Investment tips: Avoiding big losses in a volatile market

The Jakarta Post ,  Jakarta   |  Thu, 08/30/2007 1:55 PM  |  Business

John D. Item, Analyst

The recent equity market turmoil triggered by the subprime crisis in the U.S. has 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.

The recent sell-off in the U.S. equity market due to subprime lending fear brought down the Jakarta Stock Index (JCI) by more than 10 percent 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 has helped calm global markets somewhat.

However, most market experts predict the market will remain volatile in the short term, since 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 to ride out this volatile market.

The first strategy is for those who believe that the current turmoil is a normal function of the market, an inevitable market correction. Because of this, market conditions should soon return to normal (as was the case from 2004 to 2006).

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 costs nothing and is 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 could head down further, deepening your losses.

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, ensuring that your portfolio will grow, albeit slowly.

But, as a wise man once said, nothing comes for free. The safety of money market instruments carries with it lower potential returns. 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 -- a difference of around 480 percent (see chart). It's a difference that simply cannot be ignored.

Reducing the equity portion of your portfolio to balance it out is another option to consider. For investors in equity mutual funds, 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 are at the same time fearful of missing out on a rally in the equity market. Thus, through a balanced allocation of funds, portfolio volatility can be reduced while an upside potential exists in the event of a market recovery. Nonetheless, the upside potential is not as much as if you had chosen to do nothing. Rather, your compensation comes in the form of lower risk.

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 true value. In the long run, this type of investor reasons that stock prices will eventually reflect their intrinsic (true) value. Buying stocks at significant discounts on their true value should provide investors with a margin of safety, providing an ample cushion if things go wrong. Hence, some contend that such a strategy is a great way of making good profits with low risk.

Also, if you add new investments at lower market prices then your average investment costs will fall, assuming that you are already investing 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 a downside. First, the market might continue to fall and could take a very long time to recover. 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. Adding to an already losing position also has its risks. If the market continues to fall, then the losses will be greater than if you had not increased your position.

Frequently switching your assets from equity to bonds to the 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.

As can be seen, there is no single best strategy. The most important thing is choosing one you feel comfortable with in terms of your preference for risk and the kind of returns you are expecting. Make sure you understand the pros and cons of the strategy you have chosen, buckle up -- and enjoy the ride. (The writer is the head of Asset Managent of Danarekas Investment Management)

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