When investments are threatened during a crash, investors that anticipate the crash can then take steps to try to get their money out of the way. This level of risk management becomes possible when investors or their managers understand the link between crashes and the velocity of money. When investors are able to spot trouble on the horizon, they have several options for moving to safety at the right time, should the market allow it.
Pulling Back the Curtain on Buy-and-Hold Mythology
Conventional wisdom tells investors to buy and — in the case of a crash — to hold, ride out the storm and wait for the inevitable recovery. This philosophy, which is accepted as gospel in many financial circles, ignores some very unforgiving math, considering that a loss of:
Figure 1: Craig Gregozeski’s Scale for loss and recovery:
|Percent Decline||% to Recover|
|0% to -10% (Normal Correction)||0% - 11%|
|-11% to -25% (Correction)||12.35% - 33%|
|-26% to -50% (Crash)||35.13% - 100%|
|-51% to -75% (Deep Recession)||104% - 300%|
|-76% to -90% (Depression)||316% - 900%|
|-91% to -100% (Catastrophic)||1011%|
The worst stock market crash in recorded United States history resulted in an 89 percent loss. Investors who followed a buy-and-hold strategy certainly could have recovered—as long as they had a quarter century to wait for the 89 percent increase necessary to get them back to even from 1929 to 1954.
The Velocity of Money
Investors have several options that don't leave them at the mercy of a crashing market, but employing those options requires an understanding of a critical financial concept: the velocity of money.
The velocity of money uses a simple formula (GDP/money supply) to measure how fluidly money flows through the economy. Essentially, it’s the pace of economic activity that is then measured over the longer term. Take this example of a tiny economy of just two people and $100:
David sells hammers and Linda sells nails.
David buys $100 worth of nails from Linda, who then uses that $100 to buy hammers from David.
Their economy now has a GDP of $200, even though they only have $100 between them.
If they repeat this transaction twice a month, they'll have an annual GDP of $2,400.
$2,400/$100 results in a money velocity of 24.
It is a long, sometimes generational trend that takes years to develop, but when the velocity of money decreases toward 1.0, investors should be wary of repeated crashes. The overwhelming majority of major crashes (10 out of 11) have occurred when money velocity is waning. Velocity can decline for 30 to 50 years, subjecting investors to a crash-boom-crash cycle that is repeated over time. This type of physical and mental devastation, like that which happened in 1896-1945, has to be managed nimbly.
When baby boomers reached the peak spending age of 52, for example, the economy was robust and growing. After that peak, however, boomers approached retirement age and naturally began reining in spending. They downsized their homes, sold second and third homes, paid off credit card debt and saved more money after being frightened by the recent crash.
All of these factors diminished the velocity of money in the economy.
Developing a Sell-Stop Threshold
Developing a sell-stop percentage that reflects the investor's threshold for loss is key to risk management. Publications like Investor's Business Daily advise setting this threshold at 7 percent, but this number is generic and arbitrary, and while an excellent idea, further research needs to be done when executing as part of an investors process. Why?
Sell-stop percentages should be calculated according to industry or company. If biotechnology investors sold every time losses hit 7 percent, for example, they would exit far too early. Biotechnology investors have to deal with regular drops of 30 to 40 percent. Technology investors have to tolerate 20 percent drops. Drops of between 5 and 15 percent are normal for utilities.
Investors have to understand the concept of money velocity and its impact on the markets. Using the velocity of money as a breadcrumb trail to spot looming crashes is half the battle. Another half is determining which exit strategy is correct for each individual investor.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. No strategy assures success or protects against loss. Investing involves risk including loss of principal.
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