Answer these Simple Questions to guide your investing

These are the two messages investors are hearing simultaneously these days:

The first is: "Watch out! The recession is getting to look more like a depression. Safety first. Avoid shares and anything with the slightest risk."

The second is: "Shares are ridiculously cheap. This is the opportunity of a lifetime. Do you want to look back at this time and reflect that you funked it? Buy now!"



So should investors be buying shares or steering clear?

And should existing investors grit their teeth and hang on – or sell at a huge loss?


Related article:
Stock market: opportunity of a lifetime or priced for a depression?

Stock market: opportunity of a lifetime or priced for a depression?

Stock market: opportunity of a lifetime or priced for a depression?

By James Bartholomew
Published: 10:45AM GMT 09 Mar 2009

These are the two messages investors are hearing simultaneously these days: the first is: "Watch out! The recession is getting to look more like a depression. Safety first. Avoid shares and anything with the slightest risk."

The second is: "Shares are ridiculously cheap. This is the opportunity of a lifetime. Do you want to look back at this time and reflect that you funked it? Buy now!"

So investors are pulled one way and then the other. Let us not pretend it is easy. If possible, one wants to have one's cake and eat it – to finesse the problem by having exposure to shares but, at the same time, owning ones that might hold up even if things worsen.


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The trouble is, lots of people are trying to do the same, so anything that looks pretty safe gets a much higher rating than companies that could get into trouble.

The safest ones are often in sectors where it will take a lot to destroy demand. People are always going to want to eat, and will probably want to drink, too. We are going for "the bare necessities of life".

Fortunately, the stock market is so low that, even among such safer companies, shares are clearly good value for the long term. It would be easy to make a little portfolio of relatively reliable companies with modest, but perhaps sustainable, dividend yields. It could include Associated British Foods at 622p on a prospective yield of 3.3pc, British Sky Broadcasting at 452p on a yield of 3.9pc and, say, Tesco at 310p on a yield of 3.7pc.

I prefer to go for smaller companies where I believe share prices are cheaper and potential gains bigger. I have been buying back into REA Holdings, which has a palm oil plantation. Palm oil is used, among other things, as a basic foodstuff.

I have also held onto my stake in Staffline, which provides "blue-collar" labour for a variety of industries, but especially food processing. Staffline produced its annual results this week and they were a perfect illustration of how results announcements have changed.

Press releases of results often start with "Highlights". Twelve months ago, companies shone light on their growth and expansion. "Highlights" were full of bold ambition. Now, the greatest boast a company can make is that it is safe and won't be closed. On Tuesday, Staffline announced its "gearing" – borrowing as a proportion of the shareholders' net assets – had fallen from 28pc to 24pc.

In the old days, companies were criticised if they borrowed so little. They were accused of "failing to make full use of their capital base". Now, low borrowing is absolutely the fashion (except for the Government).

Staffline went on to trill about how the cost of its interest payments had tumbled by a quarter and that these payments were covered a wonderful 10 times by profits. The message was "we have been prudent, we are safe and our bankers are happy". The shares rose 15pc.

Many people feel big companies are safer than such small ones and I don't blame anyone wanting to feel safe. But small companies, as a generality, are much cheaper than large ones at the moment. They also have greater scope for growth. And, after Royal Bank of Scotland, surely no one is confident that size guarantees safety.

I don't hold any particular torch for Staffline, but it is a good example of what I see among plenty of small companies. Its share price, as I write, is 27p, a mere 2.5 times the earnings per share last year. That is seriously cheap. Over the long term, a rating of at least four times that would be normal.

A broker forecasts that its profits will fall this year but only by a little. The historic dividend yield is terrific at just over 10pc. Yes, the dividend could be reduced next year but probably not by much.

It does seem like the opportunity of a lifetime and one might be tempted to fill one's boots with the shares of companies like this.

The only thing that holds me back is the echo of the other message: that the economy is sliding down so fast and unpredictably that one should keep at least some cash in reserve.

http://www.telegraph.co.uk/finance/personalfinance/investing/shares/4961165/Stock-market-opportunity-of-a-lifetime-or-priced-for-a-depression.html

Five ways to profit from oil

Five ways to profit from oil
Analysts warned last week that the average price of fuel could reach 115p a litre over the next few months - motorists will lose out but investors could profit from this rise.

By Rosie Murray-West
Published: 12:40PM BST 08 Jun 2009

Motorists are facing a summer of rising petrol costs, thanks to recent increases to the price of oil. Analysts warned last week that the average price of fuel could reach 115p a litre over the next few months.

Goldman Sachs, the city bank, has raised its forecast on the price that oil will reach by the end of 2009, which has already convinced many speculators to take the plunge. If you think that oil has further to go, however, there are still ways that you can benefit – rather than just fuming at the petrol pumps. Here are five ways to speculate on oil.


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1. Buy the big boys
BP and Shell are Britain's two big oil and gas companies. Both have been popular buys due to their high dividend yields and exposure to the price of oil. Neither company is expected to cut its dividend in the coming months, although this is likely to lead to an increase in borrowing.

Potential investors in Shell should note that UK investors need to buy Shell's 'B' Class shares.

2. Consider the minnows
BP and Shell may be the supertankers of the oil market, but you can also buy shares in other smaller companies which will also give you exposure to this market.

Many of them have already enjoyed healthy price rises, however, and you may feel that there is little scope for future gains. Tullow Oil and Soco International have recently seen huge rises in price. Dragon Oil and Bowleven are other possibilities in this sector.


3. Look at funds
If you invest in funds, exposure to the oil price is actually quite hard to avoid as commodities and resources companies make up about a third of the FTSE Index. However, some are more heavily exposed than others. Two BlackRock funds – BlackRock Commodities Income investment trust and the Blackrock World Energy fund – have large oil investments.

Investec Global Energy is another hefty investor in a combination of oil producers, refiners and services companies. If you are looking to take risk in this area, the CF Junior Oils Trust invests only in smaller gas exploration and production companies, including many of the minnows mentioned above.


4. Try an ETF or ETC
Exchange Traded Funds and Commodities have become increasingly popular with investors seeking easy ways to take a punt on commodities or indices. An ETF is a relatively low-cost way of gaining exposure to the price of a commodity or to a specific index for either the short or long term.

They can be bought through stockbrokers. Lyxor, for instance, offers the Lyxor DJ Stoxx 600 Oil and Gas ETF, or ETF Securities offers a crude oil fund.

However, buyers of these funds should beware an effect known as 'contango', which occurs when oil prices for future delivery are higher than the current oil price. This effect has caused erosion on funds that invest in near-term futures contracts based on the price of oil, so ETF investments may not be as simple as they seem. Do consult a stockbroker if you are keen on investing in ETFs.

