Hedge your bets in volatile times

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The Straits Times
Sep 11, 2011
Hedge your bets in volatile times

Don't let your emotions take control of your investment decisions, says Yasmine Yahya

It has been a painful month for investors the world over and the end seems nowhere in sight.

It might be tempting for the risk-averse to sell off their entire portfolio now and wait out the storm, while the more gutsy among us might be considering snapping up all the bargains in the market.

But experts say this is really the time to be practising extra caution and reason.

In times of market distress, investors tend to fall into several behavioural traps that might seem logical but will actually end up hurting their portfolios in the long run.

Avoid the typical mistakes investors make

Behavioural finance is a field of study that examines how emotions and cognitive errors influence investors and the decision-making process. The head of retail sales at JP Morgan Asset Management Singapore, Mr Brian Tan, said researchers have pinpointed three behavioural issues that tend to dampen investors' profits.

The first is loss aversion. Investors tend to sell their winners too soon and hold on to their losers in the hope of breaking even.

The second issue is overconfidence: Analysts under-react to new information when they revise their forecasts and investors heed their advice.

Third, investors tend to equate 'out of favour' companies as poor investments. They believe the stock is 'cheap for a reason'.

So common are these errors that JP Morgan has created the JPMorgan Global Dynamic Fund that tries to capitalise on such human behaviour.

The fund focuses on buying fast-growing cheap stocks from all over the world, with no preference for any particular index or market.

'We believe, on average, fast-growing cheap stocks with good news flow outperform slow-growing, expensive stocks with bad news flow,' Mr Tan said.

Reassess your risk appetite and portfolio

Before you let your emotions take control of your investment decisions, schedule an appointment with your financial adviser.

Perhaps the sense of panic you feel as you watch the digits tumble away from your portfolio is a signal that your investments are not geared towards the right level of risk.

'If you were very worried about the recent down moves in the market, then you should revalidate whether your current portfolio matches your risk appetite,' said Mr Steve Brice, chief investment strategist at Standard Chartered's group wealth management division.

This is where a financial adviser can help.

He can give objective advice and help you make rational decisions based on your risk tolerance and investment profile, noted Mr William Tan, head of sales for Franklin Templeton Investments in Singapore.

'If the decision is to put your money to work in the market or continue to invest, then investors should set a limit on their losses, identify a target return and decide what their investment horizon is,' he said.

Mr Brice added that how old you are and how much cash you have are very important factors that you should take into consideration.

'Those approaching retirement or who are not generating surplus cash should be more defensive,' he said.

For those with cash to invest, there are some good opportunities to buy equities at cheap valuations, he added.

'Picking the bottom is always difficult, but gradually putting money to work in the stock market over a period of time - such as a regular savings plan - is one way of dealing with heightened volatility.'

Staying the course is critical to long-term wealth accumulation, he added. 'People need to ensure they have adequate cash levels to deal with employment or health challenges. One does not want to be a forced seller in a down market due to liquidity needs.'

It is never a bad thing to get out of a bad position, noted Ms Grace Chan, director of marketing and sales channel at Phillip Futures. 'However, before deciding whether to go into another trade, it is important to have an objective, especially on the cut-loss level,' she said.

A cut-loss or stop-loss order will automatically terminate your investment in any given asset if you have accumulated a certain amount of losses in it.

And as always, it is important to ensure that your portfolio is adequately diversified.

Franklin Templeton's Mr Tan suggested something like the Templeton Emerging Markets Balanced fund, which consists of a mix of emerging market stocks and bonds.

Mr Brice added that investors should also have a good mix of bonds in both the US dollar and Asian currencies, as well as commodities such as gold in their portfolios.

Practise dollar cost averaging

Another effective investment strategy is dollar cost averaging, Franklin Templeton's Mr Tan added.

That means putting money in regular instalments into an investment such as a unit trust that you believe has long-term potential.

'During volatile market conditions, we advise against taking the plunge and putting all your money into investment products at one go,' he says.

'Instead, it's best to adopt a regular savings plan approach, which could take the form of a monthly subscription plan that enables you to invest a fixed amount of money in a particular fund on a regular basis.'

JP Morgan's Mr Tan offered this example: Assume you are contributing $1,000 monthly for investment.

In months where markets rally, your $1,000 contribution will buy fewer units. On the other hand, in months where markets drop, the same amount will buy more units.

Such a regular investment plan is likely to result in a lower average cost than the average unit price, no matter which direction the markets move.

In short, you do not have to worry about market timing, Mr Tan explained.

