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Sunday, 20 September 2009

Buy-and-hold with capital preservation?

This strategy addresses the increasingly wider swings between booms and busts in the stock market. [similar to CreateWealth8888's strategy]

by Sani HamidDirector, wealth management(economy & strategy) Financial Alliance

MAKING money is relatively easy. What's difficult is keeping it. A key lesson many investors would have learned from the financial crisis is that the market can easily give (profits) and just as easily take back whatever it has given. This is actually nothing new, as many seasoned investors would attest.

Take, for example, the 20-year period September 1989 to today. An investor in the Singapore market would have had four key rallies or opportunities to make a killing. First was the run-up from October 1992 to January 1994, when the Straits Times Index rose from 1,400 points to a peak of 2,500.

Second was the astonishing rally from 800 to 2,500 points between September 1998 and February 2000 as the market recovered from the 1997 Asian financial crisis. This was followed by the recent mega-rally from 1,200 to 3,900 between April 2003 and November 2007 after the dotcom crash, and finally the rally we are in now, which began in March.

Investors who hung on and rode out the initial three rallies would have been repaid handsomely as markets doubled or tripled during the run-ups. But at the same time, one cannot ignore the fact that we have also had a fair share of declines over the past 20 years, mainly represented by three major crises - the Asian crisis, the dotcom crisis and now the sub-prime financial crisis.
When we pair up these up and down cycles, one thing becomes clear: relatively speaking, making money is easy - it's keeping it that is difficult. In each case, the four rallies since 1989 were followed by retracements that virtually wiped out all or a large part of prior gains.

The Asian financial crisis, which came after the October 1992 to January 1994 rally, wiped out not only all of the gains made during the rally but much more. Correspondingly, the dotcom crisis resulted in the market retracing almost 80 per cent of the September 1998 to February 2000 gain, while the recent sub-prime crisis saw a 90 per cent retracement of the April 2003 to November 2007 rally.

This tsunami of liquidity - effectively amplified by the leverage created by our fractional reserve banking and loose monetary policies - will continue to cause the pendulum to swing even further to extremes, as large inflows and outflows of liquidity result in higher market volatility. In a wider context, one can also see from the 20-year STI chart that an investor who had bought the index at 1,500 at the beginning of 1990 would have endured a roller-coaster ride over this period, revisiting that level almost a dozen times before finally ending back at square one in March this year. And it is exactly this which gives the long-standing principle of 'buy and hold' a bad name.

So why bother with the buy-and-hold strategy, one may ask. I personally believe it's a strategy that still works. However, buy and hold cannot be used in isolation, as circumstances have changed. While time is clearly the cornerstone of the buy-and-hold strategy, it would be naive to think that one can make money by purely holding on to a portfolio long enough - which has probably given rise to the tongue-in-cheek maxims 'buy, hold and regret' and 'buy, hold and forget'.

Instead, the buy-and-hold strategy has to be reinforced by another principle - capital preservation.

Anecdotal evidence suggests that capital preservation does not figure highly on many investors' lists. For instance, investors from the large pension funds to the man-in-the-street have all surrendered profits made over the years and in some cases even allowed their principal to be affected. Both the Yale and Harvard endowment funds, for instance, lost 30 per cent of their value in the recent meltdown, while many smaller investors have lost a large amount of their savings and retirement funds that will take years to rebuild.

Without a capital preservation strategy, many will find themselves in a bind, as the available time horizon for their investments to grow will have narrowed sharply, leaving them with little time to make up for such losses.

I believe capital preservation has become paramount, especially as we will have to deal with the same or even greater volatility in the future versus what we have seen in the past two decades. In my view, since the collapse of the Bretton Woods currency system in 1971 and the proliferation of derivatives in the 1990s, after they were first introduced in the mid-1980s, economies and markets have seen their boom-bust cycles become much shorter and much more severe.

This is due to massive shifts in liquidity, as the demise of the Bretton Woods monetary system effectively removed the shackles on the US and many other governments, allowing them to print money out of thin air. While ever-increasing liquidity in the global system provided the fuel, it was the proliferation of derivatives that provided the spark to ignite this global liquidity, as it took leveraging to new heights. It is estimated in some quarters that the amount of outstanding derivatives worldwide in December 2007 was in the region of US$1.144 quadrillion - some 22 times global GDP or roughly US$190,000 for every person on the planet.

This tsunami of liquidity - effectively amplified by the leverage created by our fractional reserve banking and loose monetary policies - will continue to cause the pendulum to swing even further to extremes, as large inflows and outflows of liquidity result in higher market volatility. Because of such swings, I believe capital preservation is now essential to growing capital over the long term.

Capital preservation rules are used extensively by shorter-term traders to limit their risk and preserve their capital. One can also extend this to not only preserving capital but also a portion of gains or profits made so far.

Unfortunately, many wrongly confuse capital preservation with trying to time the market. Instead, capital preservation should be considered a part of money or risk management, in contrast to efforts to time the market, which seeks additional returns for a particular asset. Hopefully, after the present crisis, investors will begin to appreciate that managing the downside risks to one's portfolio is very much a part of making it grow. I will not be surprised in the slightest if investors start asking 'what strategy do you have to preserve my capital?'.

Oh!. Use CreateWealth8888's Pillow Stocks Strategy - same principle as Buy-and-hold with capital preservation.

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