5. Spread betting
Many investors have been seduced by spread betting as a low-cost way of gambling on the price of commodities, but you should always beware the risks. With spread betting, you would take a bet on the future movement of the oil price, but could lose out very rapidly if the price goes the other way.

Companies such as City Index, Cantor Finspreads or IG will allow you to take a bet on the future price of Brent crude. However, do not indulge in spread betting unless you are sure you understand the implications and have appropriate measures in place to limit your losses.

UK Bank shares: Bargain or basket case?

Bank shares: Bargain or basket case?
As some of Britain's banks languish in the 90pc club, have the shares fallen far enough to be worth buying again?

By Richard Evans
Published: 3:26PM GMT 11 Mar 2009

Britain's banks have been a terrible investment. Many have joined the "90pc club" of companies whose share prices have fallen to a mere 10th of their former highs.

Shares in Royal Bank of Scotland, for example, had lost 94pc of their value at the time of writing, while Lloyds Banking Group was not far behind on 91pc. The figure for Barclays was 88pc. Even HSBC, which is seen as one of the strongest banks around, was trading 62pc below its peak at one stage, while Standard Chartered had lost 54pc of its value.


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Shareholders' gloom is deepened by the fact that they are unlikely to see any dividends for a while and that, in the case of Lloyds and RBS, the Government holds a controlling stake, potentially bringing political as well as commercial considerations into their decision-making.

Contrarian investors, who are used to buying at the point of maximum pessimism, may think it is time to buy the banks' shares. After all, they reason, all the bad news should be in the price, while the banks could prosper again when the economy eventually recovers. In five years' time, today's prices could look very cheap.

Others say the banks are bust in all but name and could be fully nationalised if the recent string of bail-outs fails to work.

So should investors be buying bank shares or steering clear? And should existing investors grit their teeth and hang on – or sell at a huge loss? We asked the experts for their views.

JONATHAN JACKSON, KILLIK & CO
The bottom line is that all banks are high risk at present given the lack of visibility over the economy or the level of possible write downs in the future. It depends on what type of investor you are.

We don't think RBS or Lloyds are likely to be nationalised but the state's stakes could rise further if the economy turns out worse than we think. If you buy shares in Lloyds you are effectively buying an option on it surviving for three to five years and benefiting from its huge market share. Given the lack of visibility, both share prices will be very volatile.

With HSBC, the falling shares price is a reflection of investor concern that the bank may need to come back for more capital and the presence of hedge fund short positions betting on that.

Standard Chartered should benefit from the trend of survival of the fittest; it should be able to mop up market share as weak players fall away. It operates in a part of the world – Asia – that should experience stronger growth in the long term. It is well placed, but short sellers are attracted by the fact that the share price has held up well, so there could be more volatility. In the long term it's a strong bank and is much less likely to go under.

Barclays is not in as bad shape as Lloyds or RBS and has less chance of being nationalised. The market believes that Barclays will have to join the government asset protection scheme. The risk is that it may have to come back for more money. So far, it hasn't turned to the Government for capital, preferring instead to use third party investors.

In the long term, the Lehmans deal should turn out well. We will have more visibility by the end of the month.

MARK HALL, RENSBURG SHEPPARDS
There is a credible case for believing that the equity in the UK banks should already be worthless, given the scale of government intervention that has been necessary to keep the banks afloat.

However, with the authorities seemingly intent on avoiding full nationalisation, at least for now, the case for and against the shares is not quite so clear cut. There are still very realistic scenarios under which the shares are worthless but the upside could also be very substantial for any survivors of the current recession.

The only certainty is that the shares should be held only as part of a well-diversified portfolio or by those with a very high risk tolerance. The stories of pensioners with their life savings in one or two bank shares are very distressing.

NIC CLARKE, CHARLES STANLEY
We have a great deal of sympathy for those Lloyds TSB investors who bought a low-risk bank and through its management launching an ill advised acquisition [of HBOS] have lost a great proportion of the company.

We believe that the threat of complete nationalisation has been reduced significantly through this deal [with the Government to insure toxic assets]. Lloyds says it can now weather the severest of economic downturns as its assets have been thoroughly stress-tested.

The group will be loss-making in 2009 and there is a chance that it will be loss-making in 2010, despite the synergies from HBOS coming through, unless the outlook for the UK economy improves. And of course if the group is making a loss it is unlikely to pay a dividend, whether it is blocked or not. But at least the announcement [of the government deal] should improve the group's credit ratings and takes it a step nearer to a time when the market is able to value the group on an earnings basis. Unfortunately, due to the fallout from the HBOS deal that is the best that investors can hope for and any sort of recovery will take time. Our recommendation remains hold.

Putting a value on RBS currently is really about trying to decide what the odds are that it will be nationalised or whether it remains a listed company in say three years' time when the economy has improved.

Chief executive Stephen Hester's comment that "to make any forecast is hazardous" and that credit losses will rise "probably sharply" underlines the level of risk that investors are exposed to owning the stock during a prolonged recession. On balance our recommendation remains hold.

On Barclays, one key question mark has been whether the group has been conservative enough writing down its wholesale assets. It has seemed odd that RBS's global markets/wholesale bank has performed so markedly worse than Barclays Capital. Moody's cut its long-term ratings on Barclays by two notches to Aa3 on February 2 due to the potential for "significant" further losses due to credit-related write downs and rising impairments.

It would be helpful to know more detail regarding the Government's asset protection scheme. If participation makes economic sense Barclays' risk weighted assets will be reduced, which will diminish markets concerns about its capital.

And of course whether the macroeconomic forecasts improve/deteriorate in a number of key countries (US, UK, Spain and South Africa) will have a huge bearing on stock performance. Our recommendation remains hold.

http://www.telegraph.co.uk/finance/personalfinance/investing/shares/4973811/Bank-shares-Bargain-or-basket-case.html

How to invest in a bear market

Paralysis and panic is behind us now.

How to invest in a bear market
The FTSE All Share Index lost 29pc in 12 months and there is more pain in store.

By David Stevenson, manager of the Ignis Cartesian UK Opportunities Fund
Published: 10:32PM BST 15 Jun 2009

UK equity investors have had a torrid time of it in the last year. The FTSE All Share Index lost 29pc in the 12 months to the end of March and there is more pain in store. Recent stock market rallies should be taken for what they were, short-term technical bounces rather than the market bottoming on improved fundamentals.

That said, for investors who are able to stomach the volatility and take a longer term view, there are positives. The UK stock market is at one of its lowest points in the last ten years.

In the coming 12 to 18 months, it is likely to fall further taking valuations to levels of 'cheapness' that only present themselves once or twice in a lifetime. Making the most of these opportunities, however, requires a suitable investment approach and there are key considerations for investors in a bear market.

