October 2008

Stop the markets – I want to get off!

This fall has been quite a time. With the stock indexes bouncing like a bungee jumper and the global financial system reeling like a punch-drunk boxer, what’s an ordinary investor to do?

Since mid-September, the Canadian stock market, following the path of its U.S. counterpart, has been subject to wild fluctuations. Take, for instance, the single-day swings of about 8% up on September 19 – and down ten days later... only to be followed by daily declines of over 5% in the first two weeks of October.

The Canadian stock market, like those the world over, seemed to be asking itself where the credit crisis that’s shaking up the global financial system would finally end. A few days ago, the news was more encouraging, with the adoption of a worldwide recovery plan that gave the markets a boost of confidence – for a while, anyway. The S&P/TSX began Tuesday’s trading session with a surge of 14%. Absolutely dizzying.

Not the same?

This isn’t the first time that the North American markets have made our heads spin. Have we already forgotten post-September 11, 2001? The bursting of the tech bubble? The Asian flu of 1997? In fact, since 1945, there have been no fewer than 12 bear markets in North America, with an average price decline of 30%, going by the S&P 500. The current version, with its 44% slump as of October 10, is not the worst of the lot:  in 2000-2002, the S&P 500 lost fully half of its value.

Each of those times, as we know, the markets rallied and rewarded the investors who held on. Even so, this kind of volatility is enough to make people jittery – especially when, this time, the crisis is in the very heart of the financial system:  Wall Street’s entire business model is crumbling and, with it, some of the world’s largest financial institutions. Even some States, such as Iceland, are finding themselves caught short of cash.

In the late 1980s, during another major financial crisis, millions of Americans watched their savings and loan associations go bankrupt – along with the corporation that insured them. It was a painful period, but the banking system came out stronger for it, and the stock markets recovered, too. Given the bailout measures now in place, we can expect the same thing to happen this time. Meanwhile, though, wealthy financiers and small investors alike would do well to learn from this fiasco and to rethink a factor that is at the core of any investment strategy:  risk management.

Wall Street gets reacquainted with risk

Major institutions have sophisticated tools to manage every detail of the risk inherent in their operations, in terms of both investments and credit. So how could they allow this kind of credit crisis to happen – and drive them to the brink of bankruptcy?

It’s because what we’re dealing with is the materialization of something the experts refer to as systemic risk:  the probability – quite small, in principle – that the whole financial system would be paralyzed by cross-commitments that the various institutions are no longer able to honour. In the past few years, financial institutions have introduced credit instruments that are so complex as to be opaque, even for the most advanced risk management tools. By doing this, they lost sight of the fact that these instruments were all riding on a single vector – the artificial growth of U.S. consumer spending – and they themselves were increasing this risk.

By the time anyone realized what was happening, the dominoes were already beginning to fall. There was no longer the time or the means to regain control. The crisis promptly spilled over into the stock markets and is bound to impact the “real” economy:  growth, jobs, consumer prices…

Better management of your own risk

Here’s something to make the average investor think:  if the biggest of the big can make that kind of mistake, what about us? Have we correctly evaluated the risk inherent in our own finances?

This is certainly not the time to start questioning your own portfolio if it has been well put together in the first place. But I think that the crisis offers a good time to sit down, as we do regularly, and discuss the question of risk. To start with, we can review five key principles.

  • There is no risk-free investment.

Even “safe” investments, such as bonds, present certain risks:

    • they can make us poorer if the yield is eroded by inflation and taxes;
    • they can leave us with too little money to finance our plans or retirement;
    • they expose us to the risk, limited as it may be in the case of high-quality securities, that the institution will not be able to pay out our money when the time comes.
  • Risk is not just volatility.
    There is also the risk that volatility will strike just when you need to draw on your portfolio. And the risk of your portfolio being overexposed to the specific sectors affected at that time. People who retired last year are now becoming painfully aware of this factor.
Change in the Toronto Stock Exchange composite index and subindexes
As at October 10, 2008
 1 year5 years
Information Technologies-43%-19%
Consumer Staples-28%-14%
Consumer Discretionary-41%-10%
Health Care-40%-60%
Real Estate-40%+6%
Natural Resources-36%+65%
S&P/TSX Composite-37%+17%

Source:  Yahoo Finance

  • Diversification is the best protection.
    In the past three months, the S&P/TSX index recorded a 33% loss, while the Canadian balanced fund index dropped only 17%. Times of crisis tend to demonstrate just how important it is not to put all your eggs in one basket.
  • Managing risk takes a cool head.
    The financial markets eat emotional investors for breakfast. Studies have shown that investors who jump in and out of the market impulsively miss out on nearly 70% of the returns over 25 years. That’s because market growth isn’t linear:  if you happen to be “out” during the few days when the markets make their strongest gains, you will never realize the bulk of their growth.
  • Risk goes beyond investment.

Nothing is entirely safe from the domino effect. Consider someone who works in the natural resource sector, whose house is heavily mortgaged but appreciating rapidly, who holds stock through an employee stock purchase plan, and who has an RRSP invested in Canadian funds heavily weighted in... natural resources. If the economy happened to slow down significantly and the resource sector suffered as a result, this person would suddenly find his or her job, mortgage, house, and retirement savings at risk. That’s why appropriate risk management has to look at every facet of the personal situation that could represent a risk:

    • savings
    • investments
    • loans
    • job
    • health
    • etc.
What risk management comes right down to is asking the question what if? What if you’re mistaken? What if everything suddenly goes south? Of course, you can’t expect to have a Plan B ready for every possible situation. But good risk management should help you to side-step the principal risks associated with your financial situation.