Economic Shifts: What Do Investors Do?

Topic Overview

Investing is a financial operation that has the goal to generate profit for the investor by applying capital in certain assets, such as stocks, bonds, real estate and most recently cryptocurrencies. The economic changes are strongly related to the internal political and social changes of the managing country, considering that the markets are globalized, the economic transformations also affect the other countries with which it maintains a constant trade of goods and services.

Throughout history, great changes have occurred, which bring with them a lot of uncertainty, which makes investors speculate and changes in financial markets are gestated, being the most recent one the Covid-19 pandemic.
It is important to know that there are 3 types of investors which are:

  1. Conservatives, they invest in low-risk instruments because there is certainty that there will be a profit, although this is usually small.
  2. Moderately, they invest in instruments with risk that may or may not generate profits.
  3. Aggressive, they invest in high risk instruments which can make them gain or lose a lot of capital. This shifts can affect the investors portfolio in both negative and positive ways.

Due to the declining market values, the value of the investments will diminish, provoking losses. In the other side, the assets can be purchased at a lower price and when the markets move to equilibrium the profit margins will have a high percentage.

Reactions to Their Reserves of Value

In moments of economic shifts, like a crisis, investors would get often more risk averse than they normally would be. Although they are more risk averse, they still want to maximize their utility function, with new opportunities that a crisis may bring, but keeping in mind that it’s also these times that bring more risk to their investments.

Most of the times, when markets overreacted and fell too far, they recover shortly thereafter, and those investors who sold on the fear side their portfolios, buy back those same assets at higher prices. While on the other side, patient investors that toke advantage of the moment were rewarded.

Valuable tip from Warren Buffett:

Be fearful when others are greedy, and be greedy when others are fearful

Warren Buffet, Times

What does this mean? During the 2008 crisis, Buffet was buying when other investors were selling, a lot of them were putting their money under their mattresses in order to not to lose it. On the other hand, Buffet was investing in low leveraged entities, or businesses in highly competitive positions. Although Buffett’s strategy wasn’t perfect, and he admitted his timing was a bit off on his October call to buy, since markets continued to plunge in 2009, he was right on a long-term basis.

Mr. Buffet, with the 2008 crisis gave a lot of lessons to the “normal and standard” investor. Giving huge opinions about how investors are reacting, and how they shouldn’t.
“People start being interested in something because it’s going up, not because they understand it or anything else,” Buffett said. “The guy next door, who they know is dumber than they are, is getting rich and they aren’t.”

But instead of acting on emotional instincts, Buffett’s advice is to follow the simple rule of being rational, know your companies and your peers, eventually, all crises get back and investors must invest in companies that are well established in the market and forget disregard mob fears or enthusiasms.

Investing right before an Economic Shift happens

Investing during a crisis is one thing, but what if you knew an economic shift would happen? Yes, that’s what Michael Burry did, when he bet against subprime-mortgage bonds, a nonsense at that time.
Another way to make money on a crisis, is to bet that one will happen. Short selling stocks or short equity index futures is one way to profit from a bear market. When a short seller borrows shares that they don’t own in order to sell them they hope to buy them back at a lower price, profiting with that change. Another way to monetize a down market is to use options strategies, such as buying puts which gain in value as the market falls, or by selling call options which will expire to a price of zero if they expire out of the money. Similar strategies can be employed in bond and commodity markets.

2021 and the Birth of New Investors

All these strategies have been tried before and have been proven to work, but lately there is a new breed of investors, investors which believe that the cryptocurrencies are a way to go and that they will be a new store of value in the future. That we will get rid of the regular fiat in turn for crypto and that banks and centralized finance will not be necessary in the future.

The majority of people do not like banks and to majority of people this idea is great, however how great is it truly? Can crypto be a true store of value and can crypto truthfully replace the fiat we have now and be completely decentralized and in the ownership of the people? Unfortunately, I do not think that the answer to any of those questions is yes.

To explain why I do not believe this is true, we need to start off with what a store of value is. According to Investopedia, a store of value is “… an asset, commodity or currency that maintains its value without depreciating”. This essentially means that you need to have something that you know will be worth in the future at least what you paid for it today or more. Stores of value are why we can have functioning economies and why we can exchange goods and services for money. For example, gold has been a very good store of value in the past and will continue to be in the future. Overall, for something to be a store of value you must be certain that you can exchange it for something else and that the value of that something else will be the same as the value of whatever it is that you are giving the other person.

