feel as if you’re missing out on a market move… or perhaps some growth stock is ripping higher… or perhaps someone is claiming they’ve found the “next Big Short” or that it’s time to go “all in” on some trade. IGNORE all of that. Keep most of your capital in cash no matter the temptation to do something. If you do feel the need to trade right now, keep positions SMALL. Why? Let’s say you have a $100,000 portfolio. And let’s say you’re down 10% on that portfolio due to the Bear Market so far. 

This means you have $90,000 left. Not, let’s say you move 85% of it to cash as I recommended. This means you’ve got $76,500 in cash and $13,500 in trading positions. So, your #1 position is cash and you’ve got 15% of your portfolio available to trade. Any trade you make under these circumstances should be limited to $2,000 or smaller. 

Why? Because your total portfolio is $90,000 and $2,000 is a little over 2% of this. That is a safe means of trading without wiping yourself out. You’d never take a position that loses a total of 100%... you’d sell before then… so you’re taking steps to make sure than even if you are totally wrong on a particular trade, your TOTAL CAPITAL never takes a bad hit. THAT is how to trade a Bear Market. 

The trader who does this will not only emerge from the Bear Market relatively unscathed… but he or she will be in an amazing position to buy the market when it finally bottoms: he or she has LOADS of cash on hand and minimal losses. 

Even better than this, the trader who takes these kinds of steps, and who knows how to make profitable trades could in fact see significant returns during the Bear Market. There is NO reason why he or she couldn’t grow than $13,500 in trading positions to $20,000… all by simply trading $2,000 or less. Let me give you an example. Let’s say you’re trading $2,000 per position… which again is your LIMIT for size. 

Now let’s say you are able to make money on 60% of your trades. Private Wealth Advisory has made money on 74% of trades since 2015, so this is definitely possible. If you’re making a 10% gain on your winning trades (quite possible in a Bear Market when volatility is higher) you’re making $200 per winning trade. It’s very conceivable that during a 9-month Bear Market you’d be able to accumulate enough winners to make a total of $10,000 (that’s 50 winning trades or five winning trades per month). 

This would mean that at the end of the Bear Market, our trader has $100,000 in his or her total portfolio. That means that he or she got through a Bear Market with a total loss of just ZERO... at a time when 99% of investors LOST 30% or more or their portfolios (the average Bear Market sees a 30% decline in stock values). Imagine you got through the Great Financial Crisis of 2008-2009 with ZERO LOSSES …and were able to deploy your massive cash position in March/ April 2009 when the market bottomed… and then rode the bull market for the next decade. Even if you simply bought an index fund, your portfolio would now be worth ~$450,000… and that’s assuming you never added to your portfolio during this time period! 

THAT is how a strategic investor gets rich from the markets! Now imagine an alternate outcome. Imagine a trader who NEVER moves mostly to cash but continues to trade sizable positions of his or her total portfolio during a Bear Market. First and foremost, he or she would be highly emotional since he or she is already down 10%. So, he or she would probably start trading larger positions to try and get his or her gains back. In this scenario it wouldn’t be surprising to see our trader put 10% or even 20% of his or her portfolio in a trade to try and get some big returns. Now, 10% or 20% of a $90,000 portfolio means trading positions of $9,000 or even $18,000. 

Given that Bear Markets are difficult to trade, particularly when you’re highly emotional, and it would not surprise me to see this trader make more losses than gains. And I wouldn’t be surprised to see our trader losing 20% or 30% on a position on a regular basis. A 20% or 30% loss on a position of $10,000 to $18,000 means a loss of capital ranging from $2,000 t0 $5,400. So literally every loss would mean your TOTAL PORTFOLIO losing 2% to 6%. A few losses like that and your total portfolio is down to $75,000 or even lower and you’ve lost 25% of your total portfolio. Having been in this industry for 20 years I can tell you that most investors lose MORE than that during Bear Markets. Now you see why: 1) Cash should be your largest position. 2) Your trades should be kept small in size. 

This all ties back to the #1 rule of investing: focus on RISK MANAGEMENT. Warren Buffett, arguably the most famous investor of all time, famously once stated: “Rule number 1: Never lose money. Rule number 2: Don't forget rule number 1.” Not losing money means Risk Management. In its simplest form, a strategic investor’s Risk Management is as follows: ride a bull market for as long as possible and then avoid the bear market’s losses. Let’s use some EXTREMELY simple Risk Management: the 50-Month Moving Average. A strategic investor who wants to ride a Bull Market and avoid a Bear Market would do well to buy stocks when they are above this line… and sell them when they fall below. As the chart on the next page shows, this would meant catching MOST of the Bull Markets and avoiding MOST of the Bear Markets of the last 35 years. 

