You can never really understand investing until you weather a market downturn.
by Stephanie Powers,
14:44, Tuesday 23 August 2011
The valuable lessons learned can help you through the bad times and can be applied to your portfolio when the economy recovers. Listed below are some common investor experiences during tough economic times and the lessons each investor can come away with after surviving the events.
Lesson 1 Evaluate your egg baskets:
If you're pulling your hair out because everything you invest in goes down, then the lesson you need is: Always keep a diversified portfolio, regardless of current market conditions.
If everything you own is moving in the same direction, at the same rate, your portfolio is probably not well diversified, and you could stand to reconsider your asset-allocation choices. The specific assets in your portfolio will depend on your objectives and risk-tolerance level, but you should always include multiple types of investments.
Taking a more conservative stance to preserve capital should mean changing the percentages of holdings from aggressive, risky stocks to more conservative holdings, not moving everything to a single investment type. For example, increasing bonds and decreasing stocks in small-companies maintains diversification, whereas liquidating everything and putting it in a cash account does not. Under normal market conditions, a diversified portfolio reduces big swings in performance over time.
Lesson 2: No such thing as a sure thing
If that stock you thought was a sure thing just tanked, then the lesson is: Sometimes the unpredictable happens. It happens to the best analysts, the best fund managers, the best advisers, and, it can happen to you.
The perfect chart interpretation, fundamental analysis, or tarot card reading won't predict every possible incident that can impact your investments.
• Use due diligence to mitigate risk as much as possible.
• Review quarterly and annual reports for clues on risks to the company's business as well as its responses to the risks.
• You can also glean industry weaknesses from current events and industry associations.
More often, an investment is impacted by a combination of events. Don't kick yourself over unpredictable or extraordinary events like supply-chain failures, mergers, lawsuits, product recalls, etc.
Lesson 3: Proper risk management
You thought an investment was risk-free, but it wasn't. The is lesson: Every investment has some type of risk.
You can attempt to measure the risk and try to offset it, but you must acknowledge that risk is inherent in each trade. Evaluate your willingness to take each risk.
Lesson 4: Liquidity matters
If you always stay fully invested, so you miss out on opportunities requiring accessible cash, then the lesson is: Having cash in an ISA (equity ISAs let you hold cash in them and money in cash ISAs can be transferred into shares while keeping hold of it's tax-free status) or spare money in your trading account lets you to take advantage of high-quality investments at fire sale prices. It also decreases overall portfolio risk.
Plan ahead to replenish cash accounts. For example, use the proceeds from a called bond to invest in the money market instead of purchasing a new bond. Sometimes cash can be obtained by reorganising debt or trimming discretionary spending. Set a specific percentage of your overall portfolio to hold in cash.
Lesson 5: Patience
If your account balance is lower than it was last quarter, so you overhaul your investment strategy before taking advantage of your current investments, then the lesson is: Sometimes it takes the market an extended period of time to bounce back.
Your overall portfolio balance on a given date is not as important as the direction it is trending and expected returns for the future. The key is preparedness for the impending market upturn based on an estimated lag time behind market indicators. Evaluate your strategy, but remember that sometimes patience is the solution.
Lesson 6: Be your own adviser
If the market news is getting bleaker every day and you're paralysed with fear, then the lesson is: Market news has to be interpreted relative to your situation.
Sometimes investors overreact, particularly with large or popular stocks, because bad news is replayed continuously by every news source going. Here are some steps you can follow to help you keep your head in the face of bad news:
• Pay attention and understand the news, then analyse the financials yourself.
• Determine if the information represents a significant downward financial trend, a major negative shift in a company's business, or just a temporary blip.
• Listen for cues the company may be downgrading its own expected returns. Find out if the downgrade is for one quarter, one year or if it is so abstract you can't tell.
• Conduct an industry analysis of the company's competitors.
After a thorough evaluation, you can decide if your portfolio needs a change.
Lesson 7: When to sell and when to hold
If the market indicators don't seem to have a silver lining, then the lesson is: Know when to sell existing positions and when to hold on.
Don't be afraid to cut your losses. If the current value of your portfolio is less than you paid and showing signs of dropping further, consider taking some losses now.
Selective selling can produce cash needed to buy investments with better earnings potential. On the other hand, maintain investments with solid financials that are experiencing price corrections based on expected price-earnings ratios. Make decisions on each investment, but don't forget to evaluate your overall asset allocation.
The bottom line
Downward stock market swings are inevitable. The better-prepared you are to deal with them, the better your portfolio will handle them. You may have already learned some of these lessons the hard way, but if not, take the time to learn from others' mistakes before they become yours.