One might argue that cryptocurrencies, especially Bitcoin fall into the definition of store of value, well unfortunately that can never be the case because of multiple reasons. The first and foremost is that cryptocurrencies are highly volatile and extremely manipulated by a select number of people which take advantage of unsuspecting individuals that are way in over their depth. The sheer number of crypto scams and so-called “rug pulls” which are essentially deplorable schemes which are used to create hype around a cryptocurrency and once it reaches a certain price point, the majority owners of the currency sell which cause the price to drastically fall. The latest and greatest example of that is the SQUID game token which went from over $500 to $0.016 in a matter of seconds. Thousands and thousands of dollars were lost by unsuspecting retail investors which have been taken advantage of.

Another reason why cryptocurrencies will never be a good store of value is that vast majority of them have no value on their own. Their value is derived from the price that someone else is willing to pay and not some underlying fundamentals which have value. Essentially it is all supply and demand without inherent value. Some might say that it is the same thing with fiat currency, however there are entire countries and economies that stand behind fiat currencies and just that fact makes the argument obsolete because that makes the fiat have some inherent value. If you are buying Euros or US Dollars you are buying currencies of a country, or in the case of Euro – multiple countries. Additionally, there have been arbitrage opportunities with fiat currencies but to the scale of cryptocurrencies.

We have all seen the articles that say “Here is how much money you would have today if you invested in Bitcoin 10 years ago” or any other cryptocurrency. Most of us wish that we had invested 10 years ago in Bitcoin and made a fortune, because for the past 10 years Bitcoin has had 230% annualized returns. Just saying or reading that is insane and has no connection with the real world because there has never been a case where something like that was done with a real currency or any other asset class. This is because Bitcoin is highly speculative and is dependent on the amount of “buzz” it creates which will lure new people in. For Bitcoin investors it does not matter how much money you paid for it, it matters that there is someone out there that is willing to pay for it more than you paid for it.

Of course, Bitcoin is not the only crypto that exists, as of the day of writing this article there are 15,447 different cryptocurrencies. This means that they are cannibalizing each other for market share and that is an additional reason why cryptocurrencies will never replace fiat and will be nothing more than speculative assets with no inherent value, no matter what project they put behind it. What is also encapsulated in the fact that there are 15 thousand different cryptocurrencies is that any argument of scarcity is immediately nullified because that is just not true. There might be a finite number of Bitcoins but if you are unable to get Bitcoin or it is too expensive for your price range, there are thousands of other cryptos that you can choose from, and they are constantly rising in number as new schemes and scams are created each and every day.

The reason why there are so many different cryptos and “projects” that come up and that people actually put their money in is because in 2021 there has been an unprecedented number of investors and especially retail investors. This is because investing has never been easier and more accessible to a wide audience of different people. Unfortunately, most of these people are uneducated in terms of investing and they are just following trends without real research and nine times out of ten it does not bode well for them. However, what keeps them going is that one person that makes it big and all of a sudden they think they can do the same. Matter of fact is that that kind of investing is unsustainable and not systematic, it is purely based on luck and more likely than not – cannot be replicated.

In 2021 a lot of the pricing of any asset is inflated to the point where fundamentals do not matter for anyone it is more of “buy the rumor and sell the fact”. With such large number of investors that do not know what they are doing, instead they are just pumping money into the stock market or any other market, it is bound to happen. But discussing inflated stock and asset prices and the reasons that came to be is a whole different beast to tackle as it relates to inflation and other macroeconomic and geopolitical forces for which we do not have the capacity to discuss today but it still relates to us since we see the effects of that in our everyday lives.

What I wanted to say is that since it seems as if everyone and their grandmother is investing these days, one saying that is said on Wall Street and that I like to remind myself of is “If my taxi driver starts giving me stock tips, I know it is time to leave the market”.