Obviously, this strategy would be problematic today since stocks are so massively stretched above this line. But you get my point: the investor who uses even basic Risk Management would have dramatically outperformed the investor who focuses on trying to predict the next big thing and gets overly emotional during periods of greater volatility. 

Alright, we’ve covered a lot of ground here, so let’s do a quick review: 

1) We are in a Bear Market. 

2) This Bear Market is different from other Bear Markets in that bonds and other traditional safe havens are ALSO losing money. 

3) Your largest position during this Bear Market should be CASH. 

4) Your trades should be smaller than usual, insuring that you never risk more than 2% of your portfolio on any one trade. 

5) The focus right now is on RISK MANAGEMENT, which means getting through the Bear Market with minimal losses so that you can LOAD UP on stocks when the Bear Market ends and the bottom hits. 

This is the BIG PICTURE framework to use right now. 

Please keep it in mind at all times. 

Investing as a 'Negative Art'... What to Avoid

In life, there are plenty of things to avoid.

My list includes TV shows that involve dancing celebs, queues for anything (especially fashionable bars or restaurants), and anyone with a noisy gadget in a shared public space (airport, train, bus, and so forth).

The investing world is also full of things to avoid. Which brings me to the focus of this month’s issue: investing as a “negative art”.

Strange as it may seem, both for education (or revision) and entertainment (of a sort), I enjoy watching investment videos. But I don’t just mean anything.

By and large, I’m not interested in academic theories (been there, done that) or predictions of whether the Bank of England will raise interest rates by half or three-quarters of a percentage point (yawn).

Instead, my area of interest is garnering pearls of wisdom from the investing greats.

Generally, these are people who have had long and successful careers as investment practitioners. During this time, they’ve lived through a lot of market situations, suffered plenty of portfolio pain, and learnt what really works in the long run.

One such example is Howard Marks, who is co-chairman of Oaktree Capital Management, a huge US investment company.

Marks started his financial career back in 1969 in equity research (analysing stocks). But he soon moved into the more specialised area of distressed debt, also known as junk bonds.

(This is before investment banks and asset managers niftily re-branded them as “high-yield bonds” in the 1990s. This made them sound far less threatening, in turn making them easier to flog to unsuspecting punters.)

At the age of 76, Marks is still working. It’s fair to say he’s seen quite a bit in that long career in the markets. So, he’s the sort of person that’s well worth listening to.

What is “risk”?

About seven months ago, Howard Marks gave a presentation entitled “How to Think About Risk”. 

Marks is very much a long-term investor, and this is evident in his definition of “risk”. He (sensibly) discards the typical, academic definition, which is built around the short-term volatility of market prices.

Instead, he defines it thus: “Risk is the likelihood of being forced out at the bottom.”

Or, in slightly longer form, he says this:

“Selling at the bottom ‒ turning a downward fluctuation into a permanent loss and missing out on a subsequent rebound ‒ is the cardinal sin in investing.” (His emphasis.)

Of course, most amateur investors ‒ and quite a lot of supposed professionals ‒ commit exactly that sin again and again.

They sell in a panic near the bottom of the market, when there’s a lot of fear about. They compound the error by buying near the top of the market, when there’s a lot of greed about.

Then they repeat this self-inflicted error, often again and again. And end up concluding that the market is rigged/a casino/impossible to fathom/too risky/a capitalist conspiracy to steal their money/all of the above.

Put simply, many people buy high and sell low, and then blame it on someone else. Obviously enough, this is a reliable route to the poor house.

Note that Marks doesn’t say selling at the bottom is “one of” or “among” the sins of investors, or just something to generally avoid. He says it is “the” cardinal sin when it comes to genuine investment risk.

The reason Marks takes this stance is that he believes no one has the ability to predict the future. Therefore, no one can predict the direction of the market in the short term.

In this regard, he quoted John Kenneth Galbraith, a Canadian-American economist and author (1908-2006):

“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”

In other words, confident predictions of the future are only made by fools.

If you hear someone state that “The FTSE 100 index will trade above 8,000 points at the end of the year” then you should ignore them.

