Economic crisis and turmoil on the financial markets is a time of serious trials for investors. One who gets carried away with emotions and starts rapidly selling shares may lose a great deal. On the other hand, buying during a crisis, although potentially risky, might pay off well – comments Bartosz Grejner, Cinkciarz.pl financial analyst.
Crises and economic breakdowns often appear unexpectedly, causing effects that are difficult to foresee. A sign of crisis often causes share prices to fall below their actual value. As a consequence, people who face the possibility of losing a significant part of their capital tend to make irrational decisions.
While some are scared, others invest
As it is not hard to deduce, selling in these conditions might not be an optimal solution. Investors frequently make the mistake of holding onto assets that are losing value for too long, only to put them on sale when their prices are very low. As the behavioral economy explains it, such reactions are a result of the fact that losing capital causes a much more severe emotional reaction than a reaction from the satisfaction of an analogically high profit/
Buying in a time of crisis might pay off, but is obviously affected by high risk. It is worth remembering that when negative emotions and reactions on the markets go down, fundamental factors start playing a larger role and share prices (as well as other assets that were sold out) go back to normal.
A good example of this situation recently appeared after the unexpected victory of Donald Trump in the US presidential election. This wasn’t a crisis, however, the chaos of the night of and the day after the elections affected the markets. Initially, European indexes and contracts for the American indexes were losing up to 5 percent each.
Meanwhile, Carl Icahn (52nd on the list of the richest people in the world) said in an interview with Bloomberg that when he saw the stock exchange go down, he left Trump’s election victory party and purchased one billion dollars’ worth of shares (this is how much he managed to gather on short notice). Icahn wasn’t wrong – after the initial rapid overprice, share prices started to go up and the main US index Dow Jones 30 hit its all time high within a couple days.
How to construct a portfolio to react to bargains
The situation from the first hours after Donald Trump’s triumph is a rather extreme example (in terms of time and money), but it portrays the proper investment behavior quite well. In order to be able to profit from such bargains during a crisis or other turmoil on the market, we would need to have free resources, so that we won’t be afraid of investing in such a way. This brings us to the proper construction of the investment wallet that on one hand is resistant to similar events, and on the other, enables us to buy additional assets at attractive prices, which might make profit exponentially in the future.
Even though, in a perfect scenario the investment strategy should be constructed individually so that it portrays goals, time horizons and risk appetite, we can distinguish some ground rules, which could be common for a larger portion of the investment. When investing, we should think of a longer time period. In the context of several dozen years, the inevitable turmoil that appears will eventually have limited influence on our capital.
Individual factors that make up for all our investments should most importantly be the least correlated as possible. This diminishes the general risk of losing value of our investment portfolio. Apart from its risky components, e.g. shares or equity funds that potentially give a higher rate of return over a longer period of time, it might be a good idea to secure our capital with assets, which historically record relatively good results in the time of a crisis.
These assets could include, among others - gold, silver, US treasury bonds, Japanese yen or the Swiss franc. Even though, in the time of global price increases of noble metals and market currencies prices they may not bring much profit (there might even be a slight loss), they can be figuratively be regarded as insurance that we pay, e.g. for the house. We usually decide to purchase home insurance even though we hope we will never need to use it. Historically speaking, the value of so-called safe havens was going up during times of crisis or prolonging bad sentiment on the markets, which could potentially lower the losses on risky assets. A lot depends on our risk appetite – the more we want to secure our capital, the more safe haven assets we should have in our investment portfolio.
Quick access to cash for unstable times
Of course, one can approach personal capital management in a more active way and change the share of the safer instruments depending on the current situation on the markets and our expectations toward the future. During a time of major uncertainty, restlessness within the markets or when the growth perspectives worsen, an optimal solution might be to increase shares. In such cases, one can use more advanced forms of securing the risky parts of their capital – for instance, the long or short-term strategy. Derivatives also can be used as options, for example, by paying the premium up front for the possibility of largely limiting the losses.
The basics of good preparation for a crisis or breakdown within the markets lies in properly diversifying your investment portfolio, which should include assets that are not correlated. It is also substantial to be able to turn a part of our investment into cash quickly and easily. Keeping a major portion of our investments in cash during increased uncertainty (compared to the time of stable growth) can bring two main advantages. Firstly, we can limit potential losses this way. Secondly, we can gain the possibility to purchase assets (e.g. shares) at a very low cost, often well below real value. When the fundamental approach is dominant again, investors will look more favorably at relatively cheap assets, when the period of growth will start so we can estimate the time of earning a remarkable profit.
Hope for the best, prepare for the worst
Unfortunately, crises and economic breakdowns do happen and, as the recent years clearly show, occur relatively often. The assumption that they won’t happen to us seems quite naïve. This is why it is worth preparing for shocks and negative reactions on the market in order to protect our capital and take the opportunities when they appear. The key to this is a properly diversified portfolio, which includes not only shares and bonds, but also alternative investments (e.g. gold, silver, real estate, coins, etc.), cash in various currencies (local, as well as from countries perceived as ‘safe’, e.g. yen and franc), and optionally securing strategies and other investments.
During the turmoil on the markets, people are more exposed to the influence of big emotions, which can get in the way of good decision making. However, if we are disciplined and we approach our investments methodically and remain aware of the rules that function on the market, the probability of avoiding losses or even gaining exceptional profits, is higher. The investment decision should be made in the same way, regardless of gaining or losing, to try to avoid excessive risk in order to make up for lost capital, because this might lead to even more losses.