It's a headline that every stock market investor fears will happen. The markets crash and their hard-earned nest egg evaporates. They're forced to go back to work and must resort to eating beans and rice. Is that fear justified? No.
Stock markets around the world dropped on Tuesday. The news media echoed that it was the biggest one-day drop since September 11th, 2001. The Chinese stock market dropped almost 10%. Here in the U.S., the major indexes were down over 3%. At one point the Dow Jones Industrial Average dropped over 150 points in one minute!
Should investors panic? No. The world is not coming to an end. The world's economies continue to be strong and are growing. Interest rates are still low compared to historical standards. And yesterday's decline follows 7 months where the markets recorded increases of 15%, 25%, 40%, and even 77%.
First, let's put yesterday's drop in proper perspective. I remember watching the ticker back in 1987 when the stock market tumbled. It's something that I will never forget and is one of the reasons I have developed the systems and strategies I use to manage my client's money today.
On Tuesday the Dow Jones Industrial Average dropped a little over 400 points. To equal the market drop in 1987, Tuesday's total decline would need to be 2700 points. Tuesday, the Dow dropped 3%. In 1987 it dropped around 20%!
Second, there are going to be times when the markets make rapid adjustments. This applies not just to the stock markets, but to bond and real-estate markets as well. The introduction of electronic trading and the proliferation of hedge funds only add to volatility.
That may have been what occurred yesterday. Hedge funds can be leveraged as much as 30:1. That means if they have one dollar, they borrow thirty dollars more and invest it all. If the markets go up, a hedge fund can make enormous returns. If the markets drop too much then they get a 'margin call'. That's when those that lent the money decide they want it back--right away.
When someone trading on margin receives a margin call, typically they have to sell investments to generate the cash needed to cover the call. When you're leveraged 30:1, it means you have to sell a lot of investments. Hundreds of millions of dollars can be sold in a matter of minutes with the use of electronic trading. That selling causes the market to go down, which causes others to receive margin calls. So they then have to sell.
Many of today's mutual fund managers haven't experienced a decline like 1987 or 2001. Initially, they hang in there. But as the markets drop further they succumb to the fear and decide to start dumping investments. In my opinion, that's why the sell off picked up speed Tuesday afternoon.
That brings me to my second point. Who's watching your money? When things go bad they can go bad in a hurry. That's why it is so important that you know there is someone who is closely monitoring your money and will take action if necessary to protect it.
Unlike most managers, I employ multiple strategies in each account. Some are short-term, some medium term and others long-term. Days like yesterday illustrate the benefits of this multi-strategy approach. The money in short-term strategies was quickly moved to cash. Some sales actually took place the day before the big drop. Others occurred shortly after trading started. If 25% of an account is quickly moved to cash in such instances, that reduces the overall risk to the portfolio substantially.
Third, it's important that you be selective in what you sell. Liquidating short-term positions allows me to hold on to high-dividend paying stocks and other investments that should comfortably weather the storm. Even if the market languishes, I hold strategies that pay dividends of 6-9%.
Lastly, after the market closed yesterday I saw a picture of a U.S. soldier carrying an Iraqi child needlessly killed. I talked with a client who was undergoing additional testing to see if she has cancer.
While it's my job to monitor and manage my client's money and your job to safeguard your nest egg, it's important to remember in the end, there are things in life that are much more important than money.
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