Understanding an Anniversary We’d Prefer to Forget

Making market turbulence work for your portfolio

   

Men are not always the best about remembering anniversaries, but there are a few that we would all like to forget.  Last Sunday marked the two-year anniversary of the infamous “Flash Crash” of May 6, 2010 that saw the Dow Jones Industrial Average swing by 600 points in 20 minutes.

What is perhaps most remarkable about that incident is that there was never a proper explanation for what happened.  High-velocity “algorithmic” trading is generally credited as the culprit, but what exactly happened?  And what is to prevent it from happening again?  To these questions we have no answers.

The real legacy of the Flash Crash is not the portfolio losses suffered by some investors; in fact, unless you happened to have open stop loss orders that got executed, chances are good that the entire event came and went before you had time to act.

No, the real damage was to Wall Street itself, or rather its reputation. The Flash Crash made investors cynical, making them feel the market was a casino game rigged against them.   Perhaps never again would they believe that the stock exchanges were what they claim to be: a place for holders of capital to allocate it to businesses deemed worthy of investment.

In truth, the market is a rigged game, and it always has been.  Perhaps we need a good Flash Crash every few years to remind us of that.  But rigged game or not, investors able to keep a level head can still use the market for its ostensible purpose of allocating long-term capital.  Market turbulence is something that can be embraced rather than shunned. 

The late Sir John Templeton had a great strategy for managing volatility and taking his emotions out of the equation.  He would make a list of stocks that he would love to own if only they sold for a substantially cheaper price.  He would then place limit orders to buy them at those prices.  If a wave of panic swept the market, Sir John would not be paralyzed by indecision because the decision had already been made for him.

An investor with a plan like this in place on May 6, 2010 could have made a fortune in a matter of minutes.

A similar strategy that had the added benefit of earning you a little extra income is selling deep out-of-the-money puts on stocks you’d like to own at the right price.  Under normal conditions, your puts will expire worthless and you pocket the premium.  But if prices experience a short-term dip, your options might get exercised, meaning that you would have to buy the shares in question.  Of course, that’s the whole idea.  You’d be buying shares of a company you always wanted to own at a price you weren’t expecting to get.

These strategies work fine for buying on the cheap, but what about investors that use stop loss orders for risk management purposes?  I will address that, but first I want to ask a question: would you knowingly play a game of poker if you knew the other players could see your cards?

You most assuredly would not.  But when you place stop loss orders, you have effectively done exactly that.  Don’t be surprised when the stock price dips just low enough to hit your stop before rallying higher.

I’m not suggesting that investors eschew stop losses; good risk management is essential to prevent small losses from becoming catastrophic ones.  But I am suggesting that you play it close to the vest.  Have your stop losses tracked in an Excel spreadsheet, a website not affiliated with your broker, or even a Post-It note.

And finally, while automatic techniques like these are valuable tools, they will never fully replace good old fashioned intestinal fortitude.  An oft-quoted line from Warren Buffett is to “be greedy when others are fearful.”

Today, investors are fearful about Europe, which has me feeling more than a little greedy.  I’ve recommended Spanish telecom giant Telefonica (NYSE:TEF) before, and I would like to reiterate that recommendation again today.

Telefonica is one of the finest, most globally-diversified telecom firms in operation today, and long after the current crisis has passed it will be routing telephone calls and paying its investors a fat dividend.  Use any turbulence in the months ahead as an opportunity to accumulate more shares.

Disclosure: Telefonica is held by Sizemore Capital clients and is a holding of the Sizemore Investment Letter Portfolio.


Article printed from InvestorPlace Media, http://investorplace.com/2012/05/an-anniversary-wed-prefer-to-forget-tef/.

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