Main Strategies on the Stock Market

The first thing to consider is the reason behind investing. People can invest for three different reasons:

  1. To beat inflation
  2. To make some money
  3. To realize specific ideas

People want to invest to beat inflation with just a single objective: maintain their purchase power. When considering inflation, it is easy to conclude that the time value of money plays a huge role. If prices keep going up and the balance stays constant, it is possible to observe a loss of purchase power. Therefore, beating inflation should be the main reason for investing. The second one would be to make some money. People will use their money to try to make more money and increase their assets. And the last one would be to realize specific ideas. People could invest their money to start planning their retirement, to buy a second house, to help their children, or any other personal interest.

The first thing we need to take into consideration before investing is our risk tolerance. People need to define their Risk/Reward relationship and align themselves in a more conservative or aggressive type of investment. The higher the risk they are willing to take, the higher the reward will be. For example, a low-risk investment, such as a US government bond, will have a lower risk than an option or future, but, at the same time, a lower possible return as well. And when thinking about risk tolerance we have two main approaches:

  • Index Mutual Funds
  • “Beating the Dow”

By choosing an Index Mutual Fund, a person would be taking a passive investing strategy where the returns would be aligned with the market’s average. By choosing an Index Mutual Fund, we would be taking advantage of instant diversification, the use of a portfolio manager, the possibility of liquidity at any time, and automatic reinvestment of capital gains and dividends. Therefore, this would be a solution to consider in the long run. However, using this type of investment, the investor would be subjected to possible management changes and to tax aspects, where 95% of capital gains and dividends must be paid out to shareholders.

On the other hand, there is the “Beating the Dow” perspective. This strategy can be used using different types of indexes, but the most common one is to try to beat the Dow Jones Industrial Average (DJIA) each year. This type of investment looks to achieve better results than the market average. If the market is going up, the objective is to outperform the market. If the market is going down, the objective will be to not perform as poorly as the market. This investment will try to be more rewarding than the market, so it is easy to conclude that it will be riskier at the same time.

Another thing to consider is the period that the investor has in mind, either long-term investing or short-term investing. And regarding this detail, there are two attitudes:

  • Buy, hold and watch
  • Short term investing

Buy, hold and watch is associated with long-term investing. Using this approach, the investor will hold the stock for a long time regardless of fluctuations in the market. So, by using a buy- and-hold strategy, the investor will be looking into the long run and not be concerned with short-term price movements.
The other approach would be a short term investment. By using this strategy, the time span could range from day trading to, usually, a one- year hold. As opposed to buy and hold, short- term investing will look for market fluctuations and price movements and try to take advantage of that.

Regarding the research process, there are two different options:

  • Use of a money manager
  • Do your own research

Using a money manager is the most expensive option but it also is the most time-saving one. The portfolio manager, sometimes also called a full-service broker, will take care of the investment decisions based on his research and his client’s risk tolerance.
The other option would be the “Do your own research” perspective. Within this option, there are different possibilities. The investor could use a Discount broker, where the investor would still be making his own decisions but could ask for professional advice in exchange for a fee. He could also use stock screens, a tool, usually paid, that the investors and traders can use to filter stocks based on their user-defined metrics. Finally, the investor could also do the research completely on his own, using his own methods, taking his own conclusions and making his own decisions. By doing this he wouldn’t be taking any costs but would be spending a lot of time on research and analysis.

There are some different strategies to investing. In this article we decided to cover some strategies that are suitable to use during a crisis.

  1. Growth investment
  2. Value investment
  3. Index Mutual Funds
  4. Contrarian
  5. DRIPs
  6. Dollar cost averaging

Growth investment consists of buying stocks of companies that, usually, operate in the technology area or are innovators within their sector. Normally, these stocks are characterized for having a low dividend yield and high earnings potential.

There’s also a Value investment perspective, where it focuses on investing in the stocks that are trading for a lower value than their estimated intrinsic value. Typically, these stocks have a good dividend yield.

As previously stated, investing in Index Mutual Funds is one of the most common strategies. By using this approach, the investor will adopt a passive mentality and will try to follow the market’s average.

Being a contrarian in a market where everyone is panicking and short-selling everything can be quite rewarding. When you adopt this posture in the market, you are going against the trends, that means that you are buying when other people are selling, and selling when the others are buying. Ideally you are “buying low and selling high”. This can be considered a risky strategy, but in times of fear, greed and doubt, being cold headed with your investments can be quite rewarding.

