Risk Reward Tradeoffs And Not Plain Vanilla Averaging Down Is What Matters.

``If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.” -Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser

A friend recently asked me if averaging down is the best way to approach the market, given today’s environment.

My response is- it depends.

In the investing sphere there is NO straightforward answer to glory, as much as there is NO Holy Grail or FOOLPROOF mathematical Greek “quant” formula or models to success.

For us, the success of such approach will depend on the market cycle, or it could also depend on the fundamental reasons behind the deterioration of the market or security or it could reflect on the discipline of the market practitioner.

Averaging Down = Playing with Falling Knives

Remember the basic rule is that PRICES ARE ALWAYS RELATIVE. Higher prices can become more expensive in as much as lower can prices can get cheaper.

The assumption that ALL prices that goes down will automatically always turn up is very dangerous. You may end up deeply hurting yourself by playing with falling knifes.

Table 1: Returns Required To Break Even

Table 1, as previously shown at our August 2007 article Why Cutting Losses Is Better Than Depending On Hope, depicts of the amount of losses and the corresponding gains required to offset or neutralize each losses.

The bottom line is that it takes MORE EFFORTS in the form of corresponding gains to offset every equivalent amount of loss initially generated. Imagine a 25% loss requires 33% gain to offset the original position as much as it would take a bigger 100% advance to cover up a former 50% loss. The bigger the loss, the greater the gains required to recover.

Therefore the assumption of “averaging down” means piling on more losses in the expectations that you can reduce your costs in the hope that the assets you’ve invested on would eventually recover. But what if it doesn’t? What if these assets continue to fall?

In essence, the basic problem with this assumption is that you don’t know WHEN the market/security stops falling. And if we keep adding to these losses, even if it does lower your averages, it exposes you to even more losses!

Figure 4: bigcharts.com: Averaging in Nasdaq’s Dotcom Bust Is Equivalent to Catching a Falling Knife

Market Cycles, Reference Points and Framing

Look at figure 4 courtesy of bigcharts.com. It is the chart from the US major technology weighted bellwether, the Nasdaq. If you had bought the Index in 1987 (leftmost red arrow) and held on it until today you’d still be up about 5 times even after the bust. But if you had “averaged down” consistently-periodically (say once every year on every market dips-assuming optimistically- but unrealistically- that you can catch every dips) you could have either given up some of these gains because of the sharp volatility swings during the latter half of the 90s until 2003.

But if you initiated buying anywhere near the peak of the dot.com bust in 1999-2000 and averaged during the past years (assuming equal level of the amount of purchase-with periodical averaging), you are still likely to be underwater (negative) even after eight LONG years!

And worst, if you bought into some of the favorite issues (and averaged “down” them!) during the heyday of the dotcom boom like Pets.com, Webvan, Exodus communication, Egghead.com, eToys or Furniture.com (cnn.com), you would have ended up with a big fat egg as these companies went kaput or bankrupt!

Remember, reference point always matters. Again if you initiated entry at the bottom of 2003 at the time when everybody was in disgust with technology issues then you are likely to be making some money today even if you periodically applied averaged “up” over the past few years. See the change in perspective? If I use the 1987 and 2003 as my reference point, you are most likely to be up, while if I utilize 1999-2000 perspective you are most likely down.

Don’t forget we are talking of nominal returns and not real (or inflation adjusted) returns. If we apply real returns on portfolio performance then your gains would be trimmed and your losses are likely to be accentuated (pls refer to table 1).

In essence, up or down (portfolio performance) depends on the date of entry, or prominently, on the whereabouts of the market cycle.

So we have to be wary of the nature of the “framing” presented to us by financial experts. From the hindsight everything is fait accompli, but what matters is not the past but the returns from taking on risk from the future. We can only learn from the past and apply its lessons in the future.

In addition, we can easily be captivated by the returns offered without understanding the risks behind such dynamics, this signifies as a basic caveat.

Risk Analysis Is A Fundamental Concern

In the same context, earlier this year, somebody suggested buying into US Financials as they believed that the string of sharp losses translated into feasible buying opportunities. We dissented, see Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

For us the US financials represents an epitome of a market trend that is in a structural decline.

Why? Because it will simply take years for US financials to normalize by writing off losses or by attaining full recapitalization following the gargantuan yet-to-be-revealed losses on their balance sheets, which is estimated to now reach $1.6 trillion by Bridgewater Associates (New York Times), after accrued recognized losses accounted for only about $400 billion or about 25% of estimates. Such losses may even adjust to the upside as the extent of damages becomes more visible.

In addition, financials will remain under tight pressure as it is in the process of “deleveraging” in the face of a “perfect storm”- tightening credit standards, falling economic growth, declining corporate profits, higher default rates, potential spread of asset portfolio losses (prime and Alt-A loan portfolios, commercial real estate, corporate and junk bonds) and high energy or consumer goods inflation.

