Losses sustained from a market downturn are not wholly the result of the ebbs and flows of the market. On some level, losses are the result of your broker's failure to implement RISK MANAGEMENT--the tools and techniques necessary to protect your investments from the ebbs and flows of the market.
by Lawrence C. Melton, Esq. lmelton@dhayeslaw.com
THE HAYES LAW FIRM, www.dhayeslaw.com
Why did you hire your broker or financial adviser? Most likely you hired your broker to protect your investment against the inherent risks of the market place. You certainly did not hire your broker to lose massive quantities of money and then offer up excuses. You do not want to hear the stale refrain: "too bad, the market went down." While it is true that all investments entail some degree of risk, that fact alone does not grant the broker the right to abdicate his or her responsibilities.
We are now five months removed from the 2007 market crash. Did we learn anything? Lets recap. On February 26, 2007 the market crashed and many investors lost hundred of thousands of dollars. The crash was precipitated by an 8.8% drop in the Shanghai markets. The ripple effects spread to markets across the world, leaving many American citizens in dire circumstances. See Bill Mann, Seth Jayson, and Nathan Parmelee, China Syndrome, The Motley Fool, February 27, 2007. http://www.fool.com/investing/international/2007/02/27/china-syndrome.aspx.
So, five months later, is there a lesson we can learn from the 2007 crash? Yes. The extreme losses many investors experienced demonstrates the importance of risk management.
The losses you sustained from the February 2007 crash were not wholly the result of the ebbs and flows of the stock market. On some level, your losses were the result of your broker's failure to implement tools and techniques necessary to protect your investments from the ebbs and flows of the market. You hired your broker to protect you from being pulverized should the market crash.
Irrespective of the type and designation of the account, all brokers and advisers have a duty to employ appropriate methods and techniques to measure and manage the risk associated with their customer's investments. The following is a list of risk management techniques:
ASSET ALLOCATION is the selection of a portfolio of investments where each component is an asset class (usually stocks, bonds, cash) rather than an individual security. It is widely known that 90% of any portfolio's performance depends solely upon the allocation between classes of investments (fixed v. equities), and that most of the rest depends upon proper diversification within each asset class (e.g., US stocks; foreign stocks; different industry sectors: consumer, financial, industrial, technological; and among equities and U.S. treasuries, corporate bonds, foreign bonds, etc.). See Brinson Singer and Beebower, Determinants of Portfolio Performance II: An Update, Financial Analysts Journal (May/June 1991). See Modern Portfolio Theory, Ibbotson Associates.
DIVERSIFICATION is the spreading of investments among different industries and market sectors in order to reduce risks. "It is important to have in one's portfolio stocks that do not all depend on the same economic variables, such as consumer spending, business investments, housing construction and so forth." Burton Malkiel & William Baumol, Redundant Regulation of Foreign Security Trading and U.S. Competitiveness, in Kenneth Lehn & Kamphuis (eds.) Modernizing U.S. Securities Regulation 45 (Irwin, 1992). Studies show that diversification is not possible with less than 25-30 positions.
POSITION SIZING is when the investor purchases shares or bonds in a way that the purchased position represents (1) a predetermined dollar size, or (2) a predetermined percentage size of the overall portfolio or (3) a predetermined percentage size of an asset category.
PREDETERMINED PURCHASE POINTS (and PREDETERMINED SELL POINTS). The investor, with the help of his or her broker, determines the value of a particular stock. Then they determine what price represents a price that is too rich. This is called the predetermined sell point. Next they determine what price represents a stock that is undervalued. This is called the predetermined purchase point.
MENTAL AND MECHANICAL STOP LOSS ORDERS. The investor looks at the current market value of a particular stock. Then the investor sets a percentage below the current market value and says the stock will automatically be sold if it falls to that level.
HEDGING is the the purchase or sale of securities to offset an existing securities position. A fully hedged portfolio is protected against shifts in the market, interest rates, or other identified risks. This strategy is typically used to protect an existing position in the underlying asset against a decline in value while retaining all of the upside potential.
A common way to hedge is to use derivative instruments such as a put option. A put option gives the holder the right to sell an underlying asset at a specified price on specified dates. Investors who are nervous about a short term decline that can erode the value of an asset can use a put to provide protection.
Example: Investor owns 1,000 shares in X Corporation, which is trading at 144. Investor is nervous that the price is going to drop. Investor does not want to sell the stock outright--he just wants short-term protection. What can he do? He buys 10 "X Corp. puts." Each of these puts gives the investor the right to sell 100 shares of X Corp at $140 per share (up until expiration), protecting the investor against a sharp decline in the price of X Corp.
(See Groz, Marc, Forbes Guide to the Markets, Pg. 160, John Wiley & Sons, Inc., 1999). More than likely, your broker did not adequately explain to you the information contained in this article. It is probable that your broker did not implement such measures as discussed above. If your broker had implemented such measures, you may have avoided incurring heavy losses from the market crash.
The Hayes Law Firm is a securities arbitration law firm dedicated to the zealous representation of victims of securities fraud. Visit our web page at www.dhayeslaw.com or call us toll free at 1-866-332-3567.