'Nobody, not even the professionals, can be absolutely certain when a market or a fund has reached the top or bottom of its range,' he said.

'Yet some people still try. They constantly skip in and out of markets and tend to miss the best opportunities because market turns tend to be swift, sharp and unexpected.'

Mr Tan added that he repeatedly hears stories about investors suffering big losses by 'following the herd' - buying at high levels and selling at depressed levels.

'This is indeed cliche and yet many people just can't resist the temptation to follow the craze,' he noted.

Consider hedging tools

CFDs: Savvy investors use a variety of instruments to help them hedge against risk.

One increasingly popular tool is the Contract For Difference (CFD).

Mr Gavin Ward, Asia director of CMC Markets, an investment services company that provides CFDs, said his company has seen an 'exponential growth' in customers over the past two months, partly because of the rocky markets.

'Market volatility is a big factor in this equation with a spiked interest in CFDs as they give traders risk management tools like hedging and shorting that are traditionally only accessible by institutional traders,' he said.

Basically, CFDs allow you to trade on whether the price of an underlying asset, such as a commodity, a currency or a stock index, is likely to strengthen or weaken.

You can thus take a 'long' position on say, gold, if you expect its price to rise, or take a 'short' position on Tokyo's Nikkei index if you think it will slide.

Unlike with warrants, which have an expiry date, you can hold on to your CFD positions for as long as you like.

'In times of market volatility and uncertainty, some traders and investors may find it hard to discern the market trend,' said Mr Ward.

'In such circumstances, it will be useful for clients to hedge their open positions to reduce their concentration and market risks,' he added.

'For instance, an investor who is holding a portfolio of long share positions might utilise index hedging strategies to allow him to sit out the market noise until the picture turns clear.'

So say for example that you have some Singapore Airlines (SIA) shares in your portfolio and you are worried that their value will slide but you do not want to sell them off just yet.

You could take up a 'short' position on SIA shares using CFDs, which means you are effectively betting that SIA's share price will fall.

If the value of SIA shares falls, you would still make a loss on the stock market but this would be offset by the profit you have made from the bet you made using CFDs.

Conversely, if SIA's price rises, you will make a capital gain on the shares you bought but that profit will be curtailed by the loss you made on your CFD.

As with any investment product, CFDs themselves carry risks.

They are traded on leverage, meaning that you are required to deposit only a small percentage of the overall value of the trade.

Using leverage provides the potential to magnify your profits but losses are also magnified.

Mr Ward noted that it is important to use risk-management tools like a stop-loss order to control your risk.

CMC Markets also offers free demo accounts, which anyone can sign up for. With these demo accounts, one can practise trading CFDs without putting in any real money.

VIX-based ETFs: Some time in the early 1990s, academics in the United States figured out a way to measure the volatility of any given stock market, using a 'volatility index'.

The most popular is the Chicago Board Options Exchange Market Volatility Index, or VIX, which acts as a barometer of investor sentiment.

When investors are more anxious about the short-term outlook for the Standard & Poor's 500 Index, the VIX rises. When the market is calmer, it falls.

Naturally, finance professionals have found a way for people to make money from the VIX. This is done via exchange-traded funds (ETFs).

The value of an ETF is directly related to the value of its underlying asset. Not surprisingly, the top 10 performing ETFs around the world in the past month are all VIX-based ETFs.

As market volatility has gone into overdrive, the VIX has skyrocketed to levels reminiscent of the period just after the collapse of US investment bank Lehman Brothers, and so the values of these ETFs have followed suit.

Most of these ETFs are listed in Europe and North America. There are also a few in Japan, but none is listed in Hong Kong or Singapore.

Mr Marco Montanari, Asia head of db X-Trackers, Deutsche Bank's ETF unit, noted that there are drawbacks to someone in Asia buying and trading an ETF listed in the US or Europe. One major reason is tax.

'US-listed ETFs may be taxed up to 30 per cent on the dividends they pay,' he said.

Choose the Singapore dollar

Swings in exchange rates can negatively impact investment returns, so Singapore-based investors should choose unit trusts that are denominated in the Singapore dollar, said Franklin Templeton's Mr Tan.

Investors should not pick funds based solely on that factor, but first identify the most suitable fund for your risk profile and then pick the share-class in the currency which you tend to use on a daily basis.

This way, investors can eliminate the risk of lower returns as a result of an appreciating local currency like the Singapore dollar, especially if the outlook for the currency is for it to stay strong against other currencies or continue to appreciate.

yasminey@sph.com.sg
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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