Now add to the burden of the financials is the surfacing of the issue where a supposed implementation of a new regulation (FAS 140) that would lead to a prospective technical insolvency stirred a panic over “Government Sponsored Enterprises” or GSEs in Fannie Mae (FNA) and Freddie Mac (FRE), which paid for record yields on the sale of 2 year notes, saw a remarkable plunge in their stock prices see figure 5 and the attendant volatility in the US markets led by the financials.

Figure 5: stock charts.com: Trouble at the GSEs

Figure 5 courtesy of stockcharts.com, shows Fannie Mae and Freddie Mac (F&F) having been caught in a panic frenzy while S&P 500 Financials Sector Index (lowest pane) and S&P Bank Index (pane below main window) have altogether been in a sharp retreat since May.

For starters, Fannie Mae and Freddie Mac are privately owned companies but receive support from the Federal Government. Because of this privilege they also assume of some public responsibilities.

F&F are accounted for as among the largest corporations in the world. They function to provide for a secondary market in home mortgages by purchasing mortgages from the lenders who originate them. They also hold some of these mortgages while others are securitized and sold to other investors in the form of securities stamped with the GSE guarantee (Jack Guttentag-mtgprofessor.com).

Figure 6: NYT: GSE’s Reach of Problems

The recent GSE’s problem is a systemic issue.

According to RGE spotlights (Hat tip: Craig McCarty) ``F&F own or guarantee some $4.5 trillion or 45% of all outstanding mortgages in U.S. Much of the $1.6 trillion agency debt is held by foreign central banks, i.e. sharp reduction in 2004-2006 of agency debt due to accounting restatements contributed to 'bond yield conundrum' as foreign central banks had to resort to existing Treasuries in order to compensate for agency debt shortfall.” (highlight mine)

Aside, (see figure 6) these companies provide the capital that banks use to write new loans. If F$F stop buying loans, banks may stop making new loans, freezing the US housing market (NYT). In addition virtually every Wall Street bank and many overseas financial institution, central banks and investors do business with F&F (NYT).

Another, F&F acts as major counterparties in the interest rate swap market which hedges on prepayment risks and maturity mismatches on the balance sheets (RGE spotlights-Hat tip: Craig McCarty). The role of GSEs has heightened the concentration risks for these markets.

As you can see the GSEs are heavily imbedded into the world financials institutions such that in the event of a failure or default they are likely to generate total cataclysm in the world markets, which is not likely to be the case since regulators will likely intervene.

But the other side of the coin is that taxpayers will likely pay a heavy price over these rescue efforts, notes the astute David Kotok of Cumberland Advisors, ``The government backing of F&F is “implied” and not explicit. A Congressional guarantee would change that. Studies of the cost of this Congressional failure suggest that the annual cost of this uncertainty created by the Congress is in the multi-hundred billions.”

And this is the probable reason why the US dollar index got slammed (down 1.07%) and gold soared by nearly 3%. And this too is the principal reason why we can’t be fundamentally bullish on the US dollar (yet), because even while global governments will act to “superficially” contain consumer goods inflation by increasing policy inflation (government spending-subsidies or doleouts or via tariffs) the extent of damage in the US financial system is so huge that would translate to constant intervention from authorities (which means more inflation).

This brings us back to WHY “averaging down” isn’t always a good option, take it from David Kotok (highlight ours), ``Common shares of F&F are another matter. We value them at near zero. In the Bear Stearns event we saw affirmation that the federal government had no sympathy for equity investors even as it preserved the rights of debt holders and counterparties. We believe the same is true for F&F. The stock market thinks so, too. That is why the equity value of F&F has been decimated. We have avoided F&F shares and have been selective in the use of broad ETFs where they are part of a large assemblage of stocks.”

If a stock is going to zero, what good is it then to average down?

In terms of fundamental risk analysis, owning the aforementioned shares simply because it is going down or for averaging purposes is a recipe for the total annihilation of one’s capital. It can also signify a “value trap” or prices have gone substantially below fundamentals as to draw in value investors into believing they are buying value but then experiences further dramatic decline in value.

In this case, averaging down becomes the terrifying equivalent of catching a falling knife.

If we are insistent to use “averaging” on a bear market as a strategy then extensive risk analysis on the company or the industry’s risk reward potentials should be utilized. Otherwise we must remember the 2 general rules of bear market investing: one bear markets tend to get oversold and remain oversold and two, bear markets decline on a ladder of hope where support levels exist to repeatedly get breached until hope vanishes.

Averaging Down Is A Market Discipline

Finally, averaging down is an approach that should reflect the investor’s market discipline. A risk strategy utilizing this methodology means consistency in its application throughout the market cycles. It means rigorously knowing your risk appetite and the constant assessment of fundamental variables.

We cannot be a fundamentalist when the market is down and transform into momentum traders when the market goes up, for this only heightens your risks engagements- as you put more risk capital as markets go down-while limiting your profit potentials when the market goes up. Thus the risk reward tradeoff is tilted to the side of risks. Besides, only brokers get rich with such market attitude.

As world’s most successful stock market investor Warren Buffett once said, ``Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."