Moneywise24 Personal Finance

I have to be completely honest: I love watching the markets and investing parts of my capital actively, but the current turbulence is driving me crazy:

• Greece is in the news, stocks go down,
• According to analysts stocks are oversold, so they go up,
• Productivity over the last month has increased, nothing happens,
• Volcano erupts, stocks go down,
• And the list goes on …

Currently there is so much emotion and insecurity present on the stock exchanges, that it is really hard to predict what is going to happen next. Whereas optimists claim that this is only temporary, and markets are bound to go up when certain uncertainties have been settled, others claim that this is only the beginning of a double-dip recession, or perhaps worst.

So, I decided to stop taking any new positions for the moment, at least concerning individual stocks and derivatives, and I have implemented the following action plan for the upcoming weeks or months: Read the rest of this entry →

Possibly Related Posts:

• Markets Plummet As The Fear On Europe’s Debt Crisis Dominates
• Rising Stock Markets, But With Caution
• The Benefits Of Periodical And Automatic Investing In Mutual Funds
• The Top Reaon Why You Should Pay Yourself First
• When Investing, It’s Not ‘Gonna Be Allright’

I bet everyone knows the term “hedgefunds”, especially since they have had a lot of negative publicity in connection with the financial crisis. Still, the main principle of a hedge fund is clever and straight forward: by allocating a part of the portfolio to anticipate on a downturn of the market, the portfolio is protected against sudden negative movements of the stock exchange. Hence, a hedge fund in a classical sense seeks to diversify its portfolio in such a way, that it can benefit from both a positive and a negative market.

I have been playing around with different methods in order to protect my (still small) portfolio against a sudden negative downturn. Since I know options quite well, I have used put options to protect my portfolio against sudden negative movements.

Option basics

The basic principle of a stock option is that it gives a right to buy (call) or to sell (put) a particular stock during a given period at a pre-set price. The fact of buying or selling stocks in this example is quite irrelevant, since a call option itself will increase in value when the stock’s price increases, and the put option will increase in value when the stock’s price falls.

Options can be bought on virtually anything, on stocks, oil, gold, or an index.

Buying a put option on a market index

Sometimes, concerns over a particular topic can result in sharp downward movements of the market. This does not mean that the stocks in my portfolio are bad, it is a momentarily event. If I buy a put option on a market index, I can profit from this sudden downturn market.

Since my strategy was only for the moment, I bought a put option with a relatively short timespan, say one month. Additionally, I bought an option which was out-of-the-money, meaning that the strike price is below the current price of the index; this makes the option cheap.

Last, I bought the put option with a very limited amount of money, and it made only 5% of my total portfolio.

What happened

Concerns over Greece, Ireland, the earthquake in Japan as well as political instability in the Middle East caused the index to drop by an average of 1% each day. The put option I had in my portfolio virtually exploded, since the expectation of a further decline of the markets were fed by the world news.

Although my portfolio, which in general is quite stable, fell with around 5% or 6% (I have quite some options in my portfolio, so profits and losses are considerable sometimes), my put option on the index increased by 200%. I sold the option with a nice profit, and was able to neutralize the losses on the rest of my portfolio.

Risks involved

Buying and selling options is not without risk. Especially when buying out-of-the-money options, where the price is purely based on expectation, the option can become worthless in a few days, or even a few hours. If the market does not move as you had anticipated, then you may expect to lose some considerable amount of money. Therefore, it is absolutely vital not to invest too much money into options (I would say a maximum of 10% of the total portfolio’s worth), but spread your portfolio between multiple products.

Another risk when buying options on a market index is, that sometimes particular stocks which are performing in the extremes (both positive as well as negative) may push the index contradictory to the general market sentiment.

Before investing in options, be sure to get informed yourself about this product, or speak with your financial advisor.

Possibly Related Posts:

• Markets Plummet As The Fear On Europe’s Debt Crisis Dominates
• Rising Stock Markets, But With Caution
• The Benefits Of Periodical And Automatic Investing In Mutual Funds
• The Top Reaon Why You Should Pay Yourself First
• Passively Investing In Turbulent And Insecure Times

I started investing my money actively around three years ago. My first approach was to invest a small amount of my money into mutual funds, in order to secure my retirement. But in addition to that, I wanted to get more active, invest a bit more of my assets, and start to invest in mid-term market movements.

