About that Market Hiccup...

I have been mulling over a couple other things recently and have some comments about same,
so this may be rather lengthy.

I don't think this blip is a big deal. 

I also think it has the potential for extending the bull market.

Here is why:

#1 - China gets a reality check.

Anyone who has been watching Asia, and China in particular for the past couple  years would know a
correction at some point is due and it has been a long time coming. What goes up does not stay up.

While I think emerging markets are still a good place to be, I still don't  believe in country-specific sector
funds. You don't need to look too far to see examples where speculation drove a country-specific stocks
well beyond a reasonable value and then it all collapsed.

I don't think China is going to collapse, but I do think it is nice to see China experience what happens
when market forces work against you.

#2 - Speculators got hammered.

What happens when investments go up and up?  Why, you think about speculating.

Look at housing.  How many people do you know who purchased second homes or got into something
they couldn't afford because they thought the market would keep going up?
Had to bust sometime, and bust it did.

One method of market speculation is called Buying on Margin.


Margin an investment vehicle which can let you lose more money than you initially invested. Sounds like
a helluva deal, doesn't it.  This is because you can play with money that isn't yours.

To buy on Margin, you need a Margin account.

But first, lets back up a moment and say I bought one share of GE for $20.00.

I then sold it for $40.00.

In a regular cash account, I made a profit of 100%, less commissions.

Now, Say I set up a Margin account and bought that same share.  In a Margin  account, I can borrow
money from a broker (usually 50%) to help buy the share.

I pay $10.00 and the broker pays $10.00.

If I sell the share for $40.00, I just made 200%, less interest on the borrowed money and the borrowed
money itself.

Sounds kind of tempting, doesn't it.  If you think the market is going to keep on rising, you can leverage
your money and potentially double your usual returns.

But what happens if things don't quite work out that way?

How about doubling your losses plus some.

Now lets say there is a computer glitch on the NYSE, sending the market into a tailspin.

My $20.00 share of GE is now worth $10.00. Since I bought this on Margin, I lost half of my money and the
half I borrowed - a 100% loss.

Tack onto that interest owed tthe broker and I lost more than I originally invested.

Oh yes, there is also something called a Margin Call

A certain minimum is generally required in a margin account. If the value of that account drops below the
minimum, you get a call from your broker to deposit the funds necessary to make that account whole.

This is a Margin Call.

Here comes the double whammy.

Lets say instead of buying one share of GE on margin I bought one thousand, which also happens to be
the total value of the account itself  -

My $10,000 and the broker's $10,000 

During one really bad day of trading, my GE shares lose 50% of their value.

The Margin account just lost 50% of its value which means:

I lost $5000 of my money and I lost $5000 borrowed from the broker.

I receive a call from the broker telling me it's time to pay up and make the account whole.

I owe the account $10,000 plus interest on the borrowed money.

I know the call is coming, so I opt to turn on the answering machine for a  couple days. 

I figure the market is going to turn around very quickly because the steep drop  was the result of a
computer glitch. 

If I still need to make the account whole after a couple days, odds are I will not owe much.

Sounds reasonable, doesn't it?  After all, it's not my fault.

Well.......... Here is where the losses seriously compound themselves.

Let's also say I am not totally insane and have a cash account with the broker, holding $30,000 in good,
high quality Chinese stocks.

A cash account is a 'normal' brokerage account where you buy and sell stocks, funds, etc.

Because it was a really bad day, the value of the normal brokerage account is now worth $10,000 due to a
massive sell off in China, combined with a 500 point drop in the Dow the next day.

Towards the end of the trading day, the broker calls and guess what?

He can't get hold of me.  Answering machines - one of the better inventions.

So what does he do?

When I set up the margin account, I failed to read the fine print.

The fine print says in the event of a margin call where you don't pay up,
the broker can sell stock the other account to make your margin account whole...

Plus interest, of course.

The broker sells all shares in the brokerage account, which just happens to be
worth $10,000, wiping out the entire account.

I can go one step further:

Lets say I am totally insane and all the money I have is in the Margin account. 

The account on that fateful day lost half of its value and I couldn't make Margin.

I am tapped out. I lost 50% of my money and 50% of the broker's money. 

What does the broker do? He sells my half to make himself whole.