Companies are under considerable pressure and investors need to look in detail at what they are potentially buying into.

This requires careful balance sheet analysis as heavily indebted businesses may not survive the coming years. This may seem extreme but is a reality of economic cyclicality. Companies with low or sustainable levels of borrowing, and which therefore have a degree of control over their future, are relatively attractive, especially when combined with a secure dividend yield.

Earnings provide a barometer of corporate health and are under pressure across the market. Investors can, however, mitigate that risk by targeting certain types of companies.

Defendable earnings are important and are typically generated by companies with big franchises, large market shares and leverage over competitors or suppliers, allowing them to eke out more market share or a better margin. Thinking big is generally a sensible approach.

Big brands have a footprint that will allow them to survive through a difficult environment. Companies like Vodafone, Centrica and Unilever are all likely to outperform, operating in areas where spending remains necessary. Food retailers and pharmaceutical companies are also attractive.

Investors should also focus on sectors that offer predictable growth, rather than those dependent on support from the economic cycle.

Secular trends currently include the long-term growth of outsourcing, both in the public and private sector, and the maintenance and operation of critical infrastructure, such as utility and telecommunication networks and transport links. Both of these should offer resilience in a downturn and will benefit if the government's stimulus plans come to fruition.

It pays for investors to be sceptical in all market conditions but particularly during a downturn. It is important to think independently and not be fooled by consensus views.
Fundamental analysis of balance sheets and earnings will give a clearer picture of companies' future prospects. This then allows a portfolio to be built 'bottom-up' without necessitating a 'top-down' view on overarching macroeconomic, consensus or benchmark themes.

For investors seeking exposure to the market via mutual funds it is important to analyse the investment approach of fund managers. There is a temptation for managers to alter their process when short-term performance numbers disappoint, as can happen in volatile markets.

This, however, tends to be detrimental. Proper analysis of a manager's track record is therefore important, paying particular attention to longevity, consistency of approach and performance during previous downturns.

Certain managers are suited to a rising market, others, typically those able to best identify potential balance sheet holes and signs of earnings weakness, fare better when business models come under increased pressure, as is currently the case.

Another point to consider is the level and type of trading in a fund. Fund managers are generally not good short-term traders. Investment views need to be made on at least a one year basis, and a bear market does not change that.

A sharp pickup in turnover within a portfolio may indicate panic trades or a fundamental shift in strategy. In a bear market the number of attractive stock ideas tends to fall.

This may justify holding a more concentrated portfolio, and then adding new positions when opportunities arise. The important point is to make sure a fund manager is not holding low conviction stocks for the sake of diversification.

Finally, it will pay to be patient. The UK stock market will recover, but not overnight. At the moment market conditions remain challenging and it would be foolish to invest expecting the market to bounce back straightaway.

Equities tend to move before economic data picks up but with the current levels of volatility it is prudent to wait for clear signs that leading indicators are improving and government stimulus packages have laid solid foundations for growth.

This is likely to be some way off but by reinforcing a portfolio based on the points above, and taking advantage of increasingly attractive valuations, long-term investment opportunities in the UK can be exploited.

http://www.telegraph.co.uk/finance/personalfinance/investing/5545094/How-to-invest-in-a-bear-market.html

Chartists are the astrologers of the markets

Charts are extremely popular.

Chartists believe that they can see patterns in charts which can predict future price movements.

• They like to superimpose straight lines over the charts, usually connecting a series of high or low points. Sometimes, they also have squiggly lines drawn on them as well.
• The chartists all have their own systems that they follow, normally based on the thoughts of a guru from a long time ago, or perhaps some strange pattern which exists in nature.
• And the jargon they use sounds very scientific. Expressions such as 'declining wedge' and 'fourth wave' suggest to outsiders that the systems are profound and well researched.
• The beauty for chartists is that they don't need to know anything about the market they're trading. They have no need to look at fundamentals.

You shouldn't get distracted by charts.

Chartists have no scientific basis

It is fine to look at the odd chart every now and then; it's the crazy theories that chartists use that you should be cautious on. Charts themselves are useful for a feeling of how far markets can move and how they react to news flow.

However, a few things are obvious about chartist theories.

• These ideas are not applied in the economics field which is always searching for theories on human behaviour.
• Nor do the theories have a true mathematical basis, and the chartists often do not have a mathematical background of any kind.
• How many chartists do you know who are successful? Probability would suggest that there are a few out there somewhere.

Chartists are the astrologers of the markets. They use a pseudo-science. At best, it is a clumsy way of following trends. Their methods are unsubstantiated, though extremely popular.

There is simply no reason, for example, why price moves should imitate the pattern of plant growth, star patterns or anything else.

Ref: 100 Secret Strategies for Successful Investing by Richard Farleigh

Property prices often lag stock prices

Strategy: Property prices often lag stock prices

---

What one investor did.

"In 1989, I shocked a lot of people in my dealing room when I suddenly sold my home in Sydney, and put my sale proceeds into Deutschmarks. It was viewed as rather bizzare. However, I was convinced that the property market would start to feel the effects of the share market crash some 18 months earlier.

I was also very keen to rent a stunning apartment overlooking Sydney Harbour. It was directly opposite the Opera House, and nearly as high as the Sydney Harbour Bridge. Despite having one of the best views in the world it wasn't exactly very expensive - amazingly only a few hundred Aussie dollars a week.

Anyway, as it turned out I was right about housing prices (and fortunately the Deutschmark, which went on to rise against the Australian dollar)."
---

In general, share prices have been a good leading indicator for property prices, which often follow the direction that the stock market took two or three years earlier. The economy pushes the shares and property in generally the same direction, but with property, the reaction takes longer.



1. There are always exception to rules

Recently in 2005, however, there may have been a decoupling of the two markets, and this strategy may not have been very effective.

A few years ago, stocks were dominated by weak global economies and the tech wreck. This was followed by a persistent recovery which started after the invasion of Iraq. Housing prices on the other hand, have until recently been surging, inspired by the massive drop in housing interest rates.

So housing has not shown any tendency to follow a lead set by the share market. Whither this strategy?

It is always valuable to be aware of patterns like this and when they don't work, to try and figure out the reason. On this occasion, dramatic events have dominated each of the markets and swamped any usual behaviour.

It is not too bad. We only need among all our strategies, to be right on most occasions or on our bigger positions, to have a comparative advantage.

Don't buy or sell property just because of the share market - always wait until property prices themselves started to move in the right direction, to give you further confidence before taking action.