DRIP, an acronym for dividend reinvestment plan, is a strategy that consists of reinvesting in the same stock the cash that comes from the dividends provided by the company. By doing so, the investor is slowly making the investment in the company bigger. Both investors and companies can benefit from this. If the company operates the DRIP, the investors are getting extra shares with no loss from the commissions of the brokers, since it is the company itself that is distributing the shares. On top of that, the companies may also make a discount on their stock, resulting in an overall lower cost of investment. The companies on the other hand also benefit from the DRIPs. By offering a program like that, they are making an investment on the company sound more appealing. They are also diminishing the risk of the investors selling their stock when they have a bad financial report, making the investors hold the stock for a longer time. Overall, by partaking in a DRIP program, you are granted a growth in the quantity of stock owned over time.

In a time of crisis, there can be a lot of fluctuations in the market, making being on time on the market a hard task. Times of uncertainty make people insecure about their financial decisions. Just thinking about making a poorly timed, leap of fate investment and ending up losing money is terrifying. That’s where dollar cost averaging comes in handy. This strategy consists of investing equal amounts over regular intervals, ignoring price fluctuations. The purpose of doing this is to fight the risk of having bad timings on your investments, since you are reducing the impact of fluctuations on the price of your investment.

Is It Good to Invest During a Crisis?

Economic models tend to assume that its actors behave rationally. While this may be the case during times of market stability, the numbers don’t add up in times of crisis. Dubbed the rational actor theory (RAT), it stands at the center of the efficient market hypothesis (EMH), popular in mainstream economics. Despite its widespread acceptance (the most prevalent in university economics textbooks), the theory has fallen prey to researchers’ criticism, pointing out that investors are above all else human, driven by emotions.

This introduces irrational decision-making into the equation. Emotional responses can be seen as a result of the lack of certainty in the market, informational asymmetry between actors, and the inevitable inability to entirely predict future economic shifts. Thus, shifts in the economy produce shifts in investor behavior. The question we may further ask is whether the latter can be predicted to the extent to which it can be useful.

According to the behavioral portfolio theory, people are guided by two kinds of emotions when investing: greed and fear (Shefrin & Statman, 2000).

  • People want to get rich as quickly as possible (as suggested by the growing number of ‘get-rich-fast’ schemes) and are enabled to do so in times of economic growth. However, despite pushing the market further, this way of thinking leads to the abandonment of long-term plans and ultimately an overheated economy.
  • On the other hand, fear tends to be more contagious, having in the past led to infamous bank runs and mass stock selloffs (most notably at the start of the Great Depression), all contributing to a self- fulfilling effect. The stagnation of the economy tends to set of such self-enforcing cycles.

The effects of these two emotions are magnified by what has been termed as the ‘herd instinct’, following collective action assuming that someone else has done the research. Patterns of herd behavior tend to be rooted in anchoring, whereby in the absence of new or better information, the market price of stock is assumed to be the correct price reflecting its value (and subsequently well-being of the company). Further influenced by recent trends and events, historical data is ignored, leading to uncalculated decisions. A notable consequence is investors’ over- or under-reaction to market events, causing intense price volatility directly tied to news headlines. Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns. This high sensitivity leads to market panics and crashes.

Investors’ emotions in times of crises immediately impact their investment decisions, affecting both their current portfolio and future plans. Based on the Prospect theory (also called the Loss aversion theory), However, studies have shown that rather than being just risk-averse, people are more loss- averse. The Prospect theory (also called the Loss aversion theory) thus points out that economic losses cause a greater emotional impact on an individual than do gains of equal amount. This can be used to describe investors’ tendency to hold on to losses for too long, their actions in such instances becoming risk-seeking. In reality, such demonstrations of irrationality tend only to compound the magnitude of losses.

A common example is that of a player at a casino. When he is winning, he may start playing more conservatively and betting smaller amounts to preserve his winnings. If that same player is down money, however, he may take on much more risk by doubling down or increasing bets on riskier hands in order to break even. Investors behave similarly.

