Tuesday, January 13, 2009

Don't Panic in the Midst of a Market Crash!

New investors often panic during the midst of a market crash. Suddenly you see your holdings fall drastically and you see that the hard earned money you have put into that sure-win investment evaporating. In those circumstances, there is a very strong urge to do something, anything, just so that you do not feel so helpless.

Thus, one of the biggest mistakes investors often make when the market crashes in to be emotionally driven to take wrong actions on their investments. Of course, there are different situations for every market crash. Some could be the start of a longer and overdue decline (remember the bursting of the Nasdaq bubble?), while others are just temporary and stocks would soon bounce back in time. But the key thing to remember is not to let panic take over.
Investors might do 4 possible things when they are faced with news that the market has just crashed. They might:
  1. sell off their investments,
  2. switch to other investments,
  3. hold on and just watch, or
  4. buy in further!

There is no absolutely correct decision, but we would discuss each of these responses to see when it is a good or bad time to perform them.

The first option, which many new investors are guilty of during a market crash, is to sell off everything. "I have lost 30% of my investments in a month! If this keeps up, I would lose all of it in two more month's time!" Scary as this thought is, it is as likely to happen as it is to snow in Malaysia! If you have thought long and hard before you bought your fund, and you have a reasonably diversified portfolio, you would know this cannot possibly happen. Even during some of the worst market crashes, markets never ever lost all their money. For that to happen, every single stock held by the fund manager must simultaneously go bankrupt!

Very often, by the time you read in the newspapers or hear that the market has plunged overnight, the crash has already happened. Only major crashes make the newspapers and headlines. So, by the time you make the decision to sell off everything, the markets are already down on account of whatever bad news resulted in the crash. When you look at the charts of market indices in hindsight, you often ask "if I could have bought into this market at the very bottom, I would have made so much money in 2 years!" However, if you have lived through those times invested in those markets, you would have realized that it is precisely then, when markets hit bottom, that most investors are selling off all their holdings. So, while selling off everything is the most common choice, it is also usually the worst option!

The only time when it might be a good choice to sell off your investments was if you had cleverly invested in a huge bull market and was riding the market all the way to the top! So, once you have crested it, and there is a market crash, it may signal the end of the huge bull run you have just experienced. In which case, getting out would actually be a smart move. However, this is not an easy thing to do as very often, in such circumstances, you would have been sitting on hefty profits and are wondering whether this is just a temporary dip before the market continues upwards again!

The second choice can also be dangerous and that is to switch to other investments. This is because you are effectively selling out from the current market you are invested in and moving to other investments, whether they are bond funds or other safer markets. In such situations, the urge would be strong to move to less risky pastures like bond funds, capital guaranteed funds and money market funds. But as we have stressed earlier, this is similar to selling out everything and holding cash because the underlying push is still to stop losing money based on something that has already happened! So, again, emotions might be causing a bad decision.

The third choice, which we suggest all investors do, at least at first, is to take a deep breath and hold on. Do so for 1 or 2 days. Like we said just now, with a well diversified portfolio, you can wait that one or two days until you sort out what is happening and calm yourself. While there is the strong urge to take action now, there is also a high possibility that you would be acting emotionally if you acted now! So, the best thing is to take one step back, clam yourself down, and think through everything rationally before you do anything at all! In a few days, everything might look overdone! (Market crashes very often are overdone as investors panic and drive markets lower than they should be!).

Note also that being calm and rational does not mean you sit back and start counting all the reason why you should sell off all your holdings! You should be asking questions like

"Why did I buy into this investment, are the reasons and factors still there?"

"Is this a temporary reaction from investors because of one event which would soon blow over?"

"If I did not have any investments, and had just cash instead, would I be looking to buy this investment because it is now cheap or would I be looking in some other place?"

These are the questions you should be asking yourself. What you should not be asking yourself is whether you need the money or how long you can afford to hold out before you must cash in your losses! These questions will only drive you to sell your holdings blindly. Whether or not you can afford the losses and how long you are prepared to hold the investments are questions you should be asking yourself before you buy any investment, not after you have already bought it!

Even if you do come to a decision to sell your holdings after calm and rational thought because good of and valid reasons, waiting can have its benefits. The markets usually calm themselves after a few days and there is a strong possibility or a slight rebound no matter how terrible the crash. As we saw in the month of October, and in November as well, many markets swung wildly, some within a single trading day as investors grappled with bad news from the ongoing US financial crisis. Just as markets could crash 5 to 8% within a day, they would go back up 8 to 10% the following day again.

The last choice, which is buy even more, is a brave one. Oddly enough, it often tends to be the best in hindsight. It is also the most difficult to do because your mind is screaming for you to sell! Of course, this also varies from situation to situation and some crashes have heralded a longer term decline. But generally, in most circumstances, markets are resilient and bounce back again from their crashes. Let's take a look at table 1.

Table 1

Source: Bloomberg, MSCI, all performance figures are in USD.

Table 1 shows all of the single negative years for the S&P 500 index (an index that is often used as a broad indicator of the US stock market) since the year 1929. And we include the Great depression in this analysis as well. In total, there were 26 years which were negative years, some, like in 1931 during the great depression, was were the index was down 47.1%. Since some of these were too mild to be considered a crash, we set a benchmark of down 20%. So, we look only at the years in which the market crashed by at least 20% or more within one single year. (Note that the US market has crashed 41.7% so far this year as at 25th Nov 08). When we look at only the 20% crashes, we note that there are only 5 of them.

For 3 out of 5 of these great crashes, the 1 year period following these crashes would be a positive one. In other words, there was a 60% chance after such a "crash" year that the following year would be a good one. If we extended this period to 3 years after the "crash" year, the percentage went up to 80%. The percentage fell back to 60% for a 5 year period. And we note that this long period covers all sorts of crisis from the great depression, to world war 2, to the 1st and 2nd oil shocks in the seventies. Indeed, during the great depression, in a year when the S&P 500 index crashed 47% in 1931, the index was up 111% five years later.

Thus, as we have shown. Statistically and historically, the decision to buy in more after a particularly terrible year may often, in hindsight be the best, but it is certainly one of the most difficult option to take.In conclusion, there is a strong urge for investors to panic and do something during a market crash. However, this is almost entirely emotionally driven. So, we advise that investors would often be better served holding on to their investments instead. In the aftermath of the crash, after things have settled down, the situation would then no longer look so dire. Things have crashed so much over the last two months that in many markets, all fundamentals are being ignored now. Stocks trading at a 2 times price to earnings ratio and 0.5 times price to book ratio are still rated a sell. Many Asian markets are trading at below ten times PE ratio and still the panic is present.

As we mentioned before, ask some of those hard questions and don't panic during a market crash! If the factors on why you bought the investment still stands, then all the more reason to hold on to those investments. This discipline and rational thinking will tide you over difficult volatile periods and serve most, in the long run, to make better returns for such investors.

Source : http://www.fundsupermart.com.my/main/research/viewHTML.tpl?articleNo=143

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