This is not to say that we shouldn’t think about likely scenarios and the probabilities of a range of different outcomes. In fact, Marks encourages this.

But we must always guard against being too confident or certain that one particular thing is sure to happen in the near future, and investing to profit from that outcome alone. If we were to do that, then, sooner or later ‒ and probably sooner ‒ we will get it completely wrong and lose a load of money.

Instead, we shouldn’t worry too much about short-term market moves. We should buy well and wait. We should pick up investments when they’re cheap. We should keep adding if they get cheaper. We should stick with it and be patient. We should let time and profit compounding work their magic.

Of course, other than “the cardinal sin”, there are further risks in investing that we should try to avoid. An important one is simply buying bad things in the first place, which I’ll come to later.

But the risk definition that Howard Marks gives really fits with the approach that I encourage you to take with your investing. In a nutshell, it’s the following:

1. Buy well

2. Be patient

3. Stick with it

But there’s a flip side. Which is what to avoid.

Investing as a “negative art”

Distressed debt and junk (“high-yield”) bonds are the niche areas of investing where Howard Marks chose to specialise, although he knows plenty about stock markets, too.

Marks points out that the skill of investing in this kind of debt is avoiding the bonds of companies that actually do go bust. That’s while trying to invest in the bonds of companies where there are reasons to think that their situation will improve.

During his risk talk, he highlighted a quote from the 1940 edition of Benjamin Graham’s book Security Analysis. (Graham taught Warren Buffett, and is often referred to as “the father of value investing”.)

Graham wrote this: “Bond selection is primarily a negative art. It is the process of exclusion and rejection, rather than of search and acceptance.”

“Exclusion and rejection” are unlikely to be high priorities for a company’s human resources policies. But Ben Graham and Howard Marks make it clear that they’re both essential for bond investors.

This got me thinking.

A lot of non-bond investing, especially in stock markets, is a positive art. By that I mean it’s about finding the best opportunities available at a given moment in market time.

But, surely it’s also a negative art as well? Don’t we also screen out bad companies, with shrinking businesses, weak management, repeated bottom-line losses or excessive debts? Or shares of great companies that are simply too expensive at the current time?

I know that I certainly do.

Not least, when I make a single recommendation via these pages to invest in something, it’s what remains after I’ve trawled through and discarded dozens of alternatives. This because, at that point in time, I plan to invest in it myself, with my own money.

That’s why the current portfolio includes just 13 individual shares, one country fund (Brazil), one sector fund (gold mining) and one precious metal (gold). The hurdle for admission is high.

Of course, I want to add more. But I’ll only do that when something meets my hurdles. There are a lot of companies on my watchlist. But they’re not cheap enough yet. So I wait.

This is the “negative art” in action, even though it may not always be apparent to you what’s going on behind the scenes.

Apart from that process, I realised that there are a lot of additional investment areas where I practice this negative art.

Some things are excluded and rejected just due to current market conditions. Others are things that I believe should be permanently avoided.

I’ll deal with each group in turn.

Things to avoid currently

Bonds: When it comes applying a negative art to investing, my most obvious “exclusion and rejection” has been all bonds, not just the worst ones. There was a bond bubble. This meant lots of potential for loss, but very little possibility of meaningful profit.

Given the bond market crash since, this turned out to be the right call.

I suspect that most, if not all, of the pain has already been suffered by bond investors. But yields still aren’t high enough to make bonds attractive, in my opinion.

US stocks: As explained in last month’s issue, the US stock market remains very pricey by historical standards. Despite it already dropping somewhat this year, I laid out what I consider to be a realistic scenario for British investors to see their investments in the US stock market drop by about half.

Just in case Howard Marks is reading, this is not a forecast. I know I don’t know!

But I do believe it’s plausible. I also don’t see the point of owning overpriced assets if there are better opportunities elsewhere. Even if the market doesn’t drop a lot further, it could give investors weak returns for a long time, given the current elevated level.

Naturally, there are individual bargains within the vast US stock market. But at the macro level I’d still steer clear. Its time will come again.

India: This is a country with a high rate of GDP growth, and I’d love to invest in it at the right price, most likely via a diversified index fund. But Indian stocks have been expensive for years, and a perennially weak currency (the rupee) needs to be taken into account as well.

At the end of October, the MSCI India index had a high price-to-earnings (P/E) ratio of 24.5 and a dividend yield of just 1.2%. For comparison, the MSCI USA index had a P/E ratio of 19.7, which is still quite high.

