Thursday, July 19, 2007

Approach to Market Risks

From Pacific Capital Associates.

It is often noted that in the long-run, stocks are the best asset to own. It has also been noted that “in the long-run we are all dead.” So the question becomes how long an investor must wait for that attractive long-term performance to be realized. If one is not careful, it could be a long time.

For an understanding of why this is, consider the following table which shows that at least one serious stock market correction has occurred in every 10 year period since the 1920s:
Source: Investech Research

Consider also that many investors ride down the bulk of these vicious declines only to sell near the lows because they can’t stand the idea of losing any more. Next, many investors miss the ensuing rally and then feel that their hands are tied because they have missed the rally and it’s too late to buy back in. This pattern has been repeated time and again and explains how many studies have shown that the typical investor greatly underperforms the average market returns over time.

It is easy to understand this typical investor behavior, but we must know that it will not achieve satisfactory and timely results. Investing genius Warren Buffet famously wrote, “ be fearful when others are greedy and to be greedy only when others are fearful." This is easier said than done. When it seems like everyone else is throwing caution to the wind and driving prices ever higher, it is frustrating not to be fully invested. Such an approach requires patience and discipline. One must be willing to give up potential gains by reducing market exposure during times when the markets are rising. Similarly, it requires the fortitude to invest when markets are going down and others believe that there is little hope. We believe that an investment approach based upon such discipline has a greater chance of minimizing the downside and maximizing the upside of our investments over time.

When risky market conditions prevail, it’s more important than ever to pay attention to major economic trends, to be diligent about seeking investments with strong long-term fundamentals, and above all to stay cautious. It seems like common sense to state that the top of the market is the worst time to be fully invested, but that topping moment is the point at which the most people have bought in and are most optimistic and least concerned with risk. Of course it is also the point at which the next moves are down. Interestingly, as the top nears, there are always analysts explaining why such price increases are justified, but we find that their reasons have a lot more to do with hype and wishful thinking as to why “it is different this time” than they do with the fundamentals.

At this point we will continue to look for investment opportunities in specific areas of the US market as well as areas outside the US market. After experiencing very favorable returns over the last 4 years, at this point, if the market continues to make gains, we will have to be content with a comparatively smaller return. However, we suspect that any market gains beyond this point will most likely be given back during the next downside correction. As long-term investors, that’s not the kind of gain we’re interested in.

When the next downturn is upon us, we will stay focused on this additional bit of wisdom from Warren Buffett: "Fear is the foe of the faddist, but the friend of the fundamentalist." In other words, market corrections and environments of fear and risk-aversion are devastating to trend-chasing speculators, but to long-term fundamental investors they need not be so harmful. The best approach is to minimize exposure to such downturns, to endure them, and to be ready to capitalize on them as they pave the way for better risk-adjusted opportunities ahead.

During times such as these, our strategy is to be disciplined and to focus on the time-tested measures of value, risk, and reward. The “father of value investing” Benjamin Graham famously wrote, "In the short run, the market is a voting machine but in the long run, it is a weighing machine." This is to say that on a shorter term basis, the popular stocks or sectors can rule the day, but over a longer term, it is the stocks that are supported by sound fundamentals that provide the best results. We agree


el bbub said...

Good post!
very inspiring, hehe.

Blowup risks on canadian banks.

There's also a US risk chart.
What do you think?

mohican said...

el bbub - that chart of big US banks is freakin' crazy. I don't even know what to say - just nuts. According to the poster - JP Morgan Chase has $59 Trillion in Notional OTC Derivatives.

solipsist said...

Another great post. Thanks.

and thanks for the link el bubb.

As I was reading it, and looking at "my" bank, I was wondering about splitting up my nut, because I was wondering at CDIC's backing. I don't think that the guvmint could cover everyone's deposits. Then I read the comment below:

Disaster when these guys go under. Glad that everything is PhDIC insured. BTW who insures the PhDIC ?

Then again, with a negative savings rate environment, there won't be much to cover in the event of bank collapses.

mohican said...

solopsist - that poster was referring to the FDIC in the USA and not the CDIC in Canada. The risk in the US is contained within the OTC derivatives market which is obscene.

