Can Markets can remain irrational longer than one can remain solvent?

By December 8, 2014 Trading No Comments
Can Markets can remain irrational longer than one can remain solvent?

Even John Maynard Keynes could not have testified that his quote would become so true in the contemporary financial markets. The above quote is as true today as when it was first said over 70 years ago by john Maynard Keynes – who fancied himself an investor in the stock markets but burnt his fingers