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.
Monday, 15 June 2009
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.
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 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.
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.
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.
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.)
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
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. "
---
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:
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.
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. "
---
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.
Sunday, 14 June 2009
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.
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:
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.
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.
Everyone is a hero in a bull market
Psychologists have identified that it is human nature to attribute our wins to our skill and our losses to our bad luck. Don't fall for this trap.
With trading and investment, luck often parades as skill, especially when a market is doing well. During a bullish run in the stock market you will often meet someone who is very happy with their ability to pick the right stocks, because they have backed one that has performed well.
But in the same way that a rising tide lifts all boats, even the rusty ones, many stocks do well in a bull market, even if they're nothing special. So the profit may have more to do with favourable big picture events at the time, such as a strong economy or falling interest rates, than with anything company specific. This really means that the person was lucky rather than skilful.
Be mindful of the old chestnut that 'everyone is a hero in a bull market'. As prices went higher and higher, they increased their investment sizes, so that when the crash came they had far more money at risk than they would have imagined just a year earlier. It ended badly. Profits tempted them in, and losses forced them out.
With trading and investment, luck often parades as skill, especially when a market is doing well. During a bullish run in the stock market you will often meet someone who is very happy with their ability to pick the right stocks, because they have backed one that has performed well.
But in the same way that a rising tide lifts all boats, even the rusty ones, many stocks do well in a bull market, even if they're nothing special. So the profit may have more to do with favourable big picture events at the time, such as a strong economy or falling interest rates, than with anything company specific. This really means that the person was lucky rather than skilful.
Be mindful of the old chestnut that 'everyone is a hero in a bull market'. As prices went higher and higher, they increased their investment sizes, so that when the crash came they had far more money at risk than they would have imagined just a year earlier. It ended badly. Profits tempted them in, and losses forced them out.
Listen and read very critically
Keep a critical mind when you read or hear market comments. Ask yourself:
Be a sceptic. Who is the writer? Don't listen to ill-informed, ad hoc, one-eyed, overpaid, inexperienced, sensationalist, untested, uncommitted and uninvolved people!
It is just too difficult sometimes to have a view. A commentator can gain a lot of respect if he actually said, "I don't know.' He could then continue 'because of the following...' and you know you're going to get a balanced answer. It's brave to say ' I don't know'.
- Does the commentator have any track record?
- Are they considering all of the factors?
- If they are pointing to influences which have been present for some time, why should they start moving the market now?
- Are they relying on hindsight?
- Are they hedging their bets?
Be a sceptic. Who is the writer? Don't listen to ill-informed, ad hoc, one-eyed, overpaid, inexperienced, sensationalist, untested, uncommitted and uninvolved people!
It is just too difficult sometimes to have a view. A commentator can gain a lot of respect if he actually said, "I don't know.' He could then continue 'because of the following...' and you know you're going to get a balanced answer. It's brave to say ' I don't know'.
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