Your 'nut' is protected by CDIC in the event of bank failure up to $100,000. Check it out here . In the event of a 'major bank' failure we would have more problems than just whether or not we are insured. Smaller institutions have and will go under from time to time.

I am not naive to the risk that exists in the system though. The future profits of the banks are very much at risk in the coming years if these OTC derivatives unwind in an unforeseen manner.

Some banks seem to take on too much risk from time to time.

See - here , here , here , and here .

solipsist said...

Thanks mohican. I did understand that the writer was referring to the American FDIC. It just made me wonder about our CDIC - as I have before.

You are very right about bigger problems if the big 5 start going belly up, and I was wondering how distinct that possibility is after reading your piece (or a link from one of your pieces) about Quebecor and the bond market, etc.

solipsist said...

I scanned your links above, and that is what concerns me(though maybe I am seeing mountains where only molehills exist).

I liked the one line in the 4th link that talked about all the derivitives (?) being "AAA", but recall reading (somewhere here, or a link) about how tranches work, and that there are tranches rated "AAA" of tranches rated "A".

It seems like a lot of smoke and mirrors to me.

z said...

Great Post (mostly because it panders to the what I believe in) :-)

Lately I have had more concerns about the way my portfolio was structured and how it would be impacted should a recession occur in the states. Very recently I restructured based on a book "Crash Proof" (PETER D. SCHIFF) which made a lot of valid arguments for a downturn in the (US) economy, and made a lot of interesting points for investing in Canada (yay).

Just wondering if anyone else out there had a chance to look at it yet, and how safe they think hiding out in Australian/Canadian mining markets is till it all blows over?

beta said...

"be fearful when others are greedy and be greedy only when others are fearful"

Probably the most misapplied quote in the history of investing, used by every loser with a dime to buy crap on the way down and imagine they're like Buffet while doing so.

digi said...

So how does one spot true value? The fear/measure sounds great in principal, but how can you judge the timing right? For example: builder and lender stocks are chopped down across the US as they look at more fallout from the housing bubble. Nobody wants to touch these stocks, does that mean its the right time to buy?

Deliverator said...

So how does one spot true value? The fear/measure sounds great in principal, but how can you judge the timing right? For example: builder and lender stocks are chopped down across the US as they look at more fallout from the housing bubble. Nobody wants to touch these stocks, does that mean its the right time to buy?

Digi, I am by no means a master investor, but IMHO, no. The fundamentals simply do not back up such a move. The homebuilding pie is still shrinking in the US. I think Buffet-alike would start buying the builders if a housing turnaround started that wasn't being reflected in the valuations of the builders because people still thought housing was a 'bad investment'.

Rereader said...

Mohican, why don't you advertise financial planning on your blog

mohican said...

beta and digi - very observant comments - I do agree that much of what Warren Buffett has said has been misapplied. In order to actually invest like Warren Buffett, you need to do research like him and he does an immense amount of research before making a purchase decision. He never uses what the 'market' feels about a sector or stock to help him decide on what to purchase and that is where most of his quotes come from. The actual investing strategy is grounded in some pretty rigourous financial metrics: balance sheet analysis, P/E ratio, P/B ratio, Return on Equity, etc, etc. To rely only on his quotable quotes to make investment decisions is pretty faulty.

rereader - I don't choose what gets advertised on the blog - it is all auto-content based from google's or amazon's algorithms - I suppose I could customize it more but I just don't really care that much.

patriotz said...

It just made me wonder about our CDIC - as I have before.

Rest assured, the feds will do whatever it takes to back up CDIC, up to and including the BoC printing enough money to honour all insured deposits.

CDIC-insured deposits are really a very small slice of the financial universe in Canada. It's just mom-and-pop stuff. The real money is elsewhere.

The real fracas for bank failures would be the non-insured depositors asking for a bail-out. They got it when Northland and CCIB (Alberta-based) failed in the 1980's. When BCC (Band of Crooks and Criminals) failed in the 1990's, I think they didn't.

Warren said...

Hmm, I'm glad BNS is my only big bank holding (stock).

On the investing front, digi I think you're on the right track with homebuilders, but again fundamentals still have to come in to line.

Rather than investing in them when nobody wants to, think about it when nobody else is thinking about it. For example, in 2 years, when RE is still flat/wallowing and nobody is talking about it, these blogs are long gone.. then buy.