Back in March, when I recommended the Brazil index ETF, I ran some numbers on the Indian market at the same time. My conclusion was that the market would have to drop around 70% (not a mistake!) before I’d buy. That’s still the case today.

A crash of such magnitude seems unlikely to happen, but you never know. One day. One day…

Greater China: This includes mainland China, the Hong Kong territory and Taiwan. Political risk is already high in China, and I believe the chance that Taiwan is invaded increases with each year that passes. This basically makes Greater China not worth the risk, in my opinion.

Note that many global, emerging-market and sector funds include significant allocations to Greater China.

Most real estate (houses, offices, retail): After a prolonged period of ultra-low interest rates, a lot of real estate is priced at elevated levels. Rising rates will increase debt financing costs (mortgages) and lead investors to require higher rental yields. In turn, this is likely to put downward pressure on prices.

Rising house prices over the summer of 2020, jollied along by massive furlough payments and the stamp duty holiday, will likely prove a temporary affair. On balance, it seems more probable that the average home price will fall rather than rise as we head towards 2022-23. In fact, prices could drop quite sharply (although we should never discount the government pulling another market supporting rabbit out of its magic money hat).

I was perhaps a little early. But the market does now appear to be turning as mortgages become less affordable.

As for offices and retail properties (shops), both tend to come under pressure during recessions, and we look set for a big one of those. What’s more, not all workers will come back to offices, and retail will suffer as e-commerce continues to grow and the past glut (in my opinion) of restaurants and cafés is worked off. That’s as establishments, often saddled with debts taken on to survive the pandemic lockdowns, close due to tighter household budgets.

The ideal way to invest in all these sorts of real estate is via REITs, or real estate investment trusts. These are closed-ended funds (see below for more about the risks of open-ended real estate funds). You can buy or sell REIT shares just like those of a listed company.

A lot of REIT shares currently trade at sharp discounts to net asset value (NAV) per share. NAV is the value of all assets (mainly properties at market value) less all liabilities (mainly debt financing).

Given the discounts, you might think that such REITs are cheap. But I’m not convinced.

Let’s say a REIT share is priced at 70% of NAV, or a 30% discount.  Let’s also say that the REIT has debt financing to the tune of 35% of gross assets (properties), which is fairly typical in my experience.

How far would property prices have to fall in future to eliminate the price discount to NAV?

If assets are £100 million and debt is £35 million, then NAV is £65 million. If the shares are at a 30% discount to NAV, then market capitalisation would be £45.5 million (70% of £65 million).

For NAV to fall to that level requires a drop of £19.5 million (£69 million less £45.5 million). That’s equivalent to a 19.5% drop in the current asset value of £100 million.

Could the prices of houses, offices or shops fall around 20% over a number of years in this environment? I believe that’s very feasible. Which means a REIT with these sorts of characteristics may not be as cheap as it appears at first glance.

[In my opinion, there is a big exception. That exception is logistics properties that are in high demand due to the secular growth trend in e-commerce. That’s why Urban Logistics REIT (SHED.L) remains in the portfolio.]

Still-expensive “high-quality equities”: Just because a company has a great business doesn’t mean its shares are automatically a good investment. That’s because they could be too richly priced.

To give one example, at the right price I’d love to own shares of booze maker Diageo plc (DEO.L), the owner of the Johnnie Walker, Smirnoff and Guinness brands (among many others). But not at the current P/E ratio of around 28 (although that’s already down from a higher level at the end of last year).

As with a pint of Guinness that’s served in the correct manner, patience is required before such a share should be enjoyed.

Bank shares: They have single-digit P/E ratios, and market capitalisations (company values at market share prices) that are below net asset values (assets less liabilities, or liquidation values).

So investors can be forgiven for thinking that UK bank shares are cheap. But, in my opinion, they really aren’t.

Remember, that’s from someone who spent years working in the in-house strategy department of one of the world’s largest investment banks and wealth managers (UBS Group).

We spent a lot of time valuing all sorts banking and other financial businesses. That included UBS itself, individual business divisions, competitors and acquisition targets.

A professorial Swedish colleague in the same team, with a PhD in Finance, spent large amounts of his time perfecting the correct valuation techniques for such businesses. He explained those techniques to me, in or around the year 2000, and I have applied them ever since.

