How to respond to panicking markets

The last few weeks have been a great experiment to determine those that implement \’buy and hold\’ as a strategy and those that have never actually had to do it during a market rout. Global indexes have collapsed on the coronavirus scare and panicky investors have been dumping shares left right and centre. For those investors that have never experienced it before, this is what the beginnings of a bear market look like – and believe me, they can go on for a lot longer than this little blip.

If you don\’t want to join the hordes of panicky shareholders locking in losses in falling markets you need to keep calm and stay focused on the long-term. Remind yourself; this will end and markets will return to growth. It\’s the nature of investing – market momentum and sentiment will always change eventually.

I am a huge believer in being prepared for bad markets by buying high quality companies at reasonable valuations. Not for me, the speculative companies of the world that have never made a profit but are sold at crazy multiples of their earnings. I\’m happy to be flexible with a lot of aspects of my investing strategy, but this is an absolute rule – don\’t start putting money into something that I won\’t be confident in when markets turn.

This confidence comes from a number of sources. Firstly, all my companies must have a solid balance sheet – especially when it comes to debt. The absolute number is important (a company with a market cap of £100m and borrowings of £500m would perhaps be overleveraged) but comparing it to long-term earnings is even more vital. I calculate to company\’s debt ratio by taking their total borrowings and dividing this figure by their average ten year earnings to get a percentage. Anything with a debt ratio of more than 3x earnings is a warning for me that the company is likely to struggle to service their debt, especially if revenues and profits slip.

This focus on \’manageable\’ debt also leads me to favour companies with net cash balances that can immediately pay off debts if needed meaning that they\’re not suddenly going to have the rug pulled out from under them by lenders withdrawing credit or hiking rates.

I avoid any company which is loss-making or showing declining fundamentals (revenues, margins, free cash flow etc.). There are an enormous number of these firms in the market; particularly small and microcap firms engaged in resource extraction (miners, oil and gas) but also \’tech\’ firms which sell The Dream at an enormous loss. If your portfolio is packed to rafters with this dross when the market hits a rough patch, good luck holding on as they fall like a brick. If the economy hits a rough spot (not always a given when markets are going squiffy) these companies tend to fall the furthest and fastest, as they are the most likely to collapse (after all, if they can\’t turn a profit in the good times, how are they going to in a poor economy?).

When markets are calm, it\’s easy to shape your portfolio \’optimistically\’ and convince yourself that these shaky firms will turn around. But companies tell you exactly what they are from their finances – invest in the successful, profit-making enterprises, not the debt-laden, loss-making dream-sellers.

My attitude to risk is simple – I should be able to clearly identify and understand the risks I\’m taking, and at no point should I be risking my entire portfolio on the same thing. If I lose 5% of my pot on a bad firm, I can survive that – my other companies will continue to grow and prosper and over time the loss will be recovered but if I lose 50% of my portfolio on a gold miner that fails to find gold, that is much, much harder to recover from (and I may never actually do so!).

When the markets heat up and the headlines start crowing about the apocalypse, I prefer to find other things to do with my time than sit anxiously sweating and peeking at my portfolio between the fingers over my eyes. Get up, walk away and leave it alone! If you\’re constantly watching your portfolio shedding thousands every hour, the temptation will be to do something. Don\’t. There\’s no need – find the discipline to walk away and you\’ll find things recover. IF (and this is a big if) you\’ve done your research and investing in solid, long-term prospects.

Take some time out

If you can\’t bring walk away and leave your portfolio alone then I suspect you\’re taking too much risk. You\’re worried about \’losing it all\’ due to bad analysis and don\’t trust your companies to survive and prosper. The most successful investors I know are more than capable of walking away and don\’t feel the need to slice and dice their portfolio according to every last headline. They develop a strategy and then stick with it.

I honestly can\’t stress this enough – when emotions are running high, go back to your plan and see what it tells you to do. DON\’T just start hammering buy and sell like a demented squirrel digging for a nut. Calm down and think rationally. This (whatever it is) will pass and when it does, you\’ll kick yourself for selling great companies at a terrible price. Turn off the TV, put down the paper, stop scrolling through Twitter to stay \’informed\’ and recognise that all of these sources feed off your emotions like some kind of despair squid of doom. The more they tell you the world is going to end, the more you read and the worse you feel, and the worse you feel, the more you read and the more anxious you get and on and on it goes.

When bad markets hit, you\’ll see loads of headlines talking about markets hitting \’the lowest level since x year\’ and telling you to \’sell everything now before it\’s too late\’. The reality of markets is that you should be selling when prices are high and buying when they\’re low – NOT the other way around!

Keep a check on your emotional responses

This is, without a doubt, one of the biggest challenges during a panicking market. The clue is in the name – everyone is panicking! When your portfolio falls off a cliff and prices just seem to keep falling, it\’s perfectly natural to start feeling anxious and scared. What if we ARE heading for another 2008 or worse? Watching your hard-earned investments withering away is never a pleasant feeling and it\’s tempting to sell out of your positions to stop the bleeding.

If you\’ve used leverage, the feeling is far, far worse. Let\’s say you borrowed £50,000 to juice up your portfolio and thanks to the market collapse it\’s now only worth £35,000. You still have to pay back the £50,000 at some point but what if markets fall further? If you sell now, you\’ll be guaranteed to lose £15,000 but if you wait, it could get even worse! Your stomach is in knots, you\’re tense, and your head feels like it\’s in a vice.

This is part of the reason I don\’t use leverage in the markets. Let\’s reverse the situation – you borrow £50,000 and prices shoot up. You\’re sat on a £25,000 profit and best of all it\’s with someone else\’s money! If you hold on, you could make £35,000 or even £40,000 – the sky\’s the limit! You start getting complacent and forget. That £50,000 needs paying back at some point. Until you\’ve closed you\’re positions that money is at risk and can very easily reverse into our first scenario. A situation, I suggest, which is hardly conducive to a good night\’s sleep!

Conclusion

Ultimately, it\’s down to you to keep a check on your emotions and monitor your portfolio is a way that supports your ability to do this. Personally, I don\’t \’flap\’ easily so seeing a swathe of red across the screen gives me a bit of an \’ouch\’ moment but more in a sarcastic kind of way than out of any real fear that I\’ll lose it all – so I don\’t see any problem with regularly checking my portfolio. If, on the other hand, I was of the more nervous or anxious disposition, I\’d probably want to avoid doing this (if not delegate responsibility to an investment manager to ensure a mature response)

I often find that my investments go through periods where they\’re showing some pretty big losses – particularly if I go through a period of taking profits (I\’m hugely averse to selling at a loss unless I believe the company is terminal or likely to get worse). If I sell out of a batch of investments that have had a strong run \’up\’ then my portfolio might look a little scary for a few weeks (if not months) – but, again, because I\’ve done my research, I\’m confident in holding these firms for the long-term as future winners!

This links to one of the most oft-quoted cliches in investing; cut your losers and run your winners. It\’s a great strategy but also one that can see you holding onto overpriced \’hot stocks\’ and selling undervalued \’diamonds in the rough\’. As such, my sales strategy looks more at company potential and valuation than past performance (which is more heavily weighted during my decision to buy). I also try to look at my investments in terms of an overall portfolio rather than a collection of individual companies – as long as the overall value is growing, I\’m a happy man.

My monitoring of investments is in keeping with my emotional temperament. I\’m not particularly concerned with weekly or monthly price movements and am far more interested in valuations and company performance over the mid to long-term.

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