You don’t have to take my word for it that you should buy when shares fall: In this article you can listen to Tim of the Psy-Fi blog instead.

When stock markets dive into a pit of despondency, the prices of shares fall fast, as they are treated less like claims on a business and more like lottery tickets.

In investors’ heads, the little switch marked ‘Risk’ flicks over – and at such times, investors seem to forget company valuations to focus on anything from the oil price to politics.

When we’re worrying more more about how the Italian Prime Minister is going pay for his next bout of bunga bunga than whether Tesco can maintain its earnings record, there’s something seriously awry. Yet these are excellent times to be a contrarian investor.

“If you want to have a better performance than the crowd, you must do things differently from the crowd.”

– Sir John Templeton

If you’re a seriously contrarian investor, these are the times you live for. You hoard cash like a miser while everyone is spending theirs like a millionaire, and then you spend like a billionaire’s daughter while everyone else is trying to “preserve their capital”, whatever that means. (Buying gold, perhaps, although by that account most billionaire’s daughters are already great investors).

What’s really odd is that anyone out of short trousers has lived through falling markets before: the dotcom bust of 2000, the crisis after 9/11 and the subprime implosion of 2007. Anyone intelligently investing in shares at those moments of fear has done astonishingly well, despite the fact that the noughties were supposedly the lost decade for stock markets.

Still, this isn’t carte blanche to throw caution to the wind, mortgage up the wife and kids, and start buying shares. Times of great fear reward thoughtful investors who have a plan for just such occasions.

There are many possible plans, but here’s one loose set of rules:

1. Save in advance

Build up your cash pile when other investors are fearless. Stash away dividends and funds from takeovers, top-slice, or even sell overvalued companies. Keep the money where you can get access to it – government bonds or cash are the only riskless places (and neither are really riskless, but all things are relative).

2. Create a watch list

If you want to stock pick rather than just buy index trackers, then prepare your long list of companies you’d like to buy if the price was right. When markets start falling you need to know what you want to own, and the price at which you’re prepared to own them. Make sure you have a decent margin of safety.

3. Buy when shares fall

Plan to buy when markets are down. It’s really difficult to buy today when you think you may be able to buy cheaper tomorrow, but it’s a necessary mental discipline. The late, great contrarian investor Sir John Templeton used to set deeply discounted automated buy orders because he knew how hard it was to buy in falling markets – and he was one the best investors of the last century!

4. Be picky

Don’t buy a share just because its price has fallen a long way. It may have fallen a long way because it’s a lousy company. Bear markets reward fundamental analysis as good and bad firms both get hit, often indiscriminately.

5. Be patient

Don’t buy all at once. Some panics end quickly, others drag on for months or even years. Being contrarian doesn’t mean being stupid: plan to feed your money into the markets over several months. Six months to twelve is about right, although if you’re looking at greater than 20% of your portfolio value then even longer may be prudent.

6. Lose to win

Don’t focus on how much you’re losing. No one runs through the hallowed halls of the London Stock Exchange with their hair on fire and ringing a bell announcing the end of a bear market. By the time we know for sure so will everyone else.

Although money wisely invested in the stock market should eventually reap returns many times greater than the alternatives, you can never guarantee an exact time at which you can extract it. So don’t put money in the markets that you may need to repay debt in the short-term. That’s not risky, that’s stupid.

You can read more from Tim on his Psy-Fi blog.

The best of the week’s money articles.

I don’t expect corporate earnings to collapse. I don’t expect a renewed recession, let alone the Depression so cavalierly predicted.

Could we get a recession? Sure – we always could, at any time.

A Eurozone break-up would probably do it, just like the gloomy say. If I thought it was a serious possibility, I’d hold far fewer equities, at least until it happened.

What I think is much more likely is that Western economies will continue to bump up and down, as corporates fail to squeeze much more juice out of their hard-pressed and increasingly skint workers, whilst continuing to enjoy the fat of the land from developing markets.

That might not sound particularly gangbusters, but it’s got us this far. Investors over the past month have been predicting something different, wiping roughly 20% off share prices that weren’t very stretched to begin with.

Citigroup has crunched some numbers on what happens when markets fall 20% but earnings fail to follow the script and don’t collapse:

That’s the sort of bet I like making. Unfortunately the source, Business Insider, doesn’t give any more detail on how this data was constructed.

No worries though, because adding to equities for the long-term is common sense right now.

UK gilts haven’t yielded so little since Britain had an Empire. Yet P/Es on shares are low and the market’s forward dividend yield is at least 1.5% over gilts (and likely more). Corporates are awash with cash – and occasionally even spending it. Hewlett Packard’s purchase of FTSE 100 firm Autonomy for a 75% premium seems far closer to me to an accurate valuation than the prices the trading robots and summer interns are putting on shares.

And valuations are what matter, not investors’ manic depressive swings.

[continue reading…]

A plunge protection fund is a strategic reserve – usually cash – that you set aside to deploy in periods of market panic.

This is not an official investing term. Indeed, Google tells me that across the entire Internet, only the iii blog uses the phrase like I do.

Presumably either one of us got it off the other, or else we both read the same messages in the same bottles!

Alternatively, we might both have been inspired by the so-called ‘plunge protection team’ that supposedly watches over the US market from Washington.

This team is said to have its roots in a group set up in the wake of the 1987 correction that wiped a fifth off US blue chips in less time than it takes to say “flash crash”. Some claim it’s at work whenever we have big falls today.

But despite the similar names, these two plunge protectors are quite different:

• The Plunge Protection Team (if it exists) buys distressed shares to shore up confidence, by putting a floor under prices.

