New to the “Markets”? How do you trade in these often volatile markets?
“…But if you want to try your luck, you need to earn the right to take a chance by observing robust risk management principles: watch your losses on individual trades, diversify appropriately, and consider keeping something back in cash…”
Every one reading this article will be at a different level compared to the next man. Fundamentally the rules are the same. Over 80% of retail “punters” lose money. Hopefully, here, we will try and help you be in the 20% that doesn’t.
We will cover different strategies, ideas, entry and exit plans and try and get you to just think a little more before giving your hard earned cash away. There is no right and wrong way to make money in the markets. Find a strategy that works for you.
The markets have been around for centuries, they are not going anywhere so take your time with your research. There is a plethora of information around these days with the advent of social media and the internet, use it. Ensure you have an exit plan. Any fool can buy a share, the trick is selling higher than you bought.
Over the past couple of years there’s been an influx of new private investors into the markets. Repeated lockdowns gave them more time – and in some cases savings – to commit to investment. Retail platforms – some of them free – have made it ever easier to trade an ever expanding range of securities. And the runaway rise of momentum shares like Tesla, and mercurial allure of cryptocurrencies, have held out the promise of quick, easy gains.
Many have had quite an easy time of it – until now. Equities surged through 2020 and 2021, supported by a generous market environment underwritten by the commitment of central banks to quantitative easing and exceptionally low interest rates.
“…But the volatility so far this year has been a wake up call. Some will be tempted to leave the markets altogether, or, worse, double-down on speculative trades in an attempt to recapture losses…”
Expectations of faster economic growth, strong employment numbers, and stubbornly high inflation, have finally prompted treasuries to signal a return to tighter monetary policy, including higher interest rates and the tapering of bond purchases. The speculative tech stocks that soared through the pandemic on the back of cheap money, which have powered many new retail portfolios, have plummeted. At the time of writing the tech-heavy Nasdaq index had fallen more than 16pc since its peak in November.
There have been some well known casualties, the most spectacular, perhaps, the US-listed Ark Innovation ETF that makes bold bets in the DNA, automation, robotics, energy storage, AI and fintech sectors. After recording epic gains through 2020 the fund is down 27pc this year and has halved since peaking last February. Baillie Gifford’s popular UK growth fund Scottish Mortgage Investment Trust has also suffered. Having posted the strongest return in its 112-year history in the 12-month period to the end of March 2021, rising 99pc, the fund has fallen 20pc this year, and is now trading on a discount of 3.3pc.
It’s likely that both will come good again. Baillie Gifford’s respected fund has returned 214pc over the past five years. And though the freakish gains Ark Innovation made through the pandemic are being eroded, it is still well up over the same period. Ark Invest CEO Cathie Wood argues that ‘innovation is on sale’ following the fund’s mauling over the past few months, as the fund moves into bargain territory.
The turn away from tech stocks seems to be a particularly sharp market correction rather than a crash, a rotation towards sectors that may benefit from a sharp earnings recovery: ‘old economy’ or ‘value’ shares like oil and gas, mining and financials. In this respect the turmoil presents opens new opportunities for alert investors. But market rotations tend not to be smooth transitions, a graceful passing from one investment theme to another. During periods of turbulence when the entire market plunges there is no easy escape. Everything falls togethers. The Cboe Vix index, an established measure of volatility, is well above historical averages. More than 220 US-listed companies with a market cap of $10bn-plus are down at least 20pc from their peaks. The giant tech stocks that have driven US indices in recent years – Microsoft, Apple, Amazon – have suffered alongside their speculative peers.
Though many new investors will have been singed, and sometimes burned, by explosive crypto trades, a sudden downturn in the value of the whole market that wipes out wealth generated over previous months will be a fresh, and unwelcome, experience. Some will be tempted to leave the markets altogether, or, worse, double-down on speculative trades in an attempt to recapture losses. Investors who want to stay need a plan for dealing with market downturns, a strategy for managing risk.
Essential risk management
Our series on trading the markets published last year covered core risk management principles. As we noted, if you don’t have a plan your decisions will be made on the hoof in response to events. You may take profits too soon, or more likely, leave it too long before taking any. Worse, you may stay in losing trades for too long, continually leaking money. With an exit strategy you at least close a trade, successful or otherwise, on your own terms, rather than improvising in the heat of the moment. Minimising losses on unsuccessful trades preserves the capital that allows you to continue to trade. The market will always yield fresh opportunities for making money, but the discipline to keep your losses under control will allow you to stay in the game long enough to take advantage of them.
So when buying a share you should think in advance about the price you are prepared to see it fall to before you write it off as an unsuccessful trade. This price is called a ‘stop-loss’, or sometimes just a ‘stop’. A stop-loss, whether automatic or manual, helps you confront the strong temptation to hold on to a losing share in the hope it will bounce back. Since trading began investors have found it hard to sell shares as they fall. Willingness to acknowledge a loss and sell is a psychological barrier all investors have to overcome.