These techniques had to be extremely rigorous because the people relying on them were the executive board of the world’s largest wealth manager and stock trader. Let’s say our work was intensively scrutinised by true experts with low thresholds for error.

(In such an environment, there’s a “negative art” practiced when it comes to who gets to have or keep a job. It’s very easy to lose trust and get fired…)

In short, valuing a bank has some unique quirks that are different to other businesses, although I’ll spare you the details.

So why not buy bank shares at the moment?

Suddenly higher interest rates should be good for bank profits. That’s the case in favour of bank shares.

But the same higher rates are going to put an awful lot of debt-sodden borrowers under tremendous pressure to keep up payments, whether they’re businesses or individuals. This is especially true given that spending budgets are already constrained by rising prices of fuel, energy and food.

The likely result will be a wave of bad debts that the banks will have to write off. This could hit their profits and equity capital bases for several years. That’s the basic case against bank shares.

On balance, I don’t think banks are currently worth the risk. But they could be extremely attractive in future, once the next economic cycle begins, and assuming interest rates haven’t been pinned back on the floor.

Life insurance & pension companies: These are financial black boxes.

Put another way, it’s pretty much impossible to understand the risks properly, given the very complex balance sheets and potential liabilities under different conditions.

For this sector, caveat emptor (buyer beware). Examples listed in the UK include M&G plc, Legal & General and Prudential plc.

House builders: On the face of it, after steep falls, shares in this sector look pretty cheap. They typically have single-digit P/E ratios and high single-digit, or even double-digit, dividend yields.

The big problem is operating leverage, which refers to the effect on profits of fluctuating revenue in relation to relatively fixed costs.

I’ll use the example of Barratt Developments to illustrate. The shares currently have a P/E of 8.1 times last year’s earnings and a dividend yield of about 9.1%.

Top-line turnover for the year to the end of June 2022 was £5,268 million. Meanwhile, pre-tax profit was £642 million. That’s a pre-tax profit margin of 12%, achieved during a huge boom in house prices.

Put another way, the prices of those houses would only need to drop 12% for the profit to fall to zero. That’s assuming the same cost base to build, market and sell the same number of houses.

That feels very possible to me, as does something worse. Obviously, such companies could take some cost-cutting measures. But they can’t control house prices ‒ meaning the prices of the products that they sell.

The last two house-price crashes lasted six years (1990 to 1996) and five years (2008 to 2013). In future, there will be an interesting time to buy beaten-down construction companies. But it still feels far too early to me.

Examples of companies in this sector include Persimmon, Barratt Developments, Taylor Wimpey, Bellway, The Berkeley Group Holdings, and Redrow.

Things to avoid permanently

These are the sorts of investments that I wouldn’t want to own under pretty much any market conditions.

Okay, strictly speaking, we should never say never. Every dog has its day. In financial markets, that includes metaphorical dogs that can become cheap enough to be tempting. But I’d take a lot of persuading in relation to the following areas:

Utility sector shares (electricity, water, gas providers): This is a stable but fairly low-return sector at the best of times. Typically, investors can hope for no more than slow growth and a middling dividend.

People need the things that these companies sell. But, because they’re essentials sold by monopolists or oligopolists, the prices are normally heavily regulated, such as being linked to inflation.

The main problem I always have with utilities is the risk of political interference, especially in times of higher inflation. Vote-seeking governments have a habit of imposing price caps or levying windfall taxes on such companies. That’s just when investors need their inflation-hedging qualities the most.

On top of that, in the UK, it currently seems likely that the next government will be a Labour one. And the red team are typically even more prone to such populism than the blue team.

What’s more, there’s always the risk of re-nationalisation of utilities under a Labour government. But we can only guess, since the party’s website doesn’t really contain any policies (I checked).

In any case, I don’t like to have permanently high political risk dangling over my investments. Which is why I steer clear of utilities.

Open-ended real estate funds: Imagine a fund that promises you that it will return your investment at short notice, but that invests in illiquid assets that can take months or years to sell.

This is the idiotic structure of open-ended real estate funds.

Every time there is a sharp downturn in property markets, investors start to pull money from these funds. At that precise same moment, property market transaction volumes drop as prices begin to fall and prospective buyers shrink into the shadows.

In order to meet the investor demands for immediate cash withdrawals, such funds would then be forced into a fire sale of their properties, meaning marking them down sharply just to dump them. This would give a bad result to all the fund investors, but also cause a self-reinforcing property crash if enough big funds did the same thing.

So… what do they do?