• Your Plunge Protection Fund first dampens the impact of falls, and then buys distressed shares to hopefully make you a profit from other people’s panic!

A plunge protection fund in practice

The term ‘plunge protection fund’ might be a rarity, but the advice is common.

For example, many pundits said you should be buying cheap shares in the wobble of summer 2011, from The Motley Fool to The Telegraph to, well, me.

And indeed, buying when others are selling is generally great advice. But it does necessitate you having the cash to do so.

Hence a plunge protection fund – a reserve of cash that you can invest at just those times when seemingly cheap shares litter the ground like £50 pound notes.

For example, a week prior to writing this piece, I suggested several shares were trading at grab-’em-while-they’re-cold prices due to a big sell-off.

Here’s how they have risen in the six trading days since1:

• Weir: Up 21%
• Medusa Mining: Up 16%
• City Natural Resources: Up 15%
• Tullow Oil: Up 13%
• Xstrata: Up 11%
• RIT Capital Partners: Up 8%
• Tesco: Up 6%

• FTSE 100: Up 6%

My point isn’t to show I’m a market-beating share tipper.

For a start, one or two haven’t done so well yet (though none are down)2, and six days is no time to measure a return over – it’s a crapshoot.

Besides, the strategy needn’t only apply to share picks. Index investors could use a plunge protection fund. I think there’s more chance to profit from individual companies in a panic, but if the market is essentially being sold off irrationally, then you can still benefit by investing when it’s cheap.

Most index players should aim to be passive investors, of course, where any rebalancing is done mechanically, to take emotion of the decisions.

But I included Ben Graham’s shifting bond/equity allocation strategy in our first roundup of lazy ETF portfolios for index investors who couldn’t sit in their hands.

The Wall Street legend specifically suggested moving in and out of equities depending on your reading of the market.

The problem with plunge protection

A plunge protection fund sounds a no-brainer, right? Who wouldn’t want to be protected from a plunge? Who wouldn’t want to buy cheap shares?

Unfortunately, there’s a big, big flaw to the strategy.

You see, rather like the similarly acronym-ed PPE degree that bright young things do at Oxford before joining the Foreign Office, your plunge protection fund will make you sound clever at parties, but it probably won’t make you richer.

The big reason is opportunity cost.

When it’s not invested in the stock market, your plunge protection fund is sitting around in cash. These days, that means it’s earning a barely-there interest rate. You can’t lock it away to earn more – it’s meant to be deployed in a hurry.

Even if you don’t have to wait too long for a crash to make it worthwhile, there’s still the issue of when you’ll invest it.

The trouble is, nobody knows whether stock markets are going to rise or fall over the short to medium term. Over the long-term equity markets tend to trend higher, but as I’ve already mentioned, that’s a problem for the plunge protection strategy, not a positive, since this chunk of your funds won’t be benefitting.

Just like other active investing strategies, then, the plunge protection fund is skewered by our fallibility. We might feel like we’ve got balls of steel when we invest while others are running in the other direction, but our lack of crystal balls means our move may well be unprofitable compared to if we’d just invested earlier and enjoyed some upside on our money.

Consider that the stock market rose 70% from the depths of March 2009 to the recent peak in February. That’s an awful lot of gain to forgo while your reserve is sitting around in cash, waiting for an opportunity to make it back.

Even during the sharp correction in August 2011, shares only got back to the lows of around a year earlier. And in reality, very few investors would have put their spare cash to work in the few hours that comprised the latest market bottom.

Great equity investors like Warren Buffett, Peter Lynch, and Anthony Bolton have tended to be near fully invested in shares all the time for this very reason. They concentrated on relative value – finding bargains – rather than worrying about the overall market situation.

There are a few talented fund managers like the chaps who run the Personal Assets Investment Trust or the odd hedge fund that is happy to sit in cash for as long as it takes. But over greater timeframes, what such funds achieve in lower volatility they are likely to forego in total return.

Variations on the theme

A plunge protection fund then is a glorified trading strategy. Most investors would be better off concentrating on getting their overall asset allocation right.

Still, a case can be made for a plunge protection fund – or a variant of it – for those of us who insist on being more active with a portion of our portfolios.

• Don’t underestimate the emotional benefit. Picking up bargains in a bear market helps you psychologically when your portfolio turns red. I think this alone is a good reason for more active investors to keep perhaps a 5% cash reserve to invest after a sell-off.

• You could keep your strategic reserve in bonds, or lower volatility equities – defensives shares such as utilities or consumer giants like Diageo. When the market falls you recycle your defensive holdings more aggressively. This is closest to my own strategy. Obviously it’s not going to deliver the pure results of a cash reserve – the defensive shares will still be volatile, and there’ll be the costs of churning your holdings, too.

• At times of higher interest rates, the opportunity cost of holding cash is much reduced (ignoring tax), which makes a plunge protection fund less of a luxury.

Cashing up

None of this is to say that keeping a chunk of your net worth in cash is a bad idea.

On the contrary, I think cash is an underrated asset class for private investors.

But that’s as part of your asset allocation strategy, not on a tactical level. Within your equity portfolio, it probably won’t pay to be too clever.

Get your asset allocation right for you and your risk tolerance, and consider keeping a modest extra bit in cash to act as the equivalent of a hill walker’s bar of Kendal mint cake – to keep your spirits up and give you a bit more energy in tough climates, but not to keep you fed.

Leave wholesale plunge protection to the political pros and the central banks. They have unlimited ammunition, and they need to be seen shooting! We don’t.

1. Prices from close of 8^th August to close of 16^th August and gains rounded [↩]
2. Halma specifically as well as the subscription shares that are bound to take a while to kick in due to their unique properties. [↩]