You should also use stops to ensure you take earnings on a trade that has gone well. If a stock is on a strong upward path complacency can build, tempting you to mentally bank your profits before you’ve actually taken any of them. So a trade should be entered with a price in mind – usually referred to a ‘profit target’ – at which some or all of the shares will be sold. Stop-losses and profit targets are essential for short-term trades, but can also be useful for tracking the performance of longer term investments in funds, trusts and ETFs. Picking thematic ETFs, for example, can feel just as precarious as selecting stocks in companies.
But how useful are these rules when all equities are falling together? Shuffling shares in these conditions might seem rather like the proverbial rearrangement of deck chairs on the Titanic. In these circumstances, the simple but durable principle at the heart of modern portfolio management proves its worth: diversification. You should allocate your investments across different sectors and assets to ensure your portfolio is sufficiently robust to withstand losses within a particular sector or asset class.
To recap what we said last year, that means avoiding correlation, or ‘diworsification’: the temptation to select a set of investments, each attractive in its own right, that have – sometimes obscure – relationships that make them likely to rise or fall together. For example, an investor with a particular interest in energy and natural resources may well diversify within that sector – but not beyond it. When you are immersed in a particular market, a clean energy stock can look radically different from an oil major, or a mining share. But they are actually quite closely related. In the end oil and renewables both offer the same service: energy, demand for which moves according to economic cycles. A mining company in central Africa might seem a world away from a Californian electric vehicle company. But the car manufacturer needs the materials produced by the miner.
Investors with the discipline to diversify look beyond the sectors they know best, to radically different fields like medicine, insurance, law, agriculture, and, property, disparate markets not necessarily in sync with the general economic cycle. They also think globally, looking beyond the indices with which they might be most familiar. They also look beyond the biggest players in each market. When looking at international investment opportunities it’s tempting to just consider the biggest companies: Sony, Gazprom, Taiwan Semiconductor and Lenovo, for example. But these are global players whose fortunes, not unlike Microsoft, Shell and Vodafone, depend on the ebb and flow of the global economy. Real diversification means backing companies oriented to their domestic economies, not just the more familiar flagship brands.
As we’ve seen, though, severe market downturns hit equities everywhere, across all indices. So truly diversified portfolios should include other assets. There are quite a few options. Real Estate Investment Trusts, better known as REITs, own and operate income-producing real estate. Infrastructure Investment Trusts (InvITs) and private equity trusts offer a share of the income stream from non-listed companies. There are the time honoured diversifiers like bonds and gold. And unglamorous as it is, there’s much to be said for keeping some of your portfolio in cash, which offers a sure way to protect against assets falling concurrently, and the flexibility to move back into the market when prospects are less uncertain. Veteran commentator John Kay writes that for ‘the intelligent investor, risk is a characteristic of a portfolio, rather than of the individual security.’ A well-diversified portfolio gives you the best chance that at least some assets will retain their value. As Kay puts it: ‘You can build an investment portfolio for a rainy day, but what of a monsoon?’
An illuminating article by Investor’s Chronicle writer Chris Dillow, charting the correlations of monthly returns between the main 25 FTSE sectors since 2003, shows shares rise and fall together to a greater extent than is generally realised. The correlation between related sectors like banks and life insurers – 0.78 – is as high as might be expected, as is that between chemicals and engineers. But even shares in seemingly diverse industries tend strongly to rise and fall together: between banks and engineering it is 0.57; between construction and media stocks 0.65; and between IT and chemicals 0.58. Indeed, in the short term – over one month – the correlation between all sectors was positive, averaging 0.43. Diverse sectors move differently in the longer term: over the past decade sectors like IT or beverages have tripled in price while oil, banks and tobacco have fallen. And there’s less correlation when markets are calm. But in turbulent times almost all equities fall together.
This is an unfortunate paradox. As Dillow puts it: ‘Equity diversification is most likely to work in quiet markets – but that is when we least need it. On the other hand, when we most need diversification – when prices are tumbling – it works less well.’ Stocks fall together because all are sensitive to market risk and fears of recession. Investors seeking protection from short-term market shocks must hold non-equity assets such as bonds, gold, foreign currency, and cash.
Can you time the markets?
So how much should you keep in equities during these times? The orthodox advice, especially for less experienced investors, is to batten down the hatches and stay in the market through the storm. You might want to reshuffle your portfolio to ensure it is appropriately diversified for market conditions – right now that would mean rebalancing from growth to value shares – but otherwise you should be patient and tough it out. Timing the market – selling at the top and buying at the bottom – or even just holding back investment or taking some or all of your money out of the market when you anticipate a fall – is notoriously difficult.
