An open letter to China’s new battered and bruised stock market investors

“If you think in terms of a year, plant a seed.

If in terms of ten years, plant trees.

If in terms of 100 years, teach the people.”

– Confucius

Dear investors of China, please allow me to introduce myself. I am The Investor and my website, Monevator, is aimed at ordinary people who invest their savings in the stock market in the pursuit of financial freedom or providing for their old age.

People, I imagine, very much like yourself.

The readership of Monevator is mainly from the UK, but there are plenty of articles that can be usefully read wherever you live in the world.

This is not because I have a great talent for speaking different languages, but because the core principles of investing in shares are the same everywhere.

I’d like to go through some of these principles with you, in the hope they might help your own investing – and perhaps prevent some future cases of the sort I’ve read about in recent days of ordinary people in China who’ve lost their life savings in the Chinese stock market collapse.

I hope my doing so doesn’t seem arrogant.

I understand you have your own market – and your own cultural sensibilities – and believe me while I have some disagreements with aspects of how you run your country, I greatly admire the vast contribution that China has made to the advance of civilization over the millennia, and right up until today.

Indeed most of the technology I will touch today was made in China, and I believe that in the coming years much of the intangible products we use will be created by you, too.

We’ve been here before

China is a fascinating, rich and deep country – and already a powerful economic force to be reckoned with.

But the plain truth is we’ve more experience of stock markets in my part of the world then you do in yours, for obvious historical reasons.

In fact even I have more direct experience of stock markets than most of you, and I’ve only been seriously investing for 15 years. Whereas you’re largely a nation of very young investors, whatever your chronological age.

When I look at the recent boom and bust in the Chinese stock market, I see many parallels in the history of our own stock markets.

Some of these things happened long ago – but more than a few disasters occurred recently, too.

So again, no superior preaching here. Wayward institutions in our financial system brought the global economy to its knees in 2008, and we’ve also seen huge booms and busts in technology, banking, and commodity stocks in just the past decade or so.

Indeed this article goes out as a reminder to my regular readers as well as to any I’ll find in your country.

Because we can make mistakes like the best of them.

Learning together

No, I’m writing to you not because I think we have all the answers to your different situation, but rather because I think the questions we’ll be asked as investors over our lifetimes are so similar.

So please read my pointers below and make of them what you will.

I’ve deliberately not gone into too much of the detail about your stock market collapse below, firstly because I am sure you know the specifics better than I can, but also because I think it’s better to step back and look at the bigger picture.

Western commentators criticize many aspects of how the Chinese economy is run, how data is collected and reported, and how reliable the numbers we need to base our investments on can really be.

I understand and share some of these concerns. But to me evaluating and incorporating such issues into a wider investing framework is more useful than shaking your fist at them.

Blaming a stock, a broker, or even a government for a poor investment performance is seldom fruitful for us ordinary mortals. The world is what it is.

Far better to ask the right questions and to answer them with a well-spread portfolio that is right for you, as best you can.

I hope these thoughts might help you achieve that.

1. Share prices go down as well as up

Let’s be clear about this, as it seems to surprise many new investors, wherever they are.

Share prices go down as well as up.

Stock markets go down as well as up – sometimes for years.

Individual companies can go bust and leave you with nothing.

New investors often ask me things like “Is now a good time to get into the stock market?” or “Will shares go down from here?” or “Will I lose money?” or – worst of all – they say, “I want to invest in the stock market, but I can’t take any risks”.

Sorry, stocks go down as well as up. Markets go down as well as up. And neither I nor anyone else knows over the short-term when or how this will happen.

Studies have proven forecasting is useless.

Of course, people will tell you they do have the answer to such questions. They may even try to sell you the answers!

Politely ignore them.

The fact that stock markets sometimes go down doesn’t mean you can’t invest in them.

It means you need to invest according to this reality, with a strategy designed to suit all weathers and without risking your whole financial future.

Sometimes it rains and sometimes it’s sunny, and so we own both umbrellas and t-shirts. We don’t fill our wardrobes with t-shirts and flip-flops and pretend it’ll never be winter. We know the weather is changeable and prepare accordingly.

Same with investing and the stock market.

2. 100% growth in a year is not sustainable

Shares in the Shanghai and Shenzhen stock exchanges more than doubled in the year before the crash.

Such rapid moves should be a warning sign of a market that might be overheating and a reminder to be cautious.

They should not– as they so often prove to be – be a lure to put even more of your money into the market.

True, through history the first moves out of a deeply depressed market are often swift and – in the long-term – they can hold. But you need to have a sizable time horizon. (See point 4).

Such huge gains simply cannot be repeatedly enjoyed by everyone for long though.

Try playing with a compound interest calculator. You’ll soon achieve absurd results that show such gains are not sustainable for more than a year or two.

If you hear about a market making 100% in a year, it’s not a sign that you’ve found the way that other people have been getting rich.

It’s more likely a sign that you’ve missed it.