2. Property may be the easiest market

Despite a lot of talk about whether stocks, bonds or cash are the best investment, it may be the property market that is the easiest of the markets, for three reasons:

1. You can watch the stock market for a useful buy or sell indicator, and hve plenty of time to act in the property market.

2. There are not many false trends in property prices. The market is not a listed market where everyone can see the prices - deals are done privately and price trends develop slowly and surely. You can wait for the herd to start to move and then join them for a nice journey.

3. Just about everywhere, there is no tax on capital gains on people's own homes.

Ref: 100 Secret Strategies for Successful Investing by Richard Farleigh

Currencies trading are very difficult.

Currencies trading are very difficult. They are more difficult than stocks and certainly more difficult than interest rates.

You need to learn by looking at price behaviour in the past, but trying to understand what currencies have done even recently is tough. There have been some big moves.

Take the US dollar versus euro rate, for example. It has ranged over the last few years from around 85 to 130. How is it possible that the currencies of the world's two largest economies can change in relative value by over 50%?

These types of currency moves are intriguing.

• The first thing to be aware of, is that you are looking at two economies. With stocks and interest rates, youj basically have only one economy to figure out.
• However, the second and bigger challenge is that currencies are largely driven by market sentiment, and the reason is that there is absolutely no successful benchmark for the pricing of a currency.

1. Purchasing price parity (PPP) is not much use

This theory suggests that currencies should tend towards the level where a collection of goods and services costs the same amount in different countries. PPP would suggest that if they are too expensive in one country, then that country's currency should fall.

The famous McDonald's Big Mac index is sometimes published in the Economist magazine, and it applies this analysis, to the price of the burgers in various countries.

The problem is that in reality PPP does not seem to have much impact on currency level. Perhaps it is for the same reason that people living in tiny but very expensive apartments in Tokyo do not migrate to Sydney or LA and buy a huge house. If they did, perhaps currencies would be easier to evaluate.


2. Market sentiment has the most impact

Since there are no reliable benchmarks, market sentiment is the huge factor that dominates events.

In 2005, the US dollar has been out of favour, despite an improving US economy and rising US dollar interest rates. The market is more worried about the US current account deficit. But is that econmies or fashion? There's the difficulty.


Conclusion

You need not avoid currency trading completely.

There are occasional opportunities such as the big market moves that you have seen in the major currencies during the last few years.

You should only be involved when you have a very firm grip on what's driving the market. That doesn't happen too often for any of us!

Government bond markets for major economies are not prone to crash

Strategy: Government bond markets for the major economies are not prone to crashes

The characteristics of bonds:

1. The level of interest rates set by the government are somewhat predictable
2. They are not as risky as stocks.

Many people point out that stocks outperform bonds in the long run. Perhaps. However, one comfort you do have with high-grade bonds is that you are unlikely to wake up in the morning and find you have lost 25% of your investment, which of course does happen occasionally with stocks.

Most unexpected shocks to the economy are bad news:

• a crash in consumer or business confidence,
• a terrorist attack,
• a war,
• a SARS crisis, etc.

Now if one of these pushes the economy into a dive, stocks plummet while bond prices can actually go higher (that is, pushing the yields lower).

In the 1987 October share crash, panic was everywhere. Those who were holding bonds did very well. The bad news for the economy was good news for interest rates.

There is also the interesting effect of government deficits on bond yields, especially in the United States.

• One could argue that the government bond markets should work like all markets, so that if the government wants to borrow more and more, it has to pay a higher interest rate, and sell bonds at a lower price.
• This was a criticism of fiscal policy by one brand of economists - the monetarists. They argued that 'crowding out' would mean that higher deficits don't help a weak economy, because they simply push up borrowing costs for everyone.
• However, current interest rates in the US are normal even though the deficit is at an all time high, therefore such an argument is not convincing.

As an investor in the stock market, bonds are alternatives. There have been dream runs in the share market. This article alerts you to the attractions of the bond market when your strategies steer you in that direction.

Making sense of direction and level of Short term interest rates

Strategy: Short term interest rates will tend toward the inflation rate plus the economic growth rate

There is always a great deal of discussion about interest rates, particularly US rates. Short term rates are set by governments and this can be a fascinating process to watch. The rates affect the economy and many of the markets.

The benchmark strategy helps to make sense of discussions about their direction and their level. It is a rough guide which is often missed by many commentators. With this rough valuation target, interest rates are easier to understand than most markets, where it can be hard to have a clue what the prices should be. Equities, the market that most investors concentrate on, do not have this kind of benchmark.

An interest rate is made up of the inflation rate plus a 'real' rate. That is, the real interest rate is what is left after allowing for inflation.

Interest rate
= Inflation + 'Real interest rate'

The economic growth rate is the percentage expansion or contraction in the economy with inflation stripped out. It can be loosely considered as the dividend paid by the economy in general.

Economic Growth rate
= Rate of expansion or contraction in the economy - Inflation

Rate of expansion or contraction in the economy
= Inflation + Economic Growth rate

Over time, the real interest rate moves towards the economic growth rate. In that way, the return from interest rates and the return from the economy in general, are equal.

In 2005, the short term rates in the US are 1%. When they start to rise, how far could they go? In the US in 2005, you may wish to target 4% because inflation was around 2% and growth was also around 2%. Add them and you get the target.

Rates had started moving lower worldwide and the question was, how far they could fall? Using the rate of contraction in the economy and the inflation rate gives you an estimate of the economic growth rate. As over time, the real interest rate moves towards this economic growth rate, using this simple strategy, you can have an idea how much further interest rate could move and in which direction.

As the level of interest rates are somewhat predictable, this benchmark strategy helps you to invest intelligently in the bond market.

Tracking Malaysian Fuel Prices

Be careful at the end of long trends

Another dangerous time in the markets is after the end of a long trend. The fundamentals that caused the trend may have been assessed and fully absorbed by the markets, and, until there are new strong influences, it is hard to have a view.

Choose the right markets

In many cases where you have a view on the economy, or the world in general, there will be different ways to position yourself in the markets.

As an example, if you were bullish about the Chinese economy because of the massive growth potential, some ways to invest would be:

• buy Chinese stocks;
• buy into shipping stocks (prices are already much higher on increased Chinese usage for shipping of imports and exports!);
• buy the yuan (the Chinese currency);
• buy commodities (raw materials), looking for Chinese demand to push up prices;
• buy into a currency that exports commodities (e.g. Australia and Canada); or
• buy stocks in foreign companies who sell products to China, for example mobile phone companies such as Nokia.

There are more. Do your homework to unravel the above example for the right answer. Above all, do not guess.

When you have a way, and there are a number of ways to implement it, look at the following 4 criteria. Choose the market:

1. Where the price has not already adjusted, or has adjusted the least, to the events you expect.

• This could rule out shipping, because shipping prices have already moved substantially higher in line with greater Chinese activity.

