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Monday, November 10, 2008

Buy Stocks or Hold Cash!!

I just read an article regarding the strategy to buy stocks or hold cash and I thought it might be suitable to post it over here.

OVER the past few weeks, as a result of the sharp plummet on the stock market, some investors regret not selling their stocks early as almost all of their stocks have been incurring huge losses.

However, the market recovery over the past few days caused some investors to again regret — not buying stocks when the stock market hit the bottom.

The decision to hold more cash or stocks is one of the most difficult decisions to make.

According to a study by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower in 1986, 95% of the variance of fund returns was the result of the asset allocation decision.

Hence, the right asset allocation between cash and stocks plays a very important role in determining the returns of a portfolio.

In this article, we will look into two key strategies in asset allocation, namely the constant mix (CM) and the constant proportion portfolio insurance (CPPI) strategy.

The key principle behind the CM strategy is to buy stocks when the market drops and sell them when the market recovers.

As for the CPPI strategy, it is the reverse, which is to sell when the market plunges and buy when it recovers.

We should continue selling stocks until the portfolio drops near our pre-set floor level. Once the market touches our floor level, we will hold all cash and no stocks.

Under normal market conditions, the CM strategy is an excellent tool for rebalancing our portfolio.

This strategy requires us to rebalance our portfolio based on a constant mix, where we set a constant ratio of stocks to total assets.

Assuming we have only two asset classes, namely stocks and cash, we will maintain the desired invested portion in our portfolio regardless of market conditions.

If we have a portfolio value of RM100,000 and intend to maintain a stocks to total asset ratio of 60%, we invest RM60,000 in stocks and hold RM40,000 cash.

If the overall market drops by 10%, our stocks will drop by RM6,000 (10% of RM60,000) to RM54,000. Now, our portfolio will be RM94,000 (RM54,000 + RM40,000 cash)

Our invested portion will drop to 57.5% (RM54,000 of stocks divided by our new portfolio value of RM94,000).

In order to maintain a 60% investment, we need to have an invested portion of RM56,400 (0.6 x RM94,000).

So we will use RM2,400 in cash to buy stocks (RM56,400 - RM54,000).

After this portfolio rebalancing, our new invested portions will be RM56,400 in stocks and RM37, cash.

This will bring the invested portion back to 60% with the total portfolio value of RM94,000.

The CM strategy will cause us to buy more stocks when the market drops. We will be able to acquire a lot of quality stocks at cheap prices.

However, we will continue buying more stocks while the overall market continues to plunge.

During a bear market, we will see our portfolio shrink in value as our earlier purchase price may get cheaper.

Unfortunately, not many investors can tolerate a drop in their portfolio value.

The CPPI strategy is appropriate for use in either a super bull or a super bear market.

It is not suitable for use on normal market periods as we need to sell stocks when the market drops and buy when the market is on the way up.

We may end up buying at high prices and selling them at low.

Under the CPPI strategy, the portion of money in stocks is based on the formula that:

Money in stock = M x (TA - Floor) Where M = stock investment multiplier (proportion), TA = total assets held in the portfolio, Floor = the minimum allowable portfolio value (zero risk level) and TA - Floor = cushion or funds that can be put at risk.

Assuming we have a portfolio value of RM100,000, if we set our minimum allowable value (Floor) = RM70,000 and stock multiplier (M) = 2, we will invest RM60,000 in stocks [2 x (RM100,000 – RM70,000)].

If the overall market drops by 10%, our stocks will drop by RM6,000 (10% of RM60,000) to RM54,000. Our portfolio will be RM94,000 (RM54,000 + RM40,000 cash).

Our invested portion needs to be reduced to RM48,000 as 2 x (RM94,000 – RM70,000).

We need to dispose of RM6,000 worth of stocks (RM54,000 – RM48,000) and bring the cash level to RM46,000.

Following this portfolio rebalancing, the portion invested in stock is RM48,000 with cash of RM46,000.

The total portfolio value is RM94,000.

We will continue to sell stocks and hold more cash as the market drops.

We will stop investing in stocks when our total portfolio hits the floor level (TA – Floor= 0).

The strength of the CPPI strategy is that our lowest portfolio value at any point in time will be RM70,000 whereas the CM strategy may cause our portfolio value to drop much lower if the market crashes further.

In conclusion, the choice of strategy will depend on the overall economic outlook.

Unless we know our economy will not drop into recession, otherwise — based on our current situation, the CPPI strategy has the advantage of protecting our minimum portfolio value at the floor level.

Ooi Kok Hwa is an investment adviser licensed by Securities Commission and managing partner of MRR Consulting.

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