Today, we will continue from Is it time to buy stocks in times of intense fear and volatility? Part 1: Introduction. The question was:
Surely, some of these stocks are undervalued by now right? Should you buy now? Even Warren Buffett is buying.
Well, the answer will depend on your personal circumstances. More specifically, it depends on your current level of leverage.
Before we continue, we must stress again that anything on this publication should NOT be considered as personal financial advice. We are approaching the above posed question from a philosophical point of view. Thus, we will be making many assumptions, generalisations and simplifications. The point of this article is to provoke you to think about your investment decisions based on risk-reward probabilities and should not be seen as some kind of economic analysis/prediction. Now, let get back to the gist of the article…
Let’s look at one extreme scenario. Suppose you are currently very highly leveraged. Also, you are not sure what the long-term economic outcome will be. Will the future pan out to be a V, U or L shape recession (see What type of recession is coming?)? But you believe that a V-shape recession is unlikely. Between the U or L shape recession, you are not sure which one will turn out. Now, let’s work out your risk-reward outcomes for each scenario:
- V-shape recession (unlikely): You will stand to gain immensely when the economy bounces back ‘soon.’
- U-shape recession (more likely): You will suffer some losses for an extended period of time. But eventually, you will recover and gain.
- L-shape recession (not so likely but possible): You will lose your entire life-savings, go bankrupt, lose your home and become destitute because of your high leverage (e.g. someone using their mortgaged home as collateral for their stock market investments).
Now, let’s suppose you are at the opposite extreme: complete absence of leverage (i.e. 100% in cash). Let’s look at your risk-reward outcomes:
- V-shape recession (unlikely): You gain and lose nothing when the economy bounce back ‘soon.’ Relative to the highly leveraged investors, you are very much worse off.
- U-shape recession (more likely): Compared to the very highly leveraged investors, you are better off during the downturn. Eventually when the economy recovers, you will not be too much worse off than the highly leveraged investors either.
- L-shape recession (not so likely but possible): You will be way ahead of the highly leveraged investors.
As you look at these two scenarios, it becomes clear that for the very highly leveraged investors, they will sleep much better at night by reducing risk of catastrophic loss through the reduction of potential for gain. That means de-leveraging. For the completely un-leveraged investors (maybe a person who is 100% in cash should not be called an investor?), they increase their prospect for gain (without increasing the prospect of disaster significantly) through increasing their risk of loss. In other words, for the cashed-up investor, the reward outweighs the risks.
In today’s free-falling market conditions, it is clear that the majority of investors are de-leveraging because they want to reduce their risk. Contrarian investors should be approaching the market from the position of extremely low risk seeking towards a gradual and measured increase of risks.
What if you are one of these contrarian investors seeking to increase your risk in the stock market? Which stocks to pick? Keep in tune!