2. Where there is the least downside risk if you are wrong?

• If you have more reasons for being bullish on Nokia than just Chinese demand, buying Nokia stock may provide some protection if it turns out that you are wrong about the Chinese.

3. Where there is the least random influences to mess up your idea.

• The announcement of a government election in Australia, for example, would probably dominate the movement of the A$ up or down, and the Chinese economy would have little short term impact. In the event, the Canadian dollar would be better suited as a currency play on China, until after the election.

4. Where you have the best liquidity.

• This is the ability to buy and sell easily and inexpensively. Some Chinese stocks may be too illiquid.

Very often, you cannot meet all the criteria and the different criteria steer you towards different markets. It will then be a matter of judgement.

The challenge is to always think about various opportunities and the risks they involve.

Looking for investing ideas

Where to look for investing and/or trading ideas? There are thousands of different stocks, bonds and commodities. How can an investor find anything?

You need to be inquisitive about the markets. You will probably be drawn to the markets that you find most interesting. As you get to know more, try to identify patterns and anomalies in the way they behave. These will be the basis of your investing and/or trading idea.

It can be rewarding:

1. To be inquisitive, especially in the financial markets
2. To watch crowd behaviour. Jump onto some great trends and jump off when this turn more neutral. Trade with a consensus, rather than against it.
3. To think for yourself. Always apply your own reasoning.
4. To keep an open mind. Think about crazy things. Test them by asking challenging questions. The answers are less important than the thought processes they revealed.

Warning: Watch out for US dollar exposure in commodities trading

One word of warning on commodities. Since they are usually priced in US dollars, price moves can sometimes have more to do with dollar strength or weakness than with commodities.

In periods of dollar weakness, for example, commodity prices may rise just to keep their European and Japanese price relatively stable.

This is always an important consideration if you do not want to accidentally speculate on currencies.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

The recent commodity story has been all about China

A new period has emerged over the last few years. Growing economies, particularly China, have experienced strong growth and inflation simultaneously. They have tolerated inflation, and let growth rage on. Commodities have had a renaissance. There has been debate about whether China will try to cool inflation, but in the meantime, commodity prices have soared as the hungry dragon searches the world for raw materials.

----

For instance, you could have bought Australian dollars in 2003 as a kind of commodity play.

• The widespread view then was that Chinese demand for commodities would drive prices higher, and that Australia was well placed to benefit as a supplier.
• There were other things in favour of the Aussie dollar, such as strong growth and relatively high interest rates, which gave added confidence.

You would have done well during this perid, given the usual lacklustre environment for trading in commodities.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Long periods of high growth and high inflation are rare

To invest into commodities, you can choose to buy:

• individual commodity
• existing commodity index (basketo of several commodities)
• companies, such as steel or oil companies, which will benefit from higher prices of their products, or,
• the currencies of countries which have a lot of natural resources

The best time to do so is when inflation and economic growth are both strong.

In practice, though, there have not been many periods where growth and inflation are able to rise at the same time.

• Authorities normally respond to higher inflation by raising interest rates. They only have difficulty keeping a lid on inflation if raising rates weakens the economy too much.
• When there is strong growth, the authorities have a lot of room to move without causing a recession, and so they are able to stamp down on the inflation if necessary.
• Therefore, it has been rare to find long periods of high growth and high inflation.
• (This helps to explain why commodities have seen a 50 year or so price decline in real terms.)

CRB Index since 1950:

In the 1970s:

• there was high inflation, largely caused by OPEC, without strong economic growth.
• Commodities has their best run for a long time but prices still barely rose in real terms, because inflation caused a tripling of average price levels.

In the 1980s and 1990s:

• saw the opposite experience, with falling inflation and many periods of good growth.
• This was miserable for commodity prices in real terms. The economic growth was not enough.
• The increased demand by the growing world economy was generally offset by falls in the costs of production and extraction due to dramatic improvements in technology.
• Technology also helped economies reduce their dependence on the more expensive commodities, such as oil.
• Social changes also reduced the growth in demand for commodities, as economies became more service oriented, and less reliant on manufacturing.

Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

CRB Index

While you can choose your own selection of commodities, it is probably easier to use an existing index. The most watched indicator index is known as the CRB index.

Future and options on the CRB index are traded on the New York Board of Trade. It is made up of different categories of commodities:

• Energy: crude oil, heating oil, natural gas
• Grains: corn, soybean, wheat
• Industrials: cotton, copper
• Livestock: cattle, hogs
• Precious metals: gold, platinum, silver
• Softs: cocoa, coffee, orange juice, sugar

Because it covers such a diverse range of materials, its movements will mask moves in the individual components, and smooth out the supply problems. Obviously, there are many other commodities which are not included int he CRB index.


Alternative methods

As an alternative to trading an index on an exchange, there are a number of different ways to trade commodities - apart from keeping silos full of corn in your backyard.

• You can also invest in companies, such as steel companies or oil companies, which you feel will benefit from higher prices of their products.
• Or you can even go a step bigger, and buy into the currencies of countries which have a lot of natural resources.

Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Trade in a basket of commodities

The strategy to adopt will probably be to trade a basket of several commodities, rather than any specific item. This is because to get the net effect of growth and inflation, you will need to remove a lot of the randomness in the price caused by supply factors.

These supply driven commodity markets can present extra difficulties. These markets are often turbulent.

• They can be influenced by events in remote countries, many of which can be unstable and corrupt.
• They can also be influenced by the random effects of the weather. You don't want your view that higher inflation will cause higher commodity prices to be upset by good weather causing a bumper crop in bananas.

Most of the information driving commodities can be quite obscure. It is a difficult task for investors to somehow get hold of that information. So by trading a basket of commodities, you will win some and lose some on the individual items, and allow the economic fundamentals to dominate. You would rather do that than bet on whether there will be a bad season in an unpronounceable country.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Buying commodities. When?

Buying commodities when inflation and economic growth are both strong

Commodities are raw materials. Economic growths is good for commodity prices because a growing economy needs more inputs. Inflation is also good for commodity prices because commodities are tangible assets rising in price as the value of paper money declines.

Like all markets, the commodity markets have some large moves driven by a consensus on the fundamentals, which drive the price further than generally expected. So the idea here is to identify those periods where growth and inflation are strong, and then to take a long term view with a trading position.


Related posts:
Buying commodities. When?
Trade in a basket of commodities
CRB Index
Long periods of high growth and high inflation are rare
The recent commodity story has been all about China
Warning: Watch out for US dollar exposure in commodities trading

Few assets benefit in stagflation

A combination of inflation and slow growth rarely helps any asset class. We had almost a decade of this in the 1970s, and stock and bonds suffered miserably. Even commodities struggled to rise in real terms.

