Catch a falling knife?

The title is the investment market cliche for buying into a rapidly collapsing market or share price. It is pretty self explanatory – most people will consider the risk of grabbing the sharp blade with painful results to be too great.

How can one apply a logical process to timing new purchases into a market that, as now, is manifestly much cheaper but could get cheaper still?

Firstly, my experience is that not even the most talented of investment experts ever know the exact bottom of a market until some time after the downward trend has permanently reversed. One reason for that is that there is plenty of algorithm driven trading in the markets these days, so short term reversals may just be computers buying, not people deciding the crisis is over.

A logical approach

I tend to make my decisions using the ‘opportunity cost’ approach. In other words what happens if I don’t invest and miss the the lowest price on the one hand versus what’s happens if I do invest and the price falls a lot more?

Assuming that my readers are like me with some of their assets in the market in diversified portfolios, but plenty of cash on hand, here is how one can work through the logic.

If you don’t invest and miss the bottom, your invested assets will be going back up and your cash is still available to invest when assets are cheaper than they were, albeit not the very cheapest they have been. The current correction is sharp enough for one to observe the reversal after it is set in and very likely still buy at cheaper prices than we saw a month ago.

If you do invest and the market falls more, both your invested assets AND your new assets fall and you have less cash to buy more when the reversal can be confidently expected to be set in. In addition, your stress level will go up.

It is obvious that this pair of risks is not symmetrical. The first option means losing out on some upside but still gaining something from having prudently reserved cash; the second involves a distinct misjudgment with an immediate cost and the dilution of future opportunities.

Of course, no one can be absolutely certain that a bear market has ended and a bull one has begun and some decisions to buy might just by luck be very close to the bottom.

Upslope not downslope

My approach is to aim to purchase on the upside slope of a V shaped recovery in prices, not the the downside slope. Furthermore, as I can only observe a promising rather than a certain turn around, I will buy very modestly to start with, investing larger slices of money as I become more confident. My upside slope might be a short term ‘bounce’ only.

One other point I have made recently that I want to restate is that when markets are panicking, it is really important to remember that in the end share prices and bond prices are determined by fundamentals (ie facts about interest rates, profits, dividends and so on) even if In the short term they are determined by human behaviour, just like the supply of toilet paper!

So until there is positive news that the spread of Covid-19 is contained and new case numbers are falling across the globe, I don’t see any reason to be optimistic about share prices, even if there are short term improvements in the market indices.

Readers need to think about their personal asset mix and risk tolerance and apply the sort of considered logis described above. I will post blogs frequently about my judgement on current market valuations.

In summary, at the moment I am saying: cheap, maybe good value, but still at risk of extreme volatility.