Saturday, August 04, 2007

Mindset when buying into businesses or marketable securities

Let’s look at some of the common behavior of market participants in common stocks again. During this year, the stock market was an area of much excitement. You are, of course, aware of the small-scale roller coaster ride that produced the recent withdrawal of the market. The STI advanced from about 2800 at the start of the year to a high of almost 3700 recently, and withdrawing back to almost 3400 just this week. Mr. Market was on an euphoric mood until early this month and then experienced a sudden, small seizure.

We have “professional” investors, those who manage many billions, to thank for most of this mini turmoil. Instead of focusing on what business will do in the years ahead, many prestigious money managers focus on what they expect other money managers to do in the days ahead. For them, stocks are just tokens in a game.

An extreme attitude of what their attitude leads to is “portfolio insurance,” a money-management strategy that some private investors, including perhaps some leading investment “professionals,” embraced. This strategy – which is simply an exotically-labeled version of the small investor’s stop-loss order dictates that ever increasing portions of a stock portfolio, or their index-future equivalents, be sold as prices decline. The strategy says nothing else matters: A downward tick of a given magnitude will automatically trigger a sell order.

If you’ve thought that investment advisors were hired to invest, you may be bewildered by this technique. After buying a piece of land, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price? Or would you sell your property to whatever bidder was available at 10:31 on some morning just because at 10:30 a similar property sold for less than it would have brought on the previous day?

Moves like that, however, are what portfolio insurance or stop-loss order tells a fund, or market participant to make when it owns a portion of enterprises such as Capital Land or SGX. The less these companies are valued, the more vigorously they should be sold, says this approach. As a “logical” corollary, the approach commands the market participant to repurchase these companies once their prices have rebounded significantly. Considering such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in aberration fashion?

Many commentators, however, have also drawn an incorrect conclusion upon observing such events: They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. You’d be glad if you are a small investor or even big to hear the following conclusion. The commentators’ conclusion is dead wrong. Such markets are ideal for any investor – small or big – so long as he sticks to his investing knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment choices. He can only be hurt by such volatility if he is forced, by either financial or psychological factors, to sell at untoward times.

Mr. Market will perpetually offer the true investor opportunities – you can be sure of that – and when he does, we should be willing to participate.

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