Stick to your plan through the good times as well as the bad.

3. Lower your short-term expectations, but raise your long-term ones

So what are sensible returns to expect over the long-term?

Well, as we say here, how long is a piece of string?

You will hear much debate about this, but personally with a still-emerging economy like yours I’d be comfortable expecting 10% or so a year as the average return over many years, presuming you reinvest dividends and so on.

Note that I would not expect exactly 10% every year. In fact, I doubt it’d hit exactly 10% more than once or twice in a lifetime!

Stock market returns fluctuate around their average long-run trend. They may be down 10% one year and up 30% the next, and then flat for a year or two.

It’s this volatility that scares people away from the stock market, and that in turn gives us the opportunity to profit.

To do so we need to have a long-term investing strategy that exploits this volatility, rather than loses money to it.

4. Margin (borrowing to invest) can be deadly

The first three points are why this fourth point is so important.

You can very easily end up losing more than you put in – or simply lose all your money along the way and see your broker freeze your account – if you borrow to invest.

Because stock markets go down as well as up, sometimes for years, it’s a racing certainty that sometimes your portfolio will be worth less in cash terms than it was before. Often a lot less.

Borrowing to invest can be devastating because when you’re in one of these tough times, you can’t just ignore it and wait for a recovery. You will be forced to find and put more money in to meet your margin requirements.

And you may not have enough money to do so.

You may then be kicked out of the market when it’s at a low point, and miss the subsequent recovery.

In fact, if you run a highly-leveraged portfolio (that is, a portfolio funded with a lot of borrowed money), then you have built a machine that’s almost tailor-made to force bad decisions.

In all but expert hands (and even then, sometimes) it will probably end badly – or at the least you’ll do worst than if you’d just invested your own money.

I have read many stories of Chinese investors going bankrupt in the recent stock market collapse. In every case the investor had borrowed to invest by using margin.

And whatever happens, you don’t want to lose all your money.

Let’s say the stock market falls 50% in the first year then doubles in the second year. Let’s say I’ve just invested my money, but you’ve levered up with margin to invest twice your capital in the same market.

This means that when that 50% fall strikes, I’m okay and will recover with the bounce. But all your capital has been wiped out.

• My money = 1 x 0.5 x 2 = 1

• Your money = 2 x 0 x 4 = 0

Losing money can be catastrophic when investing. Avoid losing money!

5. Stock and sector diversification is critical

Another common theme to the sad stories I’ve read of investor ruin in China is betting on the shares of just one company.

This is insanity.

Even the greatest investors in the world make mistakes. Even Warren Buffett buys shares that fall in price.

And neither of us is Warren Buffett.

If you invest in the shares of just one company, again you risk losing all your money. Split your money between two companies, and this risk is dramatically reduced.

Divide it among ten companies and you’re basically out of the woods when it comes to individual company failure derailing your portfolio (although you will certainly see its overall value go up and down in sympathy with the market).

In my part of the world, everyday savers are increasingly turning to index funds to diversify their holdings across thousands of listed companies. This entirely gets rid of the company-specific risks, while still enabling the investor to benefit from the long-term growth of the stock market.

Most people – including most professionals – fail to beat the market, anyway.

I guarantee nearly all of you will. It’s just statistics.

Even Warren Buffett says you should use index funds.

6. International diversification is also a good idea

It’s not enough to diversify between companies and areas of business. It’s also important to diversify between different countries.

Even US investors are advised to do this, and they are putting their money into the single-largest market in the world that’s tied to one of the richest and most developed economies.

With respect, China is not yet there. Your economy has shaken the globe in the past two decades, but it’s not done yet. It’s not mature, and your capital markets even less so.

It’s simply not a good idea to put your entire fortune into such a risky and immature market – especially when you’re living in the same country too, and relying on it for your livelihood.

International diversification reduces risk, can improve your returns, smooths local booms and busts, and gets rid of the danger that you have all your money in the next Japan – where the market level is still barely half what it was in 1989.

Now, as I understand it most of you may not be able to invest any of your money in overseas markets. This is a great shame, and I hope the situation improves for you soon.

If it were me faced with such restrictions while living in an emerging market, I wouldn’t think: “I can’t invest overseas, so I will have to put it all into Chinese shares.”

I’d think: “I can’t invest overseas, so at most I’ll put 10% into Chinese shares and keep the rest of my money elsewhere.”

7. Brokers are not your friends

Stock brokers and others in the financial system are not your friends. They are in business to make money.

Their advertisements are not aimed at giving you financial advice. They are aimed at hitting the right spot to get as much money flowing in their direction as possible, subject to local regulations and restrictions.

Very often their aims are in direct contrast to yours.

For instance, they may make money when you over-trade, or when you help prop up their business by putting more money into a falling market, or when you use actively managed funds instead of simpler passive products (or buy and hold strategies where index funds are not available).

They are not necessarily bad people, though some are like in all walks of life.

