Riding Out The Volatile Market

This was an article on Jakarta Post – August 30, 2007 edition, or about a month ago, printed under a slightly different title (edited by the newspaper editor, though I like the above title better).

Riding Out The Volatile Market

The recent equity market turmoil triggered by problems in the U.S. sub-prime lending activities saddled many investors with either substantial losses or much reduced investment profits. In the midst of great market uncertainty, knowing what to do next with your equity investment portfolio can be critical to its health.

 

Recently, the sell-off in the U.S. equity market due to fear of sub-prime lending problems brought down the Jakarta stock index (JCI) by more than 10% from its peak in July. Action by the U.S. Federal reserve to lower the discount rate and pump liquidity into the U.S. system helped calm global markets somewhat. However, most market experts predict that for the near term, the market will remain volatile, as the severity of the real estate problems in the U.S. are still largely unknown.

 

Faced with such a prospect, investors need to be wary. Let’s take a look at some of the strategies that investors should consider adopting in a bid to ride out this volatile market.

 

Do Nothing

This strategy is for those who believe that the current turmoil is a normal function of the market, and therefore, that such a market correction is normal and inevitable. Because of this, the market conditions should soon return to normal (as was the case from 2004 to 2006). Likewise, the market in 2007 will likely exhibit the same ‘crash then recovery’ pattern.

 

Well, if this is your view of the equity market, then leaving your portfolio intact is the best course of action. The beauty of this strategy is that it’s costless and free of market timing errors. And eventually, your portfolio will fully recover its previous losses. The danger of this strategy is, of course, that the market shall head down further, further deepening your losses.

 

Switching to the Money Market

If you believe that the equity market will continue to go lower, then switching your equity portfolio to money market instruments like time deposits or money market mutual funds might be your best choice of action as this strategy ensures that your portfolio will grow, albeit slowly.

 

But, as a wise man once said, nothing comes for free. The safety in money market instruments carries with it a lower return potential. And you may forego huge gains if you simply keep your money parked in money market instruments. The differential on returns between equity funds and money market funds over the past five years was huge, about 480% difference. A huge difference that simply cannot be ignored.

Balanced Funds or Portfolio

Reducing the equity portion such that your portfolio is more balanced is another option to consider. For equity mutual funds investors, using this strategy means switching your equity funds portfolio into balanced mutual funds. This strategy may be suitable for equity investors who are bothered by the current high volatility of the market, yet, at the same time, are fearful of missing out on a rally in the equity market. Thus, through a balanced allocation of funds, portfolio volatility will be reduced while upside potential exists in the event that the market recovers. Nonetheless, the upside potential is not as much as if you had chosen to do nothing of course – although this is compensated for by lower risk.

 

Bargain Hunting

Long-term value-oriented investors such as Warren Buffet love market crashes or market turbulence since these kinds of events provide them with ample opportunities to pick up stocks at bargain prices, and sometimes even far below their intrinsic values. In the long run, this type of investor reasons that stock prices will eventually reflect their intrinsic value (true worth). Buying stocks at significant discounts to their intrinsic values should provide investors with a margin of safety, providing an ample cushion if things go wrong. Hence, such a strategy is a great way to make good profits with low risk, they contend.

 

Also, if you add new investments at lower market prices then your average investment costs will fall – assuming that you are already invested to begin with. As such, the market doesn’t have to revert to its previous level for you to recoup all of your previous losses caused by the market slide. This increases your chances of pushing up your portfolio to its previous value.

 

However, there is some downside. First, the market might continue to fall and could take a very long time to recover its losses. For investors with a long-term horizon, this might not be a problem. But for short-term investment, this strategy might not be appropriate. Second, it is not easy to choose the right stock. What seems to be a bargain stock might actually turn out to be a poorly performing stock. Also, adding to an already losing position has its risks. If the market continues to fall, then the losses will be greater than if you had not increased your position.

 

Active Switching

Frequently switching your assets from equity to bonds to money market or vice versa, in line with market movements may look like an attractive strategy. But it’s best to avoid this strategy since the active switching strategy carries significant transaction costs and market timing risks.

Pick The Most Suitable Strategy

As can be seen, there is no single best strategy. The most important thing is choose one you feel comfortable with in terms of risk preference and return objective. Also, make sure you understand the pros and cons of the strategy you have chosen. So buckle up and enjoy the ride!

 

 

John D. Item, CFA

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One Response

  1. Re-adjust the portfolio and then.. enjoy the ride 🙂

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