Don’t make this mistake

Friday, 29 June 2018
Melbourne, Australia
By Kris Sayce

  • Don’t underestimate this technique
  • Beware of the ‘Benchmark Myth’

From Bloomberg:

When done well, shorting smaller companies does present opportunities for top returns. Glaucus’s campaigns returned an average of 51 percent from Jan. 1, 2017 through June 19, according to research firm Activist Insight, as the average short campaign lost 4 percent in the period. Blue Sky Alternative Investments Ltd. is down 85 percent since Glaucus published a short report on the Australian alternative asset manager in March. Quintis Ltd., another Australian firm, lost all its value when the company went into administration in January after Glaucus issued a report on it in March 2017.

Short-selling. It involves selling a stock you don’t own, in an effort to profit if the stock falls.

Few people understand it. Even fewer actually do it.

Big mistake.

The main reason folks don’t short-sell is because they think it’s risky. It is risky. But so is buying stocks. All investing is risky.

But the key isn’t just about the risk. It’s about whether you know how to manage the risk.

Just as with buying stocks, it’s possible to manage risk when short-selling.

That doesn’t remove all risks. But it can help to reduce them.

In our view, if you haven’t considered short-selling, you’re missing out on half the market action.

Sure, over the long term, stocks have gone up. So the idea that you should buy and hold makes a whole lot of sense.

But stocks fall too. And as much as we might like to think we can predict the exact timing of a market crash, that isn’t really possible.

That’s what makes the idea you should only buy stocks all the more foolhardy.

What happens if the market falls? What happens if the market doesn’t recover as quickly as you need it to? Could your portfolio cope with a fall of 50% or more?

We ask because after the 2008 financial crash, we received hundreds of emails from new subscribers who told us their financial planner or stockbroker had costs them thousands.

The planners and brokers didn’t see the crash coming. So they couldn’t help their clients deal with the consequences.

Those investors decided to take care of their own investments. They figured they couldn’t do any worse.

That may be true. Unfortunately, as time passes, even those who lost big money in 2008 begin to forget how and why they lost money.

Instead of managing their investment risk properly, they’re chasing big gains. Pouring more and more of their wealth into the stock market.

As stocks go higher, they pour ever more in. On it goes. Until the market stops going up. Then they wait, and watch…as the market falls.

They believe that each 2%, 5%, or 10% fall is the end of the bear market. But in 2008, that’s not how it turned out. Stocks kept falling, until the Aussie blue-chip index was down around 50% from the high.

10 years later, the S&P/ASX 200 still hasn’t passed the 2007 high. By not taking precautions leading up to the 2008 crash, many investors have never been able to recover.

A generation of retired and soon-to-retire investors haven’t been able to make the most of the recovering market. They’ve had to draw down on their retirement savings.

Once you draw down on savings, whatever is left has to work harder to earn back any losses.

So, again, short-selling is risky. But so is having too big an exposure to the stock market. Which brings us to a subject that’s fitting for where the market is right now.

Below, we republish an essay from a recent weekly update to members of our premium investment advisory, Crash Market Investor.

It doesn’t specifically relate to short-selling, but it does relate to the pressure of trying to keep up with a benchmark index, and how this can cause investors to put more than they should into the stock market…

Markets

Overnight, the Dow Jones Industrial Average closed up 98.46 points, or 0.41%.

The S&P 500 gained 16.68 points, or 0.62%.

In Europe, the Euro Stoxx 50 index ended the day down 31.61 points, for a 0.93% loss. Meanwhile, the FTSE 100 fell 0.08%, and Germany’s DAX index lost 1.39%.

In Asian markets, Japan’s Nikkei 225 index is up 25.47 points, or 0.11%. China’s CSI 300 is up 1.48%.

In Australia, the S&P/ASX 200 is up 10.91 points, or 0.18%.

On the commodities markets, West Texas Intermediate crude oil is US$71.59 per barrel. Brent crude is US$77.48 per barrel.

Gold is trading for US$1,251.33 (AU$1,693.26) per troy ounce. Silver is US$16.10 (AU$21.79) per troy ounce.

The Aussie dollar is worth 73.89 US cents.

Bitcoin is US$5,853.85.

Beware of the ‘Benchmark Myth’

All too often we see investors get caught up in the excitement of a rising stock market. They allocate most or all of their investment portfolio to stocks, believing that they’re a failure if they don’t match the performance of an index.

But the reality is that using an index as a benchmark is a fatal error. Investors will often read how a stock index has gained a certain amount per year over the past five years. An investor will then look at their own portfolio and wonder why they’ve underperformed.

Instead of thinking about the reasons for the underperformance, they often wrongly assume that it’s just because they haven’t put enough of their money into the stock market.

That’s fine when stocks are rising. It’s not so good when stocks are falling.

Anyway, what do we mean when we say that using an index as a benchmark is a fatal error? The problem is that when fund managers and the mainstream talk about the return of an index, it’s always based on a single entry point.

That is, the five-year performance of an index assumes full investment in the index five years ago. But that’s only relevant if you have all of your investable capital to invest on that date. Most investors add to their portfolio over time.

If their main investment vehicle is a superannuation fund, the investor has cash flowing into the fund every quarter. In which case, if you’re benchmarking your performance against an index, you need to benchmark against multiple entry points and entry prices.

Here, check out the table below:



chart image

Data Source: Bloomberg
Click to enlarge


The single entry column assumes you have invested every dollar of your investable assets in the stock market on a single entry date. It assumes you have no further cashflow coming into your portfolio.

After one year, the US S&P 500 has gained 13.62%. In this instance, that would be your gain.

The multiple entry column assumes that you don’t have all of your investable assets to invest on a single day. For the ease of illustration, we’re assuming you invested an equal amount into the S&P 500 on four dates, three months apart. I have included the index level on those dates.

For both the single entry and multiple entry portfolio, the end price of the index is the same. However, because the investor invested into a rising market, the investor had to pay a higher price for the index at each entry point.

The result is an overall portfolio performance of just 7.35%.

That’s a big difference. But which is the more realistic scenario? Of course, if you have retired, and you’re in the ‘draw down’ phase, then the single entry benchmark is relevant. But for anyone in the accumulation phase, where you’re building your retirement savings, using a single entry benchmark is almost completely irrelevant.

Unfortunately, most investors don’t take the time to think about that. That’s why self-directed investors often think they’re failing when they look at their portfolio performance compared to a fund manager’s performance or an index performance.

I’m not saying that you shouldn’t benchmark. It can be important. But if you do choose to benchmark your performance, make sure you’re comparing like with like. If you keep a record of your trades in a spreadsheet, enter that day’s index price whenever you add a new stock to your portfolio.

At the end of the year, if you want to benchmark your performance, you can do so relatively easily by using a few simple formulas.

The stock market has risen, including here in Australia. When the market goes up, investors have a habit of rushing in, fearing that they’re going to miss out.

We suggest caution. Yes, the market has gone up. But it only makes us more fearful for the consequences when the next market crash eventually comes.

Cheers,
Kris