A great way to do that is to build your own portfolio, using stocks and bonds. However, with stocks I found that you actually need a substantial amount of money in order to profit from it. If I only consider the commission I have to pay for buying the stocks, the smaller the invested amount, the bigger % profit I need to realize to get out with a good profit.

In addition to stocks, I have been using options for quite some time to profit from short-term market movements. However, options are also a great tool to profit from mid-term market movements. The profit can be much more substantial than when you invest in stocks, and a much lesser amount is needed to get out with a good profit. Also, I find options to be ideal if you want to ‘test’ the market, if you are a beginner.

Options may seem a lot more complex than they really are. Basically, options are are rights on their underlying value, in this case stocks, which simply gives you the right to either buy a particular stock at a certain price during a specific time range, or it gives you the right to sell a stock at a set price during a specific time frame. Of course you are not forced to exercise your right; when stock markets move, so will option prices, and you can simply sell the option at a later time.

I find options such a great tool due to the leverage effect they offer; whereas I might have had a 9% profit on a stock, I might have realized a 60% profit with an option on that stock. The key point is that you are anticipating the stock to move in a certain direction within a specified time, in stead of buying and holding your investment for years.

Options are very volatile instruments, and surely your potential to lose money is just as big as to earn money from it. Therefore, I assign only a smaller percentage of my portfolio to options. Still, I find them to be quite a good enrichment to my portfolio, and they helped me a great deal to play the market with only very small investments.

Although option trading has a very speculative image, I feel they can be treated very similar to stocks, if:

• I focus on up-trends. Markets tend to focus upwards on the long run. Speculating on market corrections or crashes can be quite risky, so I tend to focus merely on call options.
• I focus on a 3 to 24 month development. Stocks tend to make very swift market movements, and often stocks can dip for one or two months before increasing for months to come.
• I focus on fundamentally healthy companies only. I use the same kind of company analysis as I would have done with stocks. Technical analysis will also give me a hold on a stock’s trend and turning points, as well as whether the timing is good or not, but I will never invest in poor performing companies.
• Options can be very volatile, and sometimes a tiny negative stock movement can push the value of the option to a -40% loss, before increasing to a 60% profit. Still, if the value of my option drops below -50%, I consider it a loss, learn from the situation, and sell the option. On the other hand, I would sell my option at a profit of anywhere between 60% and 100%. I might buy the same option at a later time, if the timing is right.

You can read more on how options work in my previous post here.

Possibly Related Posts:

• Markets Plummet As The Fear On Europe’s Debt Crisis Dominates
• Rising Stock Markets, But With Caution
• The Benefits Of Periodical And Automatic Investing In Mutual Funds
• The Top Reaon Why You Should Pay Yourself First
• Passively Investing In Turbulent And Insecure Times

Just a quick search via Google, and the term “double dip recession” returns 1.8 million results. The topic is hot, and many people, if not the majority, believe that a double dip recession is on its way. Many articles speak of fear of a double dip, and try to anticipate whether and when a double dip might hit us.

Although such discussions are highly interesting, I tend to focus more on how to handle such a recession for now; because if it hits us, there will be nothing we can do to stop it, no matter whether we fear it or not. The question I ask myself is how I handle it, and even more importantly what I can do to stay out of trouble when it hits.

My first concern is securing my income. I am not yet in a position in which I run my own company, or where I can live off my savings for years. So, having a job is important. Where I live, in Germany, it is very difficult to fire employees. However, if a recession hits, even those employees doing a good job may be fired if else the existence of the company is in danger. Since I am male, single, and have no children, I would the first person gone. I would receive 70% of my last salary for nearly a year, but what about after that?

I took an insurance a while ago, which aims specifically at unemployment through no fault of one’s own. This insurance ensures that I receive up to a specific amount. I have calculated my minimum living standards, and added a buffer, which is the minimum amount I need to live off. If for some reason my living expenses go up (e.g. I bought a car, or rent increased), I can adjust the insurance to a new payout level.

Secondly, I continuously keep increasing my cash assets. This is my emergency fund, which I can use for unexpected expenses, either in or outside a recession. Having cash readily available gives me a more secure feeling.

On the long run I am investing in mutual funds. The amount is still small, but as soon as I sell these shares I will need to pay taxes. Therefore, I tend to keep the funds in my portfolio, but I will stop investing more money into them until the recession is bottoming out. This allows me to not unnecessarily increase my losses. Additionally, I might buy put options on one or more indexes, as a form of insurance. As the mutual funds (or stocks) are losing value, the put options are gaining value and are balancing out the losses, either completely or partially. However, I will monitor economic developments closely, and not judge too soon. The technical analysis functions help me to make an estimation of whether we are simply having volatile markets, or whether a recession is in the making.