1970s - a miserable decade

OPEC hit the world with two oil price increases. In 1973, the price per barrel went from a few dollars to over ten dollars, and in 1979 from the low teens to over 30 dollars. The west was far more dependent on oil than today.

The oil price fed into just about all prices, and inflation went out of control. By 1980, it was around 10%. People were accustomed to cycles in the economy. Normally, inflation would only rise when the economy was doing nicely and it was the excess demand that pushed up prices. However, in the 70s, jobs were scarce as unemployment also headed towards 10% and so there was plenty of unused capacity in the economy. This was inflation plus stagnation, and they had a nice word for it: stagflation.

No one knew what to do about stagflation. Australia tried wage freezes. Unions were more powerful then, and tried to ensure their members' wages were maintained. In the UK, they had 'the winter of discontent' and things became so bad that they were ready for the dose of medicine called Thatcherism.

No easy answer to stagflation

However, what could the authorities have done? A rise in the price of oil is like a tax on the entire country. Just about everyone is going to be worse off.

Unfortunately, there is no easy policy the authorities can adopt to fight stagflation. The economic theory has done a lot for economic management in normal conditions. The greatest economist ever, John Maynard Keynes, told us what to do: increase and decrease the government budget to smooth out the economic cycles. When people are not spending, governments should do the spending for them, and borrow the money. How insane were governments to reduce, rather than increase, government spending in the Great Depression! On the other hand, if people are spending too much and the economy is overheating, governments should cut back.

Keynes did not really trust interest rates as an economic tool. One reason was that in a recession, an interest rate cut may not be enough to encourage overly pessimistic consumers and businesses to borrow and spend. You can only lead a horse to water. But again, in normal conditions, interest rates can be used very effectively. When inflation rises, a little tightening up of interest rates slows things down a little, and the inflation eases off. This method of controlling the economy has become even more important as politicians have hijacked the fiscal budget for politics, rather than economics.

The trouble with stagflation is that the authorities don't know whether to boost the economy or to slow it down. Trying to create jobs risks even higher inflation, and trying to solve the inflation problem makes the job situation even worse. So it is not clear what to do with the budget balance or with interest rates.

These problems for the economy and the policy makers are reflected in the markets, and there is nothing attractive to investors. All you can do is to stay in cash, and to sell the other markets.

The stagflation of the 1970s only really ended when the US Federal Reserve gave the economy a sharp dose of very high interest rates in the early 1980s, and allowed a recession. Hopefully, we will not get another decade like the 70s for a long time.

Quality of company's management in determining its success

The quality of a company's management is by far the most crucial factor in determining its success

You have seen bad management mess up the most amazing opportunities where companies have failed despite having everything else going for them.

Often, the investor made many mistakes by focusing too much on the product, and not enough on the management. Good management will find a way to make their product work, while poor management can mess up good products.

Even big companies can make mistakes. Xerox had a fantastic product in photocopiers in the 1970s. They had a fantastic platform to expand into the technology market, by developing printers and similar devices, yet a few years ago, the company was struggling for survival. They've had a very tough time after never really grabbing the opportunity. It does seem to have been a management problem.

On the other hand, good management can often build something out of almost nothing. They are good at developing the business in the right direction. They spot opportunities, and have creative solutions. If their products are not selling, they may find ways to improve the product by research and development, or by buying or merging with other companies. They can weed out the wrong people and they face up to difficulties early.

It is easier to assess the management of smaller companies than larger ones.

There is a much greater variation in the level of talent within smaller companies. Just about all managers of big companies are very talented, even those who fail. Unfortunately, for smaller companies that is not always the case.

During the tech wreck, many small tech companies fall while others somehow survive. The survivors generally had good management. They weren't necessarily those with the best product, but they were those that cut expenditure when times were getting tough, and made plans for keeping the business alive for three or four years until the market recovered.

The track record of the managers is also very useful. Sometimes the managers are very appealing because previously they have taken a company all the way from nothing to good valuation. They may have built up a good reputation and made money for themselves in the process, and you know that they have choices apart from working for the company in which you're potentially investing.

Management strategy can also reveal a lot about their quality. Many investors focus too much on current revenue and profits while ignoring strategy. It's this that can be vital to a company's future, particularly with smaller companies that have fewer resources to recover from mistakes.

The fundamentals had changed and the trend may not be your friend

"I didn't invest in this or just about any other tech company in the final twelve months of the boom, and I tried where I could to sell my tech investments. I had been investing in tech since 1995, but, to me, the fundamentals of the tech sector had changed. The quality of new tech companies had dropped tremendously and they were being funded with a lot of cheap money from naive investors."

The above investor made his decision despite the fact that share prices in the tech sector were trending straight upwards and that decision saved him a hell of alot of money when the crash came.

The tech crash is a great example of where fundamentals are the most important consideration, and where the trend may not be your friend. The strategy here is to monitor the fundamentals and to cut positions accordingly, even if the trend is still in your favour.

If the fundamentals have changed, adjust the position accordingly.

The 3% rule for wealth preservation

If you want to maintain your wealth in real terms, you can probably spend no more than 3% of your capital each year.

The idea is that real interest rates are generally around the 3% level. At the moment for instance, five year rates are roughly 5%, inflation is roughly 2%, and that leaves you 3%.

Now you may think that you can earn more than the 5% offered by interest rates. Investing in the share market for example, has outperformed interwst rates over the long term, so that could help. But by trying to do better than interest rates you will also risk losses. The share market can be volatile with long bleak periods for investors who move away from low risk investing. The other problem of course is tax.

The fellow who won the lottery could probably have counted on earning $30,000 per year in real terms if he had invested the entire $1 million. That is probably less than his job was paying. So even though he feels rich, and all his friends want a loan, he may struggle to live off his capital. He would need to be frugal; perhaps the cars and the studio weren't such a good idea.

The task of just maintaining wealth is a challenge for many people, not just those lucky in the lottery. The era of low risk, high returns of over 10% is over for the moment. Those days are gone and wealth preservation is more difficult.

With success, bank some profits

If the fundamentals continue to look good and are supported by a favourable price trend, do not take profits.

However, if you are doing particularly well, you should cut winning positions to keep a balance in your portfolio and take cash out of the market.

There have been some very high-profile billionaires who have gone completely bust. They probably took a lot of risks to get there, which were too bold for most people. Why didn't they just put a lazy hundred million on the side, in case it all went horribly wrong?

Here is a sensible way to lock-in some wins.

Value all of your positions on the basis of the current market price. This process ignores your original entry price, and any other price along the way, such as a high or a low.

