Here's how the best investors protect their money from market bubbles and FOMO

MW Here's how the best investors protect their money from market bubbles and FOMO

By Darius Dale

Managing risk and avoiding 'volatility drag' is absolutely critical to achieving long-term financial goals

Retail investors who consistently achieve the best results manage financial-market risk the same way institutional investors do - dispassionately and systematically.

With the U.S. stock market priced for perfection and artificial-intelligence speculation driving a boom in tech-related stocks, many investors are asking if this is a stock-market bubble that could burst at any moment. Investors, especially those pursuing a "DIY" strategy, should approach their portfolio decisions with risk mitigation top of mind.

But calling something a bubble in itself distracts investors from rational decision-making. All bubbles eventually pop. The word conjures up visions of an inevitable market crash and triggers a highly emotional response. Investors would do well to avoid thinking about market risk in such emotional terms.

Retail investors who consistently achieve the best results manage financial-market risk the same way institutional investors do - dispassionately and systematically. With regard to bubble fears, this can be achieved by first determining the probability of a market crash within the next year and then establishing rules to guide a response.

For retail investors, the timeline of their investment life cycle is far more important than timing the market. Young investors who are relatively early in the accumulation phase of their retirement journey can afford to stay "in the market" and ignore short-term swings. But investors in midlife and beyond don't have the luxury of time to rebound from significant drawdowns in their portfolios.

How volatility erodes returns

Managing full-cycle market risk to avoid what's known as volatility drag is the most important step retail investors can take to help their portfolio achieve its long-term goals. To understand volatility drag, consider the following scenarios, which we'll label Strategy A and Strategy B. Both strategies assume an initial $100,000 in net asset value.

-- Strategy A's return sequence is a steady +50% in year one, +50% in year two and +50% in year three.

-- Strategy B's return sequence is much more volatile, at -50% in year one, +100% in year two and +100% in year three.

Both strategies generate identical +50% average annual returns over a three-year compounding period. But at the end of that period, Strategy A has a value of $338,000, while Strategy B is worth only $200,000. Volatility drag is the relative loss of net asset value in Strategy B compared with Strategy A, due to the volatility that Strategy B experienced.

This example demonstrates the significant impact volatility drag has on investor portfolios - particularly when its harmful effects are compounded across market cycles.

Simple risk-management rules

Once a more risk-aware asset allocation is established, it's important to establish a few simple rules to improve your odds of consistently remaining on the right side of market risk. Sure, complexity will likely improve the results of any risk-management process - but that isn't necessary if you're starting with little to no risk-management process at all.

A rule can be as simple as this: If the 50-day moving average of the S&P 500 SPX closes below its 200-day moving average for three consecutive trading days (known as a "death cross"), that could be a signal to sell. Conversely, the 50-day moving average closing above the 200-day moving average for three days (a "golden cross") could signal a buying opportunity.

Adhering to rules can help smooth out portfolio returns for most retail investors - many of whom tend to rely exclusively on fundamental research to manage risk, something few successful institutional investors do.

Avoiding costly mistakes

Successful investing primarily involves avoiding costly investment mistakes because growth in the money supply, population and economic productivity takes care of the rest. The most common investment mistakes are "Type 1" and "Type 2" errors. A Type 1 error is a "false positive," where a decision to buy (or sell) is not rewarded by subsequent appreciation (or depreciation) of the asset. Conversely, a Type 2 error is a "false negative" - a decision to not buy (or not sell) is punished by subsequent appreciation (or depreciation) of the asset.

In short, Type 1 errors protect investors from experiencing both FOMO - the fear of missing out, which causes investors to buy at cycle tops - and FOML - the fear of more losses, which causes investors to sell at cycle lows.

Type 2 errors, meanwhile, inevitably result in FOMO and FOML. These emotions are the two of the most powerful forces for exposing investor portfolios to harmful volatility drag.

No investor is immune to FOMO or FOML, which is why all of the most successful investors - both institutional and retail - operate with rules-based risk-management overlays. And as with all worthwhile activities in life, it pays to emulate the best and ignore the rest.

Darius Dale is founder and CEO of 42 Macro, which provides research, analysis and model portfolios for investors.

More: If you're this type of investor, get out of the stock market now

Plus: Why 'buy the dip' is not that great a strategy - and what works better, according to this quant firm.

-Darius Dale

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December 06, 2025 14:44 ET (19:44 GMT)

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