Panic and rash choices lead paper losses to become real losses amid stock market meltdowns. Sameh Sakr* sets out the principles of wise financial investment The recent two-day decline in the Egyptian stock market has rocked the Egyptian bourse. While the almost steady decline since the beginning of the year has gotten investors and businessmen to expect more declines, a decline of this magnitude surpassed the wildest nightmares of the most pessimistic investors. Huge one-day losses, just like huge one-day gains, can occur. To shed light on the size of the catastrophe, Black Monday's decline in the late 1980s was in the vicinity of five per cent. The sum of decline on Monday and Tuesday, 6 and 7 October, in the CASE 30 index was almost 25 per cent. The good news is that investors as well as businessmen choose whether or not to participate in such a tragedy. Investment in stocks requires not only discipline but also resolve. Investors who resist the urge to sell at the heat of the moment prevent paper losses from being actual or realised losses. Businessmen and bargain hunter investors will abuse the event by buying stocks with the possibility of leveraging their results by borrowing the money. Corporations, knowing the "true" value of their stock could initiate a buyback as some of them actually did on 7 October, preventing the index from further declines. Never in the history of all world markets had an index declined, regardless of the size of the decline, and not risen again to surpass the previous peak. The million-dollar question is when it will happen. If you are out of the market during the blues of the declining times, you do not even stand a chance to enjoy the rosy days when the index will eventually rise. The best advice right now is not to sell, and if you are thinking of entering the market, there's no better time. Exact timing of when the light at the end of the tunnel will appear on the screen is hard to predict. In other words, there might still be some losses around the corner. The hype in the press to halt trading and to close the market in the hope of preventing further declines is very much overrated. Circuit breakers, the term used for halting trade in the whole market, were initiated after one of the severe crises that rocked Wall Street. While it is hoped that such halts will give time to markets to "cool off", the theoretical reasoning and the empirical evidence supporting such a notion is shaky at best. Some practitioners and academicians believe that we are only postponing the inevitable. Once markets reopen all of the declines that were "waiting" to happen will strike the market in a one-time decline. Meanwhile, calls for transparency and the need to disseminate information from authorities assume that authorities know, or at least have an idea about, the reasons of the trough and when the trough will hit rock bottom. While the reasons of the decline are easy to figure, over and over again markets have defied all expectation as to when the turnaround -- for better or worse -- will occur. All one needs to do is to examine the recommendations of financial advisors and the rhetoric in the financial press right before the peaks of all major crises. Predicting the eventual turnarounds (if done correctly once) should not be the basis for future speculations on when it will happen again. It is easier said than done, as those who have experienced the euphoria of winning big have realised when their bet on the direction of the market turned sour. For all of that, I raise my hat and bow in respect to the Egyptian bourse's president's refusal to relent, noting that the stock market is not a vegetables market and those who cannot endure the inevitable losses of the stock market should take their money elsewhere. No disrespect intended to the vegetables market; it is just that closing the stock market, Egyptian or otherwise, sends a negative signal that is not in the interest of anybody. Just imagine the effect that your desire to liquidate your investments is struck by a "market is closed" reply. Another point that needs to be considered after the smoke of the current episode subsides is the investment mentality of small investors. Trend chasers (attempting to benefit from a recent price change), herding (following the masses), hit and run (being in the market for a one time -- hopefully successful -- transaction and then exiting), basing decisions on assumptions and treating such assumptions as facts, outright biases, and getting emotionally involved are just examples of pitfalls that the small investor ought to avoid. Markets evolve. Yesterday's winners, as far as countries' economies and sectors/industries are involved, are not necessarily tomorrow's winners. Economies experience cycles and the position of the economy in the cycle might dictate a change in the sector you are emphasising in your portfolio. Sector rotation, the name of this investment strategy, is quite popular and might be considered if the investor is able to monitor where in the business cycle is the economy, and which sector to emphasise during different phases of the cycle. Assumptions need to be spelled out in writing. Writing down your assumptions allows you to examine their validity. You will be astonished after reading the assumptions you have written down. Calls to lower the average price by buying more -- while such calls are often made after any decline and they always enlarge the brokers' pocket at the expense of the small investors -- are perhaps substantiated during this decline because of the severity of the decline. Hopefully, this wakeup call will remind investors of some basic advice that personal finance advisors preach regardless of the current crisis: lunch money should not be invested in stocks. Money you invest in stocks should be money that you do not expect to liquidate before three and preferably five years. That way you do not experience one side of the cycle only. Several investors feel that they are currently trapped in the market, having invested large sums of money in the hope of winning big only to be bombarded by huge losses and feeling that there is nothing they can do about it. Again, the best course of action right now is to hold your ground (i.e. do not sell) and if possible increase your purchases, provided that you will not need to liquidate these assets before three to five