In times of crisis, investor perceptions on risk, return, and expectations fluctuate based on losses sustained. Thus, we find substantial swings in trading and risk-taking behavior during the crisis that are driven by changes in investor perceptions. Namely the perceived level of risk increases at the height of the crisis, while the tolerance of risk decreases (alongside return expectations). These findings match observations regarding investors’ sensitivity to bad news.

What is of interest to us, however, are the observations towards the end of the crisis. The study (Hoffman, Post & Pennings, 2012) found that risk tolerance, risk expectations, and even return expectations recovered to nearly pre-crisis levels. Once the dust settles, and the economy enters a phase of recovery and build-back, investors’ anxieties are calmed. Interestingly, this return of optimism goes hand in hand with rebound prices, with markets responding to analytical predictions rather than perceived turmoil.

Buffett once said: “Unless you can watch your stock holding decline by 50% without becoming panic- stricken, you should not be in the stock market.”
Shifting thus the focus to the market as a whole, historical data suggests that there is always a light at the end of the tunnel. A study by Ned Davis Research group looked at numerous global crises over the last century. One of the key findings was that each time markets overreacted and fell too far, only to recover shortly thereafter. Speaking in numbers, in 19 cases, the Dow Jones Industrial Average was higher six months after the crisis began.

The average six-month gain following all 28 crises was 2.3%.

Perhaps the most relevant result recently has been the 2008 crisis. Following The Great Recession, efforts were made to ensure a quick recovery, and policies were set in place in order to prevent it all from ever happening again. The Dow Jones Industrial Average (DJIA), which had lost over half its value from its August 2007 peak, began to recover in March 2009 and, four years later, in March 2013, broke its 2007 high. For workers and households, the picture was less rosy. Unemployment was at 5% at the end of 2007, reached a high of 10% in October 2009, and did not recover to 5% until 2015, nearly eight years after the beginning of the recession. Investors were also quick to bounce back, graced by a 6-year bull market after the end of the crisis.

Given the historical data, investing during a crisis seems to yield favorable results. Taking advantage of the low prices at the low points of crises remains one of the soundest tactics to beat the market, with earnings following the inevitable trajectory of growth. For the most part, investors who sell out of fear amidst crashes find themselves having to buy back their portfolios at higher prices, while those that are more patient are rewarded. The most common ways to invest reap these rewards are by holding, investing, or shorting.

  • For those with money in the game, seeing the loss of a large portion of their equity portfolio is a hard pill to swallow, and holding is not always a viable option. However, in the long run, selling early only compounds the damage by missing out on the recovery growth. Exiting the market too early, or fleeing with the herd, can thus tear a large hole in already existent portfolios.
  • Assuming the availability of liquid assets, market lows are the optimal time to acquire more or new stocks, suited to each investor’s individual level of risk-aversion.
  • Shorting, or short selling stocks or short equity index features is another way to profit from a bear market. Similarly, one can opt for options strategies.

However, investors are always advised to proceed with caution, even ‘buying the dip’ carries risk due to the uncertainty surrounding the timeline and scope of a recovery. Double-dip recessions are a real possibility, and attempting to pick a bottom is largely a matter of luck. Two things to keep in mind is that a dip in one single asset isn’t a strong indicator to buy, investors should instead look for dips in the indexes (which are much more indicative). Alongside this, diversification of the portfolio remains an important concept, covering investors for present and future losses. Furthermore, flexibility and timely re-evaluation of one’s investing strategy avoids unnecessary losses. In reality, companies often go bankrupt during crisis, with the stock going to zero. This is why it’s important to research the numbers instead of blindly following the red line.

In the end, the verdict is that there are foreseeable opportunities to beat the market in periods of crisis, provided you have a good level of caution and skill. What we have seen is that while greed pushes the bull market higher, fear plunges the bear market lower. The observed existence of the herd instinct shows a complete disregard for long-term investing based on sound calculations. In times of crisis, both emotions may prevail at the same time. While investing during this time may be profitable (caution and good research are always advisable), it is worth noting that it is not an option open to everybody. Crises strike deep wounds in the pockets of many, forcing them either to cash out whenever possible, or leaving them with no liquid assets to invest. Further, shorting, derivatives, and options are not tools available to every player in the game, nor can they be practiced effectively by everyone. Investing during a crisis thus comes with a bright yellow ‘caution’ sign.



Published by lisboninvestmentsociety


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