It’s simple. The funds slam their gates shut. Basically, in the fine print of the fund agreements there will usually be the option for the fund manager to suspend investor withdrawals, known as “gating”.

Investors are then stuck. What’s more, the property market may continue falling anyway, perhaps for many years. Investors have no choice but to sit it out as the losses rack up. Given the slow burn nature of property crashes and booms, it could take many, many years to reach break-even again.

I have no idea why regulators still allow illiquid assets like real estate to be owned via open-ended funds. But they do.

All I can do is to recommend that you avoid them completely. If you are invested in a property fund and don’t know if it’s open-ended, phone them up and ask. If they say it is, my recommendation is to get out (if you can).

If you want an easy way to invest in real estate, then stick to shares of real estate investment trusts (REITs). You can exit any time by selling the shares. Meanwhile, as closed-ended funds, the managers have permanent capital and won’t be forced to sell any properties if they don’t want to.

That said, see the earlier section concerning the REITs to avoid at the moment, which is most of them. But that will change at some point in future.

(Actually there are lots of types of real estate investments that are best avoided. Apart from the regulated but badly-structured funds mentioned above, it’s a sector that’s notorious for scams, frauds and just plain old failures. Personally, I wouldn’t touch any collective/shared real-estate “opportunity” with a barge pole, other than the right REITs at the right price. All other property is best owned solely and directly by you, and no one else.)

Financially shaky companies (high debts and/or burning cash): These need regular injections of new capital (debt or equity). From time to time, such as during recessions, sources of new capital dry up. That’s when these companies go bust, if not before. Why take this unnecessary risk?

Enough said…

Infrastructure funds (including renewable energy): These funds invest in things like toll roads, toll bridges and tunnels, railways, pipelines and power generation. Unsurprisingly, in recent years, a lot of them have been focused on renewable energy projects such as wind and solar farms.

By and large, the underlying assets are fine, providing lowish but inflation-hedged levels of income. The problems come with the fund structures.

Because the cash flows are seen as stable, fund managers tend to take on debt leverage to goose up returns. This leverage is often hidden, since it’s not taken at the fund level. Instead, it’s buried within underlying legal entities owned by the fund. Those underlying entities then invest in the actual assets.

Making the long story short, infrastructure funds have a habit of getting into trouble due to too much debt. With interest rates rising, I’d say that the risks of a wave of problems is high once more. Avoid.

Individual shares in complex and risky sectors: Every investor has what’s known as a circle of competence. You should always stay within your own circle, or make sure that anyone helping you stays within their circle.

As mentioned above, I know a lot about the financial sector. But I tend to steer clear of companies in the life insurance & pensions sector, which I consider to be black boxes.

I also tend to avoid individual mining companies, except perhaps the very biggest, most-diversified ones. Picking the winners in the junior mining world requires specialist knowledge and skills.

Biotechnology is another sector where I definitely wouldn’t pick stocks. I’m neither a biochemist nor a medical doctor, so I can’t understand the complex science. What’s more, most developmental drugs don’t reach approval stage, despite huge research and development spend. This makes biotech companies very risky.

I’m similarly lost when it comes to picking winners in new technologies in general (most fail), or understanding the more technically advanced industrial companies. (Which computer chips are best this year?)

Another good, current example is harnessing hydrogen as a clean fuel. I’m interested, but it’s too early to work out which niche ideas will prevail, let alone which companies. In the meantime, I’ll stick with oil & gas companies like BP, and trust that they make good investments in the hydrogen sector as they transition away from hydrocarbons.

In short: there are enough ways to make money without investing in sectors that very few people properly understand (including many that claim to be experts).

Junk (“high yield”) bonds: (… bringing us back full circle…) These should only be invested in via actively managed funds run by the best experts at screening out the duds. Unless you’re very rich already, you probably won’t have access to such funds. This area is best left to Howard Marks and his ilk.

And finally…

That was quite a long list. But I felt it was worth sharing.

Do you practice this “negative art”? What did I miss?

Let me know if you think of something else important that we should avoid, especially if you’ve had personal experience with it.

In the meantime, remember that risk definition from Howard Marks (provided that your investments are solid ones in the first place).

“Selling at the bottom ‒ turning a downward fluctuation into a permanent loss and missing out on a subsequent rebound ‒ is the cardinal sin in investing.”

Be angelic. The market downturn will pass.

Remember: buy well, be patient, stick with it.