On Being A Forced Seller in a Panic

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On Being A Forced Seller in a Panic

Photo Credit: wackystuff

No one wants to be a forced seller in a panic. So how does anyone get into that situation? Two things: bad planning and a bad scenario.

Let’s start with the obvious stuff: the moment you start using leverage, there is a positive probability of total failure, and more leverage increases the probability. Other factors that raise the probability are lack of diversification of assets, a short term for repayment on the leverage, a run on the bank, or restrictive rules on what happens if your assets decline too much in value.

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For the big guys, I think that covers most of it. With little guys, there is one more painful way that it happens, with insult added to injury.

Assume the man in question has no formal leverage, except maybe a mortgage on his house. He has a stock portfolio, and like many, has bought popular stocks that everyone thinks will do well. Then a significant panic hits the market because enough corporate or banking debts are incapable of being repaid.

The value of his portfolio falls a lot, but he doesn’t sell or worry immediately, because he has a solid job and has a buffer of a few months expenses set aside. Then the shock hits. In the midst of the panic he faces one of the following:

  • The loss of his job (or severe trouble in his business)
  • Disability with no insurance
  • An uninsured casualty of some sort
  • Divorce
  • Health problems not covered by insurance
  • Death (and his wife has to pick up the pieces)
  • Etc.

Guess what? Even though he planned ahead, the plan did not consider true disasters, where two things fail at the same time. His buffer runs out, and in order to live, he has to sell stocks at a time when he thinks they are undervalued.

This happens to some degree in the depths of bear markets, because unemployment and credit panics are correlated. Other contingencies may not be correlated, but a certain number of them happen all the time — the odds of them happening when the stock market is down is still positive.

What can be done? Here are a few ideas:

  • Hold a bigger buffer. Maybe toss in some high quality long bonds, as well as cash.
  • Reduce fixed commitments.
  • Insure most reasonably possible large insurable contingencies — death, disability, health, liability, etc.
  • Keep a rolling hedge of protective puts (costly)
  • Increase portfolio quality and diversification to lessen the hit.

The time plan for a flat tire is before you have one. As an example, I keep wrenches that are better than what the automakers put in their tire changing kits in my cars. The same is true for financial disasters. The planning is best done in the good times, like now. Consider your financial and personal risks, and adjust your positions accordingly, realizing that no one can survive every panic. Eventually you have to trust in God, because no earthly security system is comprehensive.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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