Dillow, however, goes against the grain. Investors should think hard about whether they are prepared to take the body blows dealt by downturns, which can be severe, and prolonged. He cites three powerful examples. The Nasdaq lost 70pc between 2000 and 2002 when the first internet bubble burst. Quality companies fell along with the rest: Apple by over 70pc and Amazon more than 90pc. The Nasdaq only returned to its 2000 peak in 2015. After years of robust growth Japanese shares peaked in 1989, halving over the following three years. The Nikkei 225 is still lower today than it was then. Going further back in time UK shares halved between 1928 and 1948. Remarkably they only returned to their 1928 level in real terms in 1993. For Dillow the ‘idea that you can ride out losses if you stay in the market long enough can be dangerously wrong.’ Yes, in the long run the evidence of history is that a diversified portfolio will recover. But not everyone can afford to hold a portfolio for the number of years it requires to come good. As the great economist (and investor) John Maynard Keynes observed: ‘In the long run we are all dead.’
So when should investors who can’t afford to hold for the long term, or are quite understandably distressed when patiently accumulated wealth plummets, sell? To say the least, it’s an inexact science. Dillow suggests a useful rubric: consider selling at least some equities when prices fall below their ten-month moving average. It isn’t perfect: it never gets you out of the market right at the top or into it at the very bottom. But it protects you from ‘the long and deep bear markets which happen when bubbles deflate and which can really destroy our wealth’, delivering ‘better long-run risk-adjusted returns than a buy-and-hold strategy in markets as various as Japan, the US, UK, emerging markets and mining stocks.’
Those on the other side of the debate do not disagree with Dillow about the desirability of protecting wealth by withdrawing from the market during severe downturns. They simply ask whether it is ever possible to time exits and entries effectively. One of the UK’s best known fund managers, Fundsmith Equity’s Terry Smith, argues in one of many broadsides against the possibility of timing the markets that ‘there are only two types of investors – those who know they can’t make money from market timing, and those who don’t know they can’t.’ Checking out before the market peaks and rejoining to enjoy the recovery from its lows sounds great, but ‘the trouble is that very few, if any of us, are any good at it’. For Smith it ‘is hard enough to have the strength of conviction to convince yourself that markets are too high and sell when the background is looking rosy and everyone else is bullish. But it requires an extraordinarily flexible psyche to be able to complete the required volte face at the bottom and buy the stock, market or fund after your predictions have come true, its prospects look bleak and the price has fallen.’
The evidence is that money tends to flows in when markets are cresting a wave, and flows out when it has crashed – effective market timing in reverse. And Smith notes you only need to miss being in the market for a few days to seriously damage your investment returns. In the decade from 1994 to 2004, for example, the S&P 500 Index generated a compound total return of 12.07pc each year: $10,000 invested at the outset of the ten-year period would have become $31,260 by 2004. If you had tried ducking out during downturns you need only to have missed a few of the market’s best days to seriously damage your returns. If, for example, you.had missed just the best 10 days your return would have been just 6.89pc a year, leaving you with $19,476. And if you had missed the best 30 days, your returns would be negative.
For Smith, to successfully ‘implement such market timing strategies you not only have to be able to predict events – interest rate rises, wars, oil price shocks, the impact of the coronavirus, the outcome of elections and referendums – you also need to know what the market was expecting, how it will react and get your timing right. Tricky.’ He asks us to consider the Dow Jones Industrial Average Index from 1970-2020. If you had successfully pursued a strategy of investing only when the market hit periodic bottoms, you would have secured a 22pc higher return than if you had simply invested an equal amount every trading day throughout the period irrespective of market conditions. But that works out as only 0.4pc outperformance per year. And to achieve it you would have had to time every call perfectly. If you had only got a few calls wrong you would have fallen well short of the market’s long term return.
Another prominent UK fund manager Nick Train, who oversees popular funds including Finsbury Growth & Income Trust and LF Lindsell Train UK Equity, agrees. Investors should have the humility to stay invested and have faith in the market’s longer term capacity: ‘We … have no idea what’s going to happen in the next six months, but in the longer term we’re confident that markets will do what they’ve done for the past 200 years – steadily go up – albeit with volatility along the way.’
Faith in the future
The market timing debate is one of the oldest in the investment world – perhaps the oldest. It’s not for TMS to adjudicate, only to introduce the arguments on both sides. Only you can decide whether you want to stay wholly or partially invested during downturns.
It’s worth noting that, as we noted in last year’s article on AIM and risk management, some believe market volatility can offer small cap investors particular opportunities. Premier Miton small cap manager Gervais Williams, for example, argues that exchanges like AIM offer enterprising private investors exposure to vibrant microcaps that cautious institutional investors charged with securing reliable returns tend to overlook. Versatile small caps have the potential to perform strongly through the harshest economic headwinds, driving much of the innovation that propels the wider economy forward.
And so far this year private investors have demonstrated continued confidence in markets. They have been net buyers of US equities and ETFs every trading day this month, the scale of daily inflows passing the 2021 average on all but two days since the start of the year. Downturns have been mitigated by rallies in which retail traders have played prominent roles.
But if you want to try your luck, you need to earn the right to take a chance by observing robust risk management principles: watch your losses on individual trades, diversify appropriately, and consider keeping something back in cash. And when times are tough remember the evidence of history: there is no need to take big gambles. Over the longer term the global market has consistently proved its facility to generate wealth. Investors should have faith in its continued capacity to do so.