It is easy to overlook risks in a bull market. Rising stock prices, optimistic comments from investors and analysts and upbeat earnings forecasts can make many investors focus solely on returns.
However, risks do not disappear during a bull market. In fact, the threat of loss on investments could be relatively high, since narrow margins of safety and overvalued shares can mean there is significant downside.
As such, following value investors such as Oaktree Capital cofounder Howard Marks (Trades, Portfolio) could be a worthwhile pursuit. His defensive investing strategy may be useful in the current bull market.
Expecting a perfect future
Many of today's stock valuations suggest that investors may have unrealistic expectations about their future performance. Indeed, the valuations of a relatively large number of companies are at or above their long-term averages, despite continued economic uncertainty. In addition, many companies have high earnings growth forecasts that are based on optimistic assumptions regarding economic growth over the long run.
The past performance of the stock market shows that risks are omnipresent. In some cases, they can be identified ahead of time. However, at other times, they can appear suddenly and without warning. Notable examples include the March 2020 Covid-19 market crash, with stock valuations falling heavily in a short space of time without warning.
Failing to account for known and unknown risks via discounted valuations and conservative forecasts can mean that investors overpay for stocks. The performance of today's richly-valued stocks could prove to be relatively disappointing should risks materialize.
Defensive investing
In my view, it is imperative to always obtain a margin of safety when investing. That applies to existing holdings, as well as new purchases. For example, it may be worth selling an existing holding if it rises to a price that suggests it is overvalued.
A margin of safety helps to protect against known and unknown risks that could derail a company's future performance. It will not necessarily prevent paper losses in a bear market. But it could allow an investor to purchase a stock at a price that provides long-term capital growth potential even if the stock market's performance is disrupted by economic, political or other factors.
Howard Marks (Trades, Portfolio) has practised defensive investing during his successful career. As he once said:
"We have to practice defensive investing, since many of the outcomes are likely to go against us. It's more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones."
Considering company fundamentals
It may also be prudent to focus on other company fundamentals alongside a margin of safety. For example, requiring that a company has modest debt levels, ample interest payment coverage and strong cash flow could help to neutralize potential threats including rising inflation and economic uncertainty. Similarly, companies with wide economic moats may be better able to adapt to what remains a very fluid economic and political outlook.
Defensive investing and considering risk may not sound as exciting as contemplating a company's growth potential and strategy. However, it could be a more efficient means of allocating capital that is especially useful in today's bull market, where many investors appear to have forgotten about the market cycle.
Disclosure: The author has no position in any stocks mentioned.
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