If your investments are going really well, you may find that their mark-to-market value significantly exceeds the original risk amount you had in mind.

As an example, say you, allocated 20% of your assets to trading, and the positions have done so well that on a mark-to-market basis, they are now worth 40% of your total assets. Here you should probably reduce your positions and bank some profits. This would even be regardless of supportive fundamentals and a trend in your favour.

Over the years there were times when an investor or trader reduced positions which were doing well and which looked good going forward. Those decisions had nothing to do with their views on their fundamentals, but were simply to take cash out of the market.

Exiting a winning position for traders

A reliable way to exit a winning position with good fundamentals is to allow the price trend to finish. This demonstrates that the idea has run its course. The price reaching an arbitrary target or a period of time elapsing is not a reliable signal. Even if a trade is doing well, keep an eye on those fundamentals.

You will never have the satisfaction of getting the best price or the biggest possible profit. If the fundamentals remain the same, wait for the trend to turn, before getting out of a winning position.

Buy and Hold - may have had their day

Buy and Hold mantra

One popular theory is that investors should buy and hold their stock investments. They should not try to outguess the stock market. This idea became a mantra after the market recovered so well following the 1987 share market crash. The crash now only looks like a hiccough from the great bull market of the 1980s and 1990s. That recovery was a manifestation of the market's long term resilience.

A related theory is that the stock market should always outperform bond yields over the long run, as stock investors are compensated for the extra volatility.

These types of theories may have faded a little now, after global investors experienced the bear market in 2000 and the recent 2007-2009 severe bear market. In the US, the broad stock market indices closed lower in 2005 than five years earlier. Five years is a long time, even for patient investors.

As the buy and hold theories have become widely held, the effect has been to push prices higher, increasing the entry cost for new buyers and removing their attraction - a kind of self-defeating prophecy.



Using PE ratios

Other theories, based on ratios, such as PE ratios, would have been very effective in signalling the tech crash a few years ago. However, using this would have made many investors over cautious, and missed much of the fantastic bull market in the five years earlier. That would have cost investors a large amount of missed profits. (Caution!! Maybe risky strategy.)



In summary

Choose the best periods to be invested in the stock market. There are long periods of over and underperformance.

Watch the economy and the big picture influences.

The best way to time investments is to allow some broad consensus to build in the market and invest after the price begins to move. (For example: There is a consensus building that the worse of the recession is over and the world economy is heading towards recovery. Moreover, the prices have moved.)

Crisis situations almost always provide an opportunity

Don't buy into falling markets. The occasional successes will not pay for the more numerous failures. The falling markets can surprise many of us by how far they move. Recall the recent 2007 -2009 severe bear market and those who bought big and get caught in the falling market. Among them, Temasek, Oei Hong Leong, the German industrialist who committed suicide for betting on a auto stock, and others.

Panics can lead to an imbalance in supply and demand

Nevertheless, there is an exception: crisis situations. In crisis situations almost anything can happen because there is panic in the markets. You see the most controlled and sensible people completely lose all their judgement when they are under intense pressure. Sometimes the whole market is awash with nail-biting investors and traders, feeling nervous and confused. With the volatility we have experienced the last 25 years, there have been many such episodes. The share market crash of 1987, the emerging market crisis of the late 1990s, the tech wreck, and 9/11 are just a few that come to mind. And, undoubtedly, there will be many more.

The reason that there are opportunities on these occasions is simple: a falling price triggers more panic selling than it does bargain-based buying.

During these crises, many players will be forced to cut their positions regardless of the price. Some funds will have lost so much money on many different investments, that their very survival would be threatened if they lost more. They may reason that by selling, they take a dreadful loss, but at least it does not put them out of business. Even though holding on may be a great trade, they simply cannot take the risk. There have been many instances of a senior manager ordering a fund manager to cut, and ignoring their heartfelt plea not to do so.

At this point fresh buyers could come into the market looking for value. However, at times like these, potential buyers may be too distracted with their own problems to do anything. This particularly affects smaller markets since fewer people are watching them anyway.

Suffering from this lack of buying, the market could paradoxically be struck by new selling. Some hedge funds and other momentum players may ignore fundamental valuations and see selling as an opportunity, as they look for the price to go even lower.

While all of this is going on, you may be able to step in. Hopefully, you will have followed good risk management so that you yourself are not facing a crisis, and you can keep a cool head even as others panic. You should be extremely choosy over how you get involved in the market - try to consider many different opportunities and don't necessarily jump at the first one you see. In a genuine crisis, there will be no shortage of ideas.


Ref: 100 Secret Strategies for Successful Investing by Richard Farleigh

Pros and cons of using stop-losses

Here are two episodes to illustrate the pros and cons of using stop-losses:

Cons

"So, in December 2003, I invested in the company at an effective price of 90 cents, which implied a market capitalisation of about $220 million. Over the next six months the price had a strong trend - downwards. In July 2004, it fell to as low as 55 cents.

This was around the stop-loss level I had in mind when I invested.

There didn't seem to be any reason for the dramatic fall. Everything seemed to be going on track for the company. The network was being set up, trials of the system were progressing and the modems they had ordered were being delivered.

Here was a classic stop-loss dilemma. If I had thought that there was any way the price would drop so severely, I would not have invested. The fundamentals were sound, so if anything the company was a buy at this price, rather than a sell.

I held on to my investment. Since I had quite a large position, I didn't buy any more. Fortunately for me, the price recovered as the company achieved some success with its product launch in August 2004 following a strong advertising push. That sent the price to over $1.10. I later exited my position at around $1.00, when I became worried about potential competition emerging from other companies."

Pros

"I had a tough experience with my ARC shares, where cutting a deteriorating position would have been the better choice than hanging on, and where clearly I was stressed and lacked discipline - exactly the problems that a predetermined stop-loss strategy seeks to avoid. "


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In the first episode, the investor did not use a stop-loss, and the market recovered allowing him to salvage a small percentage profit. His confidence was rewarded.




Summary on stop-loses

Have a stop-loss in your mind when you invest and if the price hits the stop-loss level, always cut if:

• the loss is threatening to be destructive;
• you are confused about what is going on; or
• the fundamentals are moving against you.

You should only keep the position and consider increasing it if you remain genuinely confident about the underlying fundamentals. Experience will help you recognise when you are starting to rely on nothing but hope. If you do stay in, choose another stop-loss level as a reference point, and stay disciplined.

You should also manage risk by not betting too much on one idea and by anticipating market moves twice as big as seem reasonable.

