Wednesday, January 17, 2007

Check risks and returns at current level

The KL Composite Index's current level of about 1,120 points poses a higher market risk than when it was at the 880-level seven months ago. Investors will face higher market risk if they decide to invest now. They need to check if the potential returns commensurate with the risk that they will take writes OOi KKok Hwa, an investment manager licensed by the Securities Commission and managing partner of MRR Consulting.

Since I missed the good opportunity to invest last year, should I invest now?

Since the low of 886 points on June 15, 2006, the KLCI has surged by 26% to the recent high of about 1,120. There had been no major pullback over the past seven months.

Investors who were not in the market last year will be wondering whether it is still not too late to invest right now.

However, investors who have invested since June 2006 are getting uneasy with the current market level and are tempted to lock in their gains.

“Buy from pessimists and sell to optimists”are investors more optimistic or pessimistic now?

Benjamin Graham said we should “buy from pessimists and sell to optimists”. We should buy stocks when nobody is interested in buying them and sell them when everyone in the stock market has become excited.

The market's recent strong gains coupled with the high trading volume of more than one billion shares per day imply that retailers are getting excited and have more confidence in the market outlook.

Obviously, if we were to follow Graham's advice, we should be selling as investors are more optimistic now compared with seven months ago.

Risk is higher if you invest now

Any investor who decides to invest at the KLCI's current level will be at a greater disadvantage compared with those who invested earlier at the 880-level.

If there is any major market crash, investors who invested at current levels will face potential selling pressure from investors who have invested earlier at the 880-level because the latter can still sell their holdings even if the market were to drop below 1,000. Investors who had bought at the 1,120-level would have to face the pressure to cut their losses.

Most investors always find it difficult to cut losses as they prefer to gamble than to recognise a sure loss. In behavioural finance, we call it “loss aversion”, whereby a sure loss is worse than the risk of losing a little bit more with the gamble. Investors feel bad when they lose money, but twice the loss does not make them feel twice as bad.

Potential 7% gain versus potential 21% loss

At the beginning of 2007, some fund managers predicted that the KLCI would touch 1,200 this year.

Assuming that their prediction is correct and the 1,200-point level is the maximum level for this year, there is only a 7% difference between 1,120 and 1,200 points.

However, if there is a major market pullback and the market gives back all its earlier gains, the KLCI can retreat by 21% to 880 points from the present 1,120 level (although the market may not tumble as much as 21%, a 7% drop is more likely than a 7% gain, given that the market has gone up 26% within seven months without a major pullback).

Hence, investors need to decide whether it is worth taking the risk on a potential 7% gain versus a potential loss of 21%.

The above calculation is based on the assumption that the maximum movement of the KLCI this year is 1,200 points, whereas the maximum pullback is at the 880 level.

Nevertheless, we would not be surprised if the KLCI went beyond 1,200 points, given that the stock market is always a place with irrational exuberance and can be a haven for speculation.

Consider the timing and the value that you pay

Although the index has surged by 26%, not all stocks have increased at the same percentage. There are still a lot of laggard stocks that are selling at low prices.

Philip A. Fisher in his book entitled Common Stocks and Uncommon Profits said: Don’t fail to consider time as well as price in buying a true growth stock”.

Some of the good and promising companies might have shown good results lately, but investors should also pay attention to the price they are going to pay.

Stocks with low prices are not necessarily cheap and vice-versa.

We need to make sure there is enough margin of safety, which means we should not invest in a stock unless there is sufficient basis for us to believe that the price being paid is substantially lower than the value being delivered.

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