How to Weather the Financial Storm

With all the emails yesterday about the Lehman Brothers collapse, the acquisition of Merrill Lynch by the Bank of America and the US Federal Reverse and Treasury’s overnight emergency resuscitation of the American International Group (AIG) with an $85 Billion USD breath of air – I thought I would put up a post about some of the best ways to get through the current financial mess. No doubt your portfolio has already taken a big hit over the last 11 months, not to mention the fact that your superannuation is going to force you to work another couple of years and your tolerance for risk has just about dried up.

So how to get through ?

1) In my opinion, the first way to get through is to start liquefying any relevant risky financial positions and cease entering ‘quick money’ arrangements which carry high risk. At the very least, a substantial reduction in these types of instruments will ensure that you are not hammered by adverse market movements. For the average portfolio holder – it’s all about reducing the risk and exposure. This may also mean closing down any positions where you have the thought that the stock ‘may go up, but will more than likely go down’. If the probability of ‘down’ is greater, in your opinion, than the probability of ‘up’ and the financial loss is not enormous – then it makes no sense to hold these so called ‘fence sitter’ positions in the current market. You are either going to lose massively, or gain a little – think sensibly and not greedily. A small loss is much better than a huge one.

2) Avoid any relevant exposure to the counter party risk that is reeking havoc to basically every major investment bank at the moment. You see this is where the biggest problem has been for all the US financials. Basically, all the major investment banks have engaged in credit default swaps which allow a buyer or ‘fixed rate’ party to make periodic payments to a ‘floating rate’ party in exchange for the ‘right’ to a payoff if there is a default or credit event in respect to a third party – called the reference entity. Simplistically, the lower the credit rating of a contracting party the greater the risk that the third party reference entity will default on its payments and this increases the cost of the credit swap.

Of course, because of the huge mortgage problem in the US at the moment – this has meant that the counterparty risk associated with these instruments has gone through the roof as contracting parties are defaulting on their obligations which has basically engulfed a lot of companies - American International Group (AIG) most prominently. The reason they have taken such a massive hit is because they offer insurance to the financial markets on so called ‘non-risky financial instruments’ such as ‘credit defaults swaps’. Of course, traditionally these instruments have never really been in the ‘high risk’ category – hence the reason AIG insured them – but in the current United States financial market where the securitisation industry is getting pummelled in every direction and the underlying price of houses are next to nothing – these instruments are now obviously, high risk. Do some research, don’t invest in companies who haven’t stated their entire position to the market yet or who ‘may be’ even the slightest bit exposed to credit swaps with contracting parties who are considered high risk.

3) Diversification should always be a part of any good portfolio position and if you portfolio isn’t diversified chances are you are either holidaying in Hawaii off your recent profits, or needing to buy another case of wine to calm the nerves from the losses you have sustained. In a market like this, it’s the turbulence that makes it very difficult to try and find good investments. I tend to argue that good performers over the last 2 years, will be good performers in the next 2 years assuming they can weather the financial storm. Most recent stock losses primarily relate to two things – the first being plan old market panic, and the second being a big sell off of any company remotely connected to ‘mortgages’ or ‘securities’. Does this make sense? Yes and no (I’m not going to go off down this road for this post). Most importantly, think sensibly and rationally – all the major financials in Australia will recover because regulators don’t give them a choice. More so, interest rates will fall – this is really inevitable otherwise the economy will come to a roaring halt which the RBA won’t let happen – so once again banks etc will be able to lock in profits from a reduction in funding costs and their share prices will rise in correlation with these interest rate reductions. Remember to look at any relevant dividend payments and focus on the underlying growth of businesses which you are analysing and/or looking to invest in.

4) For traders, please ensure that you ALWAYS use stop losses. No matter how ‘good’ you are – you are never better than a good stop loss. If you trade a lot you will already know this, if you are starting to trade – don’t bother in this market – and if you have never traded, don’t start yet. By all means practice with a Excel spreadsheet and “fake” money, but trying to pinpoint good investments in this market and trade them well with little experience is really something that I wouldn’t recommended to anyone at this current point in time. It’s best to learn in this market, but not best to use your own money. Practice, practice, practice using a real live trading program so you get a ‘realistic’ exposure to how difficult it is to trade in turbulent markets. If you find yourself ‘more up than down’ – let it stay that way until the market settles.

5) Keep rational, stay focused. This is probably the most important thing to do in a market such as this one. Don’t take risky CFD positions or Index options or even attempt to create complex trading systems which can ‘beat the market’. There’s a ‘high risk’ chance you will end up down and I recommend you re-read point 1 above if you are even thinking this. You can bet your bottom dollar that billions of dollars was lost in call options alone in the United States because many financial experts had suggested ‘the worst was over’. The worst is never over until the Regulators start shaking down the biggest companies and demanding they account for their risk and balance sheet exposure. Once you see this start happening publicly as it is slowly starting to happen in the US – then you will start to see the ‘true state of affairs’. This hasn’t happened to a great extent yet, and I think in the next few months there will be a few more issues in the pipe particularly around investor sentiment leading up to the next US president and their respective economic policy.

These are just a few tips in order to “weather the financial storm”. Feel free to contact me via the Contact Page above if you have any comment.