Key Lessons Learnt From The Ups And Downs In The Stock Market

Foreword from ShareInvestor

This article “Key Lessons Learnt From The Ups And Downs In The Stock Market” by Luke Foong was first published in the Dec 2009 – Jan 2010 Issue of INVEST magazine and is reproduced in this blog in its entirety. With the regional stock markets ending mixed and the local stock market sheding gains seen earlier in the day to end flat yesterday, read on as the Author shares with you the lessons retail investors ought to glean from the volatile stock markets in face of the varied global macroeconomic developments.

What was your reaction when you came across the news headline in March that said the Straits Times Index had shrank by a whopping 60 per cent from its 2007 peak? Regardless of how composed a person you were, I reckon such a headline would have caused you several sleepless nights. The sense of fear soon turned into amazement as the STI recovered from its March 9 low of 1,456.95 points to reach 2,028.71 points on May 4. Another six months later, on Nov 11, the index closed at 2,740.43 points, which represented a rise of 88 per cent from its March low.

For many of us, it is indeed unbelievable that the market could have experienced such a ‘roller-coaster’ ride over the past few months. In fact, most of us would readily admit that if anyone had boldly predicted in March that the STI would soon embark on an upward surge, we would have dismissed him as a lunatic!

Against the backdrop of market volatility in the past 12 months, what lessons have we learnt? As a retail investor, what are the key considerations we should always bear in mind?

1. It’s Impossible To Time The Market

“The stock market cannot sink any further,” many retail investors claimed at the turn of the year. Hence it came as a shock to them when the markets dived and hit a low in March. During such uncertain times, the valuations of some micro-cap stocks can sink to unbelievably low levels of 1 to 2 times the P/E ratios – despite no imminent dangers of the companies going bust. Those traders who panicked and sold their stocks based on the ‘minimise losses’ mentality would have missed the subsequent rally which would have helped them recoup some of their losses if they had remained in the market.

Similarly, those who had opted to wait for the “real trough” also missed the opportunity to ride the rally as the lower STI that they had hoped for never materialized. Hence, the first lesson learnt is that it is impossible to time the market. Instead, we should have a focused strategy that is based on valuations computation, and that our stock picks should be quality companies with sound fundamentals.

2. Investing Without A Sound Strategy Is Simply Equivalent To Pure Gambling

“Trading/Investing is profitable and easy”. This is the most unscientific yet broadly held belief when markets are having a good time (bull phase). Some retail investors even gave up their full-time salaried jobs and plunged themselves into full-time stock punting, based on an illusion that they can easily earn big money from trading and hence can afford to retire early.

The bearish market since the financial crisis erupted is indeed very cruel and devastating, but it also provided a valuable ‘wakeup call’ for many who held the belief that making money from stock market trading is easy. Retail investors ought to acknowledge that investment, especially trading, is never easy and is not for the faint-hearted. Those who do not spend time doing detailed research and/or analysis could end up paying dearly. In the real world, there are indeed some extraordinary star traders who have mastered a superb level of trading skill sets and trading seems profitable to them, whether in bull or bear markets. But these highly talented people are very small in numbers, and their skill sets and inherent instincts are almost impossible to emulate.

Thus the second lesson learnt is that trading is not for everyone, and investment without a sound strategy is simply equivalent to pure gambling.

3. Never Rely Solely On Experts And Reports

We often hear retail investors grumbling about the confusion caused by the diverse range of opinions in the media telling us where the market is heading. It’s common to find pessimistic, cautious or bearish views as well as optimistic and bullish reports in the same news daily.

Most of us would have turned to the Internet to receive our daily dose of updated financial information and business news from leading websites such as Bloomberg, CNBC and Reuters. As an ordinary investor, we are always turning to experts’ ‘advice’ or views on the direction of the stock markets.