But they are not on your side.

8. No government can demand a higher market for long

Take it from me, if a government could create wealth simply by ordering the stock market higher – either explicitly, or via the many mechanisms being tried in China currently such as halting trades, banning sales, purchasing securities, hunting for alleged wrongdoers, and strong-arming participants into buying more stocks – then our politicians would have already done so.

Of course, that doesn’t mean our officials haven’t tried from time to time, like yours is currently doing.

In the financial crisis, for example, the short-selling of financial shares was suspended. This possibly soothed the fear a little, but it didn’t stop major British and Wall Street banks going out of business.

And even where these short-term measures are perhaps justifiable in a time of great panic such as the one you’re experiencing, ultimately there’s a longer-term cost – which is that people start to ignore the fundamentals (including those very real risks of share investing) and instead begin to feel the government “has their back”.

It doesn’t – it can’t, in a functioning market.

It will always be tested beyond breaking point eventually (as we saw in the UK with George Soros’ attack on the British pound in the early 1990s).

You cannot buck the market. That’s why markets work.

Now I’ll add a few points on that, before I get inevitable complaints from angry readers.

Firstly, people who are/were wrong about something often claim the market has been manipulated or distorted in unfair or unforeseen ways. It doesn’t make them right, but it does often make them loud.

For instance, some people have never gotten over the bull market in the US that followed the crash, and claim it is all a sham.

They are wrong, but it is something to beware of seeing in yourself. (I’m not immune. For a long time I thought similar about property in London, but I’ve gotten over myself).

The second, related, point, is that markets and economies do loosely go hand in hand.

Often you’ll see intervention aimed at reviving the real economy having a big impact on the stock market. Again, people will miss the former and claim the intervention was to provoke – successfully – the latter.

So in this part of the world we have very low interest rates and quantitative easing that was designed to stop banks from becoming insolvent, to stop asset prices (principally property) from collapsing, and to ultimately encourage more investment in the wake of widespread value destruction in the crisis.

Not surprisingly, the stock market looked a much better place to put money following those interventions than beforehand.

But it is a mistake that many make to think simply raising the level of the market was the principle aim. That narrative has evolved over time to become something like an accepted truth, but it’s wrong.

I’m waffling, but the main point is never to think: “The market can only go up because the government has my back”.

Hundreds of years of stock market history in the US, the UK, and elsewhere shows that governments have no such power.

9. Markets are ruled by fear and greed

In the long-term, the value of stock markets is driven by the earnings of companies.

Those earnings – and what portion of the gains you see as an investor – will be influenced by many factors ranging from the strength of the economy to productivity gains to inflation and interest rates to the political climate towards business and wealth creation.

However in the short to medium-term, markets are driven by the spirits of fear and greed.

• Most people rush into markets when they’re strong and things look rosy, pushing them to new highs. Bull markets often top out when there’s nobody left to buy – which is why, ironically, peaks tend to occur when things look the best for the economy and investing, and everyone feels good about everything.

• People fear the market when value is being destroyed in a crash, and many will dump their holdings just to avoid further pain – irrespective of the long-term potential. This creates a vicious feedback cycle that drives markets lower than you’d ever have thought possible in the good times.

Does this mean falls in the market are always irrationally fearful?

Not at all – often they’re unwinding irrationally gleeful periods that proceeded them.

I’d argue that is what’s happening in your market now. It was driven far too high beyond what the fundamentals justified, and now it is correcting.

It’s also what we saw in the technology boom over here in the late 1990s.

In some ways value investing can be seen as a game of arbitraging short-term emotional distress for the long-term ownership of productive assets.

Buy unwanted cheap-to-fair-valued assets and hold tight for the long-term!

10. The stock market does not mirror the economy

A final point – while there’s clearly a relationship between economic activity, business activity, and the performance of companies, studies have shown that there’s not a clear relationship between GDP growth and stock market returns.

There are many reasons suggested for this.

One is that anyone can spot an economy with a potentially great future ahead of it – such as China’s – and so they overpay for owning a piece of it via stocks.

Even if the economy does well, they then only get mediocre returns because they paid too much in advance.

Another reason is that fast-growing economies are often emerging economies, where there are more claims on the economic bounty thrown up by growth.

These claims might vary from the good – such as poor workers demanding higher wages – to the bad – such as governments and other institutions appropriating more of the surplus via taxes or the black economy.

However proud you are of China’s status in the world and however optimistic you are about the great future you see growing up around you, keep this in mind.

You’re not buying the Chinese economy – and much less a declaration of your patriot feelings.

Rather, you’re buying stocks, which are at best an approximation of your economy, and may not even be a very good one.

Never stop learning

Try to buy shares when other people don’t want them, and remember everything else I’ve written above.

And good luck!

Perhaps we’ll meet somewhere sunny in the world a few decades hence, and you will tell me how you eventually got past a tough start in stock market to retire rich, after reading an article on some weird foreign website…