years. Size also matters. The percentage of your portfolio invested in stocks should be in the vicinity of 100 minus your age. As we get older, we ought to shy away from risky stocks and towards more safe investment havens, like bonds and money market funds. Young investors can stomach the recent 25 per cent loss because their investment horizon extends further than that of an older investor. Older investors on the contrary have fewer investment years in their investment horizon and their ability to make up the losses in future market rises -- which will happen -- is less than that of young investors. One more lesson to be learned from this episode: while stock picking is important, the asset allocation decision is even more important. Dividing your money among different investment vehicles such as stocks, bonds, real estate, gold and collectibles is the decision that you need to devote more time to. The reason is that when markets rise, all of the stocks' prices increase. The same happens when stock markets decline. Of course some rise more than others, and some decline more than others. However, usually the moves happen across the board. As much as 80 per cent of the variance of returns between different portfolios can be traced or explained by the asset allocation decision and the remaining 20 per cent can be explained by the specific stocks or bonds that are chosen. While most experts agree that the ability of today's economies are much better in adjusting their production decisions, which lowers the chances of and the severity of declines, the current crisis has reminded everybody that downturns in the world economy are inevitable. This should by no means undermine the importance of diversification. Your portfolio should have no less than 10 stocks scattered over different sectors and preferably over different stock markets around the world. Where do we go from here? Rather, when will the current crisis end? Several experts believe that the worst is not yet behind us. Until US bank managers come clean as to the size of their nonperforming loans we will continue to see declines in the US economy that will ripple through the world economy. The more integrated an economy with the world economy in general -- and with the United States economy in particular -- the more such an economy will be adversely affected by the crisis. International trade and cross border investments have increased the ties among different economies and such ties are not expected to wane in the near future. Is this proof that capitalism does not work? My answer is that capitalism has not been tested. Neither the United States nor the world can afford to go through the test. So far, the measures that have been taken to rescue the US economy are far from capitalistic, to say the least. Capitalism means we let banks (relying on "too big to fail") that extended loans to borrowers who can not afford to pay them back fail and exit the market, either through a merger or through an acquisition. These bank managers' incentives prior to the crisis have pushed them to jeopardise the safety and soundness of their banks and now they are the ones to blame and the ones who must pick up at least part of the tab for what has happened. Capitalism has no mercy and while these bank managers have enjoyed hefty bonuses and other perks afforded to them by their shareholders' money during good times, it is only fair that they pick up the tab right now by leaving their management positions to those who can do a better job. The managerial labour market prices management teams according to their ability to make decisions that maximise shareholders' wealth. What can Egyptian officials do to improve the investment climate? One way is to increase the protection afforded to small investors. Two pressing issues need to be dealt with. First, insider trading needs to be criminalised to a larger extent by increasing the fines and handing down jail sentences for repeated offenders. Fines should not be viewed as a way of legitimising the offence (as has been done in a recent monopoly case) by offering the government part of the illegal profits. Rather, fines should be so high to make prospective offenders think a thousand times before committing the offence. I have personally witnessed high officials in the government bragging about the size of the returns they have achieved through tips from board members of corporations in whose stocks they trade. Insider trading hurts the economy and society by making the stock market a less desirable market to invest in. Giving a market participant an advantage over the rest of the market is unfair. Second, the government needs to work on improving disclosure, both voluntary and involuntary (which is even more important). Increasing the transparency of corporations listed on the exchange will also help in decreasing the incidents of insider trading. Last but not least is improving on governance at both the macro and the micro levels. No one knows who will take over if something happens to the current president. I doubt that Hosni Mubarak himself has a clue. Such an uncertainty, I believe, is the biggest impediment to investment in Egypt. As I have mentioned, money invested in the stock market needs to stay there for a minimum of three years and preferably five. If you do not know who will be leading the country where a president is around 80 years old, this by all counts is not encouraging, to say the least. As for the micro level we have a long way to go. Managers' salaries need to be filled at the end of every year. Possible conflicts of interest need to be disclosed by mentioning the other board seats that a board member occupies. Stockownership records of key managers in their corporations need to be filled, made public and continuously monitored by the General Authority of Stock Exchange to help in curbing insider trading, alleged and otherwise. Finally, stick to your saving and investment plan. Investment needs to be done according to a plan where a percentage of your monthly income is invested in the market. After providing for the basic necessities, insurance, and putting away some money for emergencies, put some money every month into the stock market. This is an assured plan for you to achieve your financial goals, whatever they may be. * The writer is an assistant professor at the Arab Academy for Science and Technology.
