Jan 23, 2016

3 Types of Market Situations You Should Cut Your Investment Losses




Your investment portfolio has lost 10%.

You are worried that it may lose another 40%, but on the other hand, it may rebound back in a couple of weeks time. So should you cut loss on your investment or not?

The recent market concerns about the state of the China's Economy and Oil prices have caused some of the stock markets around the world lapsing into a Bear market since the high reached in May 2015. Many of the markets are located in the Asia Pacific including Singapore, Japan, China and Hong Kong. The definition of a Bear market is a market decline of more than 20%.

For many of my readers who are exposed to Asian equities, there has been many queries on whether they should cut loss on the current crash or not given that I have been quite pessimistic about  the Asian economy for the past few years. There has been many crashes and corrections in the past few years and many a times, the rebound from the bottom is a V shape rebounding catching most investors off guard after they have exited from the position.
One of the key lessons I have learn from major crashes similar to this one, is that cutting loss when the crisis is in progress will result in the portfolio being worse off than doing nothing about it. The reason why is because the rebound from the bottom is often very sharp and fast, often contributing 30-50% of the rally. However, there is also a concern about a prolonged crash like the Financial crisis of 2008 whereby losing 10% is better than losing 50% of the portfolio value and cutting loss is probably the best strategy to embark on. At the end of the day, investors will have to make a call: Cut loss or not to cut loss!

As a portfolio manager of many years, I have come to observe certain similarities between a prolonged crash or a short lived correction. In order to decide on whether to cut or not to cut, an investor must first analysis the root of the crash. 


Criteria for Cutting Loss


 So under what circumstances should we cut loss when a crash is on-going? This depends on the cause of the crash. If the crash is due to a leveraged asset, such as property, derivatives or a debt leaden major economy which will have a magnified effect due to leverage, that is when we will cut loss as these kind of crisis typically will take years to resolve. Here are the 3 Market situation you should always cut loss on your investment should you get caught in the initial stages of the fall.


1) Property Market Crash

Property is one more the most leveraged financial instrument with the majority of the property investors taking a huge loan on the property. Property also amounts to a bigger proportion in most individual's net worth. The worst recessions in the history of financial markets are related to property.

2) Derivatives and Debt Implosion

Derivatives and debt are instrument of leverage which will magnify both profits and losses. In this context, countries or entire industries which employ lots of debt and derivatives for their daily businesses will result in bankruptcy and liquidation which will take years to clean out from the balance sheets.

3) Super Bubbles

Super bubbles can occur in any asset classes, ranging from tulips to technology companies. This happens when investors pours money into unsustainable businesses resulting in sky high valuation with obscene PE ratios.  

Take for example, the recent market crash:  

China Stock Market Crash (Again)

The sell-off started is due to the blunder of the China's stock regulator in resulting in another crash in the Chinese stock market. The average participation of the Chinese stock market is still low among the retail investors with only 10-15% of their wealth invested into the stock market. The stock market has also a huge delink from the actual fundamentals of the companies behind the stock and so the Chinese stock market should be considered as a casino with little indication of the actual health of the Chinese economy. I will consider this event as a short term correction event and as an indication of how Chinese investors will behave in a market crash scenario which will be useful for other potentially more exposed and risky investment instruments in the Chinese investment ecology.

Oil prices
Think about it: For oil price to fall from $100 to $30 within a year, supply of oil must either have expanded by 200% or demand must have shrank by 70%, which are both unreasonable explanations for the fall in Oil prices. The reason behind the depressed oil prices are more attributed to speculation rather than fundamental reason which will correct itself in due time when the speculators lift their brakes off the accelerator. I will be more concerned should the reason for the crash is the popping of the property sector in China or the bankruptcy of a major economy like Russia. Low oil prices are good for consumers in general, especially in US, Europe and India and works more like a stimulant to the economy as people will have more to spend.

In the current situation, maintaining the current portfolio and riding through the crash is the best course of action for now as most of the market movement is caused by 70% market speculation and 30% market fundamental.


However, should the situation deteriorates to a level whereby countries and companies are declaring bankruptcy on a large scale like Lehman Brother, or the property market in China starts to fall rapidly, you should cut loss immediately. 

In short, understanding the macro economics environment and the underlying fundamental reasons for the crash is one of the essential knowledge for any good investor who is maintaining a long term portfolio. Learning how to identify the potential severity from one crash to another will allow you to make a better decision on whether to cut your losses or maintain your position should you be caught in another market crash.  



4 comments:

  1. Replies
    1. Thanks! Seems like my analysis for this crash has been pretty much spot on for now. The market has recovered mostly from the Jan crash. Let's pray that the trend continues.

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