Experienced investors understand how to allocate their money in a way that elicits the best opportunity for appreciation without taking on too much risk. Careful considerations regarding asset allocation, risk tolerance, due diligence, and stock selection are taken into account when designing a portfolio. Long term mindsets mean that sophisticated investors don’t panic during market corrections and they doggedly stick to their plans whether the business cycle is cresting or sinking to a trough. However, when the unexpected happens that sends ripples throughout the global marketplace, even the most steely-eyed investor can find themselves second guessing their entire portfolio and make poor trading decisions.
It’s impossible to know when a global crisis will occur, or how it will ultimately affect the marketplace before it happens. Crises have many names and come in the form of natural weather phenomena to man-made conflicts and wars. When breaking news occurs, trading jumps in volatility as traders attempt to manage perceived risks but the real impact of these events is often far removed from how Wall Street acts.
The Many Faces of Crisis
A crisis, whether small or large, can have far-reaching consequences that may be hard to pinpoint until after they happen. An oil spill in the East China Sea will understandably impact oil prices and energy stocks but could also affect many other industries. Local economies that rely on fishing would be hurt and shipping lanes could be closed down which would impact international trade. The expense of cleaning up the spill would affect multiple countries in the region like China, Japan, Korea, and many others would take money away from other potential uses like capital expenditures and investments that would’ve otherwise boosted the countries’ GDPs.
U.S. investors may think that the spill won’t affect their portfolios, but having a global economy means that everything is interconnected. Many companies operate worldwide or rely on imported and exported goods in order to do business. The grocery store you go to down the street may well raise prices on certain goods or even run out of them if they normally get them from countries in the affected region.
On the other hand, there could be some short term benefits you shouldn’t overlook. Oil-spill removal companies could see a bump in value and the manpower required to manage the clean-up might help boost unemployment figures. Value investors often wait until a crisis drives out those investors with a weak stomach and then they take advantage of depressed prices by buying stocks at discounted values that would’ve otherwise been too expensive.
Real World Scenarios
We don’t have to look far to find recent examples of disasters and crises that have and still are affecting the economy. Here’s a few different recent situations and how they impacted the economy:
- The Government Shutdown in 2013 – While it only lasted a few weeks, the government shutdown had lingering effects on the market. Standard & Poor’s released a report that an estimated close to $24 billion was taken out of the economy during that time. U.S. growth estimates were cut from 3% down to around 2% and 4th quarter GDP growth was slashed by 0.6%. Considering that the debt ceiling issue is on-going, the report further stated that a total default in the near future would result in GDP loss of 4%; thrusting the nation back into a recession.
- The Crimean Crisis – The geopolitical crisis in Ukraine had the world holding its breath earlier this year and rocked financial markets as uncertainty caused volatility to skyrocket. Energy markets struggled to correctly price in risks with oil and gas products and investor confidence was shook resulting in fewer investments into the U.S. economy.
- Iraqi Instability – Unrest in Iraq, one of the largest oil producing nations in the world, is taking its toll on global energy markets. The increase in oil and gas prices means that consumers who would’ve otherwise had money to spend thereby boosting the economy, are now forced to pay for higher utility bills and fuel costs. The crisis may have an upside though. Investments in local energy projects could increase to wean the U.S. off of foreign oil dependence which could result in higher domestic GDP.
Wall Street’s Disconnect
Investors are notoriously fickle, especially when it comes to bad news. An unexpected event almost always causes volatility in the stock market to jump. Many traders react without analyzing the situation attempting to sell perceived high risk holdings and delevering positions. The relatively new field of behavioral finance shines some light on how and why Wall Street reacts poorly to the unexpected.
Herd mentality governs many moves in the stock market – whether it’s rational or irrational. The idea of following the masses is steeped deeply in our human evolution. We tell ourselves that the majority can’t be wrong and we tend to second guess our decisions. This is commonly how bubbles form. Think back to the dotcom bust or the mortgage crisis when people invested with the assumption that prices would just keep rising in perpetuity.
Efficient market hypothesis tries to explain how new information is absorbed and reflected in a stock’s price but reality doesn’t necessarily follow those rules. Investors tend to overreact to news creating a larger-than-warranted change in value.
The idea that overreaction is a part of everyday markets was put to the test with a study in 1985 by behavioral finance academics called, “Does the Market Overreact?” They created an index of stocks that were the best performers and another with the worst performers labeled “winners” and “losers” and followed them over a 3-year period. They found that over time the “winners” underperformed the S&P 500 while the “losers” outperformed it.
It seemed that whether good news was introduced or bad news, investors tended to overreact which reflected in a stock’s price. “Losers” would be oversold on bad news until investors realized they were trading at value prices and “winners” kept being bought until they realized that their exuberance wasn’t justified and began selling.
If we look at the recent Crimean crisis, we can see where stocks were oversold without justification. While Russia may be the 8th largest economy in the world, it doesn’t have much spillover to the global economy. In fact, Russia only accounts for less than 3% of total global economic output. It also has the smallest role in trade chains which means that any interruption would have only minor impacts on foreign suppliers.
The Notorious Black Swan
Prodigious investor Nassim Taleb coined the phrase “black swan” in reference to unexpected events that have far-reaching effects. It refers only to high-profile, hard to predict, and rare events that have major implications for the future. The terrorist attacks on 9/11 and “Black Monday” are examples of black swans that affected the global marketplace.
There are 3 criteria for identifying a black sawn according to Taleb:
- The event comes as a surprise.
- The event has a major impact.
- The event can be rationalized in hindsight – observers can look back and see the course of events that led to the event as if it could have been predicted.
Black swan theory addresses concerns in risk management that focuses on mitigating events that occur with standard probability and leave investors unprotected from extremely rare catastrophes. Hedge funds that attempt to position their portfolios to address black swans have met with mixed results however. Universa Investments LP, where Nassim Taleb is an adviser, saw gains of 115% in 2008, but saw returns of -4% in 2009 and 2010.
How to Manage Risks
Investing without mitigating risk is essentially gambling. Diversification helps alleviate risks but it can’t defend against everything. Global crises are events that affect broad markets and create both regional and systemic risks that require a different approach to protecting your portfolio. Properly managing portfolio risk can be accomplished without sacrificing returns.
Taking the concept of diversification further, spreading out your exposure to international markets can help alleviate regional and political risks. Hoarding assets in one country, even it’s among a diverse set of assets, can lead to big losses. If you have investments in other markets overseas, then events like the government shutdown won’t hurt your entire portfolio at once.
Systemic risks are harder to defend against. The collapse of entire markets or a financial system affects all sectors regardless of individual company performances. The financial crisis in 2008 is a perfect example of systemic risk. One banking failure led to another which began to bring down every economic sector which relies on steady financing to operate.
Diversification alone won’t help against this type of risk; it requires insurance or hedging. Options are the best defense against systemic risks. Selling covered calls and using the proceeds to buy puts on stock you own is a great way of protecting your investments. Also using way out of the money puts as a way to purchase stocks once they become heavily discounted can provide an organic hedge to market downside. Fully hedged options are the only way to completely protect yourself against catastrophic losses. If the market collapsed overnight because of some unforeseen event, you could limit losses to negligible amounts while everyone else watches their wealth evaporate.
It’s important for investors to keep their long term goals in mind when the unexpected happens. Panic selling will never result in a profit and overreacting is part of a herd mentality. Be careful when you execute a trade and do it based on fundamental reasons with the big picture in mind instead of reacting to temporary events that are forgotten the next day.
CEO, Elite Wealth Management
Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions on the companies mentioned through stocks, options or other securities.