When it comes to stocks, I tend to follow cyclical movements. I am not a big fan of the notorious buy-and-hold strategy, since these strategies were largely developed in the last millennium, where markets were not as volatile as today, and steadily increasing. When I buy stocks, I will look at undervalued or high-potential companies, but I will consider their cyclical movements. This means that I will set a stop-loss at all times, and in the event of a recession the stock will be sold automatically. Following the recession movement, it allows me to re-enter the market at lower prices.

During a recession, my expense policy changes slightly. I watch more closely not to buy items I do not necessarily need, and I am very keen on building my cash emergency assets. I might use the car less and take public transportation, and use each and every opportunity to save a bit of money. Also, I find a recession a great opportunity to visit friends at their homes, or invite people over, and just stay home and have a fun evening.

Surely I hope the double dip will not come… but a next recession will come for sure. Just as a fact: by the end of 2012, another batch of mortgage contracts will phase out, and there is a real estate bubble in China in the making, which is 5 times as large as in the US in 2008/2009. This is another reason why I prefer to stay out of any mutual funds or stocks with a real estate focus.

Possibly Related Posts:

• Markets Plummet As The Fear On Europe’s Debt Crisis Dominates
• Rising Stock Markets, But With Caution

I have to admit, I don’t have the best ‘education’ when it comes to doing investments. I didn’t grow up in a family, that taught me all about finance, and even during my education International Business Management, investments and the stock market wasn’t dealt with in great detail.

I did my first investment in 1998… or rather speculation, when I bought an option in a company, which later appeared to have falsified its bookkeeping; and thus they went bankrupt. I didn’t touch investments for a few years. Then I learned a bit more about fundamental analysis, and I thought I got it… I learned about technical analysis, and I had thought I had understood it.

But it’s when I started reading about behavioral finance, that kind of opened my eyes. I realized that everything I had done wrong, and my losses were more the result of submitting to my emotions rather than bad analysis. I want to deal with three of these typical emotions, and how they can ruin virtually any potentially good investment.

Information Bias

One of the main problems, is that people are very subjective beings. I always found it strange that for some reason I found a lot of proof, supporting my belief about a particular stock, bond, or mutual fund. Then, it didn’t work out as it was supposed to, I panicked, and suddenly I found tons of material, supporting the opposite.

Information bias is a distortion in the perception of human beings. If we have an opinion of something, we unconsciously search for information that supports this opinion, or it seems to be dominantly present. As such, we may make wrong decisions. Information bias often exists since people want to go with the flow, or the masses. Not going with the masses might mean making a fool of yourself, or being put off as ridiculous.

Selling too early, selling too late

Being successful in the stock market often means limiting potential losses and letting profits rise. At some times, I have been guilty of doing the exact opposite: selling very early with a small profit, but selling much too late, letting my losses be driven up.

Relating to stocks, we often become very excited at small changes, and the bigger the change, the more relaxed we get. Therefore, many people tend to sell early at a small profit, being euphoric that they made a profit and fearing that they might lose it. On the other side, these people might become scared at having a small loss, hoping that the stock will recover. If this does not happen, often people tend to think that it would be useless to sell the stock now anyway, and the further the stock falls, the less emotional and involved they become. It is not unusual, that these people sell the stock at exactly the least beneficial point: when it has reached its bottom.

Making up for losses

Luckily I have been largely able to control this. However, many people want to make up for their losses, just as quickly as they occurred. This is very difficult, since a 50% loss requires a 100% profit to make up for it. Many people are willing to take more risks, and invest more money after they have lost some, just to make up for it. Some go bankrupt in their attempts.

I know I have a lot to learn, and I will certainly get more into this topic and write about it occasionally. Until then, I can recommend the following articles I found, which I find worth reading:

• Portfolio Management: The Pitfalls of Behavioral Finance
• Behavioral finance to the rescue?
• Why Smart People Make Big Money Mistakes (and How to Correct Them)

Possibly Related Posts:

• Markets Plummet As The Fear On Europe’s Debt Crisis Dominates
• Rising Stock Markets, But With Caution
• The Benefits Of Periodical And Automatic Investing In Mutual Funds
• The Top Reaon Why You Should Pay Yourself First
• Passively Investing In Turbulent And Insecure Times