But it isn’t as easy and straight forward as we would have preferred. In recent months, we have heard respectable economists warning of the possibility of double dips and the future anemic pace of global economic growth. During the same period, we have also read of how some successful fund managers see encouraging signs of improvements in the macro-environment which they reckon would benefit the stabilization of the financial markets.

The set of conflicting signals would result in a large group of confused investors who might be afraid to buy more shares as the market surges upward amid warnings of possible market corrections by experts. At the same time, another group of retail investors would be afraid to sell their shares as they do not want to miss out any market rally if the global economic recovery turns out to be strong and sustainable as predicted by the optimists.

For me personally, I would read what these experts have said and remind myself of the possibilities of major downside risks and gain a better understanding of the potential factors behind the current booming asset prices. At the same time, I also understand that the main macro trend now is “coordinated global recovery” that is fully supported by “massive liquidity injections and near ZIRP (zero interest rate policies) by the major economies central bankers”. Thus, retail investors should get neither too pessimistic nor too optimistic; we just have to focus on a sound investment strategy and always remind ourselves never to act rashly simply because of what a ‘renowned’ expert has just said.

4. Never Depend Merely On ‘Luck’ Or ‘Confidence’

Placing all your bets aka the “show-hand” style – this is a very common mistake made by retail investors. It has to do with the psychological mindset of retail investors who often place their bets based on mere beliefs of “luck” and/or “confidence”, thinking that they will always be lucky.

One should always remember what Mr Warren Buffett has suggested as an investment golden rule: Rule 1 – Never lose money; Rule 2 – Never forget rule 1. It’s always a good practice to leave at least 20 to 30 per cent of your available cash on hand as we would never know when the cash is needed for personal and emergency usages.

5. Hedging To Minimise Risks

It is common among many retail investors to hold an investment portfolio that lacks protection from downside risks. The majority of retail investors are long-only equities investors and more often than not, they are not fully aware of how to make use of techniques or certain instruments to hedge their portfolios. I have often heard retail investors blaming the “shortists” (traders who “short” stocks by selling in the market shares that they borrowed, and later buy them back from the market at a lower price, and hence profiting from the price differences) as though the losses they suffered are entirely due purely to “evil, black-hearted” shortists.

As a matter of fact, besides diversifying their stocks’ portfolio, retail investors should learn from their brokers on how to legally borrow shares to take up short positions or use less than 5 per cent of their capital and buy a structured put warrant as a kind of portfolio insurance, as and when they anticipate high downside risks.

Should retail investors deem the above trading executions too risky or find the process too complicated to understand, they may also find out from their brokers or financial advisers how they can buy certain type of short ETFs (Exchange Traded Funds) that are available in the market. Of course, retail investors should always remind themselves that whatever they decide to do to hedge their long-only stocks’ investments, they should only do so provided they fully understand the instruments they’re buying. While proper and carefully structured hedging can help to mimimise losses, it is crucial that the ordinary retail investor seek professional guidance.

6. Trading on a short term basis or investing for the long term? Or both?

A trader who opts to collect his profits within a short period of time or an investor who holds a belief that the underlying investment will, over time, increase in value? This is a topic that is always the subject of debate between pure “market” traders and “business-like” investors. Must an investor be either a trader or an investor?

Based on my observation, an investor who held on to his blue chips even when these stocks are battered down during the first three months of this year would have been as happy today as a trader who opted to collect his profit for a stock whose sharp decline in its share price would have revealed a lack of strong fundamentals supporting the company.

Hence, based on the recent experience of a brutal bearish market and the subsequent ultra-strong market rally, I would suggest that investors should incorporate both “short-term trading” and “long-term investing” techniques into their investment strategy. Again, the key is to have a focused and well-planned investment portfolio.

Conclusion

Some observers have said that equity investing is an art rather than a science. In my personal view, successful investing is based on both art and science since it requires certain skill sets and analytical mindsets. Always remember that it’s better to profit less through well-planned and sound investing strategies than to incur a heavy and irrecoverable loss through reckless stocks punting.