MONEY THOUGHTS: Volatility transfers wealthFebruary 18, 2018 @ 2:05PM
By Rajen Devadason
When is widespread panic a good thing in investments? As I write this, investment market volatility is higher than it has been in a long time. This nerve-wracking rollercoaster ride started in the US stock markets on Feb 2 and spread like wildfire across the world.
The unpredictable zigs and zags have sent the blood pressure of professional speculators sky-high each time it looks like another index freefall is imminent. Unsurprisingly, investment novices have grown twitchy and terrified.
Interestingly though, some more experienced — often older — investors, fund managers and financial planners are adopting an opportunistic and calmer frame of mind for one common reason: They know market shocks always fade away... eventually, yet not permanently; it is in the nature of this beast to intersperse long periods of quiescence with ground-shattering tantrums of unpredictable length.
So, as I write this, there’s no telling whether our current wild ride will end in two weeks, two months, two quarters or two years. I don’t know so I won’t make any predictions.
What I can tell you though, with utter confidence is that: “This too shall pass!” That famous phrase comes down to us through the thick vapours of history from an unknown Persian (Iranian) king.
What we need to know is that protracted periods of extreme volatility result in large wealth transfers from weak hands to strong ones.
Something — let’s label it commonsense — tells me you crave to position yourself amongt those stronger market participants. If I’m right, here are four guidelines you will find useful in strengthening your internal fortitude and boosting your financial strength:
1. Only use your own money to invest, do not trade on margin.
2. Diversify across three dimensions.
3. Always maintain separate liquidity for living expenses.
4. When buying on dips and trimming on surges, always do so in percentage, NOT absolute terms.
1. AVOID TRADING ON MARGIN
Margin trading involves using leveraged or borrowed money to increase the size of a market bet. The practice is driven by greed, plain and simple, because should the leveraged speculation succeed, a lot more profits can be gained than is possible through an unleveraged investment.
But when a leveraged bet goes sour, much more than the original capital can be lost! If you’ve ever seen the faces of impoverished speculators facing massive margin calls turn ashen, you’ll understand why I advocate avoiding margin trades. (I don’t use them, at all.)
It’s safer and wiser to eschew greed and settle for a gradual, more predictable accumulation of wealth through the power of compounding over long periods. Patience truly is a virtue.
2. DIVERSIFY IN TRIPLICATE
Don’t put all your eggs in one basket. In fact, don’t even distribute them across several baskets of the same type. Instead, use three different types of containers, by which I mean scatter your investments across different asset classes and geographic regions, and also across long timelines.
3. SEGMENT YOUR LIQUIDITY
When the economically-savvy use the term liquidity, they aren’t referring to water or some other thirst-quenching beverage. No! Liquidity here pertains to cash.
Cash is one of several (say, three, four or five) important investment asset classes. It’s also one of two savings asset classes, the other being fixed income comprising low-risk bonds. And cash provides the most effective financial cushioning against life’s different species of emergencies, including general, career, medical, surgical, automotive, vacation and household.
4. NIBBLE BASED ON PERCENTAGES
When market dips or nosedives occur, they provide buying opportunities to lower the weighted average price of an investment that we like and might continually wish to accumulate under the right circumstances.
Let’s say you have RM100,000 in investment-related liquidity — apart from your adequately funded separate pools of liquidity for, perhaps, your general EBF (Emergency Buffer Fund), your MBF (Medical Buffer Fund), and your VBF (Vacation Buffer Fund). Then the investment market of your fancy drops 30 per cent in a sudden flash crash!
You could opt to allocate, say, RM20,000 of your investment cash into your now cheaper target investment. Or you could opt to allocate 20 per cent of your existing residual investment liquidity.
At the first averaging down move, both options result in RM20,000 being added to the cheaper asset. But if it falls again, putting in the same absolute sum results in another RM20,000 being deployed. Three more such moves and there won’t be any more liquidity to spare.
In contrast, allocating 20 per cent of residual liquidity each time the asset’s price falls — as long as you truly believe it should recover — results in a shrinking series of additions but an exhaustless reservoir of those additions because each time a 20 per cent allocation is made, 80 per cent of the smaller sum is still available! Always!
So, if the downward slide continues for a much longer time than expected, there will still be a small but exhaustless cash allocation available to buy a great investment that goes into a long slide resulting in very low prices before (hopefully) recovering with a vengeance!
Remember, our goal in investing is to always try to buy low and sell high. So take comfort in knowing that recoveries always occur if the quality of the investment asset remains highly attractive! Therefore, we should rearrange our affairs to position ourselves amongst the winning minority.
© 2018 Rajen Devadason