Now I have nothing and adding insult to injury , I also owe interest.

If you compound that by tens of thousands of investors and gazillions of dollars, it will give you a fair idea
of what happened in the year 2000.

You end up losing an  additional $30,000 (if all returned to normal in a couple days) to satisfy the $10,000
owed to make the Margin account whole.

Think the spouse is going to be real happy about that?

Of course if you want to look on the bright side, you can deduct $3000.00 a year as a capital loss at tax
time for quite a few years.

I think this computer glitch served to shake some speculation out of the market.  The shaking is probably
not done yet and it may end up helping in extending the current bull market.

#3 - It Shook the Tree

People who should not have been in the market in the first place, probably aren't now. There are likely
fewer speculators.  People are thinking twice about future investments.

As an aside, I wonder what Ben Bernake thinks about Greenspan shooting his mouth off overseas. 

Everything got a sanity check which I think is a good thing.

Sensible Speculation

What is Sensible Speculation? 

I'd say it is speculating (or gambling) with an amount that can't hurt you, but could put a little icing on the

Real Life Example:

I know an older gentleman who loves to play the pennies and doesn't do too badly either. He does a lot of
research and even calls the companies he is interested in.  He's made trips to see the physical company
when really interested.

With him, I think he views this type of speculation as more of an intense hobby than anything else.

His wife however, is of a different stripe. 

She told her husband, 'I have no problem with you gambling, as long as for every dollar you spend on
these penny stocks, you buy me the equivalent  amount in Wal-Mart shares.' 

I understand she owns a whole lot of Wal-Mart shares.

Intelligent Speculation tempered with Sensible Investing = Sensible Speculation.

Weathering these Upheavals

Think in Percentages - the Right Way, not Dollars - the Wrong Way.

Before you had an investment portfolio, odds are you thought about everything that involved a dollar, as
a dollar.

Starting out in life, first time out on your own and 25 years old, $1000.00 is probably a fair chunk of
change and you think about it  in terms of dollars.

Your really would not like to lose $1000.00 because odds are you are living from check to check, with maybe little saved for contingency.

Fast Forward Ten Years to 35 Years of Age:

You now have a house, a car and an investment account.

All that schooling really did pay off.

Your investment account consists of several good no-load mutual funds and a few quality stocks. 

The market has been good to you and your account is worth $25,000.

You are not stupid and you know the market gyrates, although it really hasn't affected you.

Not bad.

That is, until the market goes haywire and drops 4%, or about 500 points in one afternoon. 

Your $25,000 just turned into $24.000.

You lost $1000.00, or 4%.

Thinking in Dollars:

If you think about this loss of $1000.00 in terms of dollars, then you could be setting yourself up for a
a costly mistake.

You are not 25 years old anymore, when $1000.00 was a month's wages and then some.

If you are thinking about money as you did 10 years ago, panic could set in and cause you to sell the
entire portfolio at the wrong time for the wrong reason.

Emotional investors frequently think about investing in terms of dollars.

Your financial status has changed over the last 10 years but the way you think about money has not.   

This needs to change.

Thinking in Percentages:

Looking at the days loss in terms of percent, you lost 4%.

10% corrections in a bull market tend to extend the market.

Losing 4% is to be expected.  The market gives and takes.

Not much of a reason to panic if you regard the loss as percentage.

It is a matter of using the correct perspective, which means you are maturing when it comes to investing.

Lets Exaggerate this a Bit.

Suppose at 45 years of age you have a cool $500.000 in your investment account.

The market dropped 4% in one day and you just lost $20,000.

How would you react?

Would you immediately sell everything and stick the proceeds under a mattress?
At one time that was time more than you made in a year.

Would you note the 4%  and carry on as usual?

Would you take another look at your portfolio and ensure your allocations are where you really want

If you think about the loss in dollars, trouble's headed your way.

If you think about the loss as a percentage, rationality rules the day.

Time to get of the soap box.  Lunch is over.

Oh yeah, I almost forgot - the usual disclaimers appply. What you do is your own responsibility, etc.

Footnote:  I've seen this business about not thinking about your investments in the proper manner play itself out many times,
and with bad consequences. If you know a better way to present this topic, feel free to contribute.  I think it is important.