The stop-loss dilemma

This technique enables an assessment of the potential cost if things go wrong. If the investors buy a stock at $100 with a stop-loss price of $75, they know in advance that their maximum loss is $25. There are also other variants which aim to limit the potential reversals of profitable positions. With a trailing stop-loss, the stop-loss price rises in line with the market price. So if the market rallies by $10 to $110, the stop-loss price might also rise by $10 to $85.

The benefits of a stop-loss

It forces an investor to be disciplined. When a position goes wrong, it can cause stress and cloud people's judgement. Anticipating this, and deciding on a stop-loss level in a calm and relaxed manner beforehand, can ensure that an investor will remain objective.

A stop-loss also allows a specific amount of capital to be allocated to each idea. So an investor might be prepared to lose say, $10,000 on a hunch, and say, $25,000 on a firm conviction.

The argument against stop-loss

It doesn't seem very scientific.

Is this necessary if the other risk management ideas are followed?

The choice to cut a losing position is a dilemma.

On the one hand, the positives for managing risk and preserving capital are clear.

On the other hand, if you are confident an investment is a good idea but the price moves against you, perhaps you should be buying more, or at least holding, rather than cutting.

How you may overcome this dilemma?

One discipline which you should use is to value your position regularly using the current market price. A losing position clearly means that something unexpected has happened.

When you invest, have a stop-loss in your mind. If your investment hits the stop-loss level, make a judgement on whether to cut, based on your confidence at the time about the position.

If the loss is threatening to be destructive to your finances, it is absolutely vital to cut. To be at this point, the price must have moved a really long way against you, if you have not bet too much on the idea in the first place.

You must also cut if you are confused about what is going on, or if the fundamentals are moving against you. In these situations, you see the prices go further than expected.

The decision not to cut

There are times not to cut a position, even if it reaches your stop-loss level. These are when two conditions are satisfied:

1. you have the capital in case of further losses;
2. you understand the reasons for the adverse price move, but remain confident that there will be a recovery.

Here it may make sense to hold the position and even to consider buying more. (It is sensible to see the market starting to recover before adding to a position.)

The decision to keep a losing position must not be based on emotion or on any sense of living in hope. You must admit to yourself that things have not gone the way you expected, and that since you have been wrong up to this point, you may well be wrong again. There is an old saying along the lines of 'the market can remain irrational much longer than you can remain solvent'.

Summary

Stopping out is the hardest transaction. No one likes to give up hope. But it is essential in some circumstances. Beginner investors should be especially cautious about mounting losses.

Sometimes you cut a position and then the market recovers. Don't be put off stop-losses by those experiences. The horrible feeling of cutting a position only to watch the price turn and recover is one of the worst for an investor. You are talking about probability and random events, and over time all sorts of good and bad things will happen. You have to look at the long term. Normally after cutting a bad position there is a strangely cleansing feeling - some people say it's a bit like getting out of a bad relationship!

Stop-loss maybe unnecessary for some or many investors if the other risk management ideas are followed.

Qualitites of the successful investor

Drive and ambition are absolutely essential. You won't make it in the financial world if you're lazy.

The risk-taking elements of investing require self belief and genuine confidence. This is particularly important to handle losses. On the other hand, a big ego is a negative because markets cannot be fooled by bravado.

Intelligence and practicality are essential. Intelligence is the ability to sort through a lot of information and to see what is important. There are many educated and knowledgeable people who are not especially intelligent. The ability to use the information is what they lack. An ability to simplify a complicated subject has its rewards.

Above all, you need to enjoy what you do. Financial markets are the most exciting experience imaginable.

A level of optimism like this is important. There is a book by Dr. Martin Seligman, Learned Optimism, which relates the level of a person's optimism to their success. It argues that the most successful people are rational optimists. Optimism relates to an attitude towards risk. Pessimism stops people taking any risk.

Assess risk - and then double it

Risk assessment is not always an exact science.

Occasionally, you hear of investors who have been hit by losses so big that they find themselves "out of the game". The reason is the same in every case: they have not managed their risk.

The most important is to always have a rough idea of how much money you could lose if the markets move against you, and you should be able to withstand that loss if necessary.

Risk assessment is not always an exact science. Judging how much a position can move against you will be nothing more than a gut feeling. It is difficult to be more scientific about it because:

• using history as a guide is not always effective, as the world is always changing.
• even in normal conditions, there is a lot of 'volatility of volatility', as the market goes throught quiet and crazy periods.
• the size of the theoretical maximum loss is all of the investment, because a price can go to zero. But this is hardly expected to happen.
• sophisticated statistical analysis has often proved inadequate, which is why LTCM had come unstuck.

Here is how one investor estimate his maximum loss for each position based on what he feel could happen in a normal environment. A normal environment is one which applies four years out of every five. (For every 5 years of investing, you can expect to meet 1 bear year.)

Step 1: He assumes for risk purposes:

• Blue chip stocks will not fall by more than 25% in the four years out of five. So for every $100 invested in the big names, he could expect to lose $25.
• Smaller stocks are normally more risky. These will not fall by more than 50% in the four years out of five. Therefore, for every $100 invested in a small stock, he was risking $50.

With this estimate for each position, he can simply add them all to get an idea of his total risk ($R). This gives an estimate of how much he could lose in reasonable circumstances - four years out of five.

Step 2: For the one bad year in five, it could be worse than that. The loss will be worse. For this reason, he assumes that he could possibly lose double that amount ($2R).

Step 3: Making some deduction to my total risk. It would be fair to expect that not all of his rainy days will happen together. This is the benefit from diversification. Therefore, he can make some deduction to his total risk if he feel not everything can go wrong at once. (But be careful, some big name hedge funds have come unstuck by underestimating how their positions are correlated.)

To summarise:

This simple and logical technique of risk assessment involves:

• for each position, assess how bad a loss could be in a normal environment;
• double the amounts; and
• add up the potential losses, and take some off the total if it is justified by diversification.

The idea is to be comfortable with the total risk level. It is vital that you could withstand that loss, because a disaster may happen. So simply choose the size of positions so that potential losses are manageable. No market is too risky if the position is not too big.

With the right approach, you should be able to "stay in the game". Do not take too much risk.

Was the potential reward worth the risk?

An investor may be tempted to chase that little bit of extra return on his investment. Perhaps, he may put his life savings into saving schemes that pay slightly more than ordinary bank deposits. However these types of deposits are a little bit more risky. Every now and then they can blow up. It's always sad when these, usually, small investors have lost their savings that way.

Is the higher return worth the risk?


There are many types of investment which pay above market returns. The problem is that every now and then there can be a big crash which can take away the profits and cause losses. These types of investments can give the illusion of being very comfortable when they are doing well. However, there is an asymmetry, because most years they will pay-off, but in a bad year they can be horrendous.

If an investment opportunity looks too easy, it's time to smell a rat.