5 Ways to Avoid Getting Creamed by Falling Markets

Ways You Can Reduce Your Risk and Protect Your Assets

Source : http://beginnersinvest.about.com

The financial markets are nutty. How’s that for a basic truth? To give you an example from my own life: One of the companies in which we are currently acquiring shares is literally trading for less than the cash the business has in the bank! These situations are relatively rare, but it goes to show that an undervalued stock can get even more undervalued, regardless of the irrationality of it. Sometimes this happens because investors panic, sell the mutual funds in their 401k to switch to cash, forcing otherwise good money managers to liquidate their shares of great companies, driving the prices down further. That’s why one of the 20th centuries’ greatest economists made the very wise observation that markets can remain irrational far longer than you can remain solvent.

That’s why I’ve put together a short list of five things you can do that might help you avoid getting creamed when Wall Street loses its mind.

1. Don’t borrow money to buy stock

Unless you are exceptionally liquid, or have substantial resources outside of your brokerage account, when you go into debt to acquire an investment you are taking on a partner of sorts. The problem with this approach is that the decision when to sell is no longer up to you and, as the folks at Tweedy Browne have pointed out in their past letters, they are apt to panic sooner than you. They are going to have a different incentive system than you are – the upside for them is the interest rate you pay, which is probably not ridiculously high – but the downside is a complete loss of the money they lent. Therefore, when things start going south, they are not concerned with your potential loss or the gain that you could be giving up in the process by selling out an inopportune time, rather they are going to do whatever it takes to make sure you don’t lose any of their capital.

In our case, we own a collection of cash generators that produce operating income from their regular daily activities. In exceptional cases, I may begin acquiring positions utilizing some small degree of leverage, and as the business deposits are electronically sent to the brokerage firm, these balances are wiped out in the ordinary course of our banking life. For most people, they don’t have expanding enterprises or tons of excess liquidity sitting around so it’s not wise.

2. Realize that you don’t know it all.

In the financial markets, overconfidence kills. You could be right nine times out of ten, but if you go full-throttle, all-in for each and every one of your positions, it only takes that one mistake to wipe out your capital. When the market does turn, not only will you be unable to participate, you will be forced to suffer the agony of watching all of the things you that knew were cheap trade at far higher levels. This tragedy beset no less a giant than Benjamin Graham himself when he risked his own capital, plus some borrowed funds, buying up shares in the beginning of what was destined to become the Great Depression. He was buying companies at very attractive prices, but the complete devastation that the markets suffered caused healthy enterprises to sell for pennies on the dollar with price-to-earnings ratios of less than one or two! Yes, it was the worst economic time in roughly 650+ years, but that would have been little comfort if you were the one destitute on the street because of your overconfidence.

In other words, admit to yourself that you don’t know everything and be on the lookout for times when you are risking more than you can handle if the stock exchanges were to close for ten years.

3. Be on the lookout for six-sigma events or “black swans”

What if a nuclear bomb went off in one of the world’s major financial centers tomorrow? How about if an earthquake caused a tsunami that wiped out parts of southern California? What would happen to your personal portfolio, your job, or your property? You need to always be on the lookout for correlation. If, for example, you live, work, and invest all of your money in New York based firms, a localized disaster could destroy your life. Good insurance executives are acutely aware of this sort of unchecked and unrecognized correlation, but many people blithely go through their own lives without realizing that if they were to lose their job because of a hurricane, the banks in the region may be closed.

Of course, I’m not advocating paranoia here, just a healthy dose of risk management. There’s a reason that my family and companies maintain multiple banking, brokerage, and insurance relationships. Take Charlie Munger’s advice and simply ask yourself: What could go wrong? Then figure out how to protect yourself from those financial events.

4. Look for hidden landmines in a company’s financial statements

Airlines looked wonderfully profitable back before deregulation. Construction firms appeared to bring owners fountains of cash before asbestos. Textiles once made shareholders very rich. Look for where you think capitalism is going to take away major sources of wealth. Personally, it is my own opinion that I’d be nervous owning shares of video rental chains given that it appears the Internet will make digital delivery of content the wave of the future – why drive to a store when you can simply click a button to see the newest Hollywood blockbuster? Could I be wrong? Absolutely. But in my own assets, that’s not a risk I’m willing to take.

On the same note, you should look for hidden assets.

What if you found a chain of video rental stores that owned the real estate? In that case, you could find a company that was trading at a going-out-of-business price yet get far more value because of these sources of value that aren’t factored into the price by shareholders, analysts, or other professionals.

5. Never invest unless you have a backup, emergency source of liquidity

No one knows what tomorrow brings or holds. Financially, if you want to remain on stable footing in good times and bad, it is wise to maintain a backup source of liquidity, preferably liquid cash, that can be immediately and unquestionably accessed in the event of an emergency. What if a car hits you? Or you lose your job? Or find out that your employees have been stealing from you and your vendors haven’t been paid? Or you come home to find your spouse is leaving you and they have already drained the joint accounts? Regardless of the situation, prudence dictates it wise to immediately, and unquestionably, have the ability to solve the problem. For many people, a pristine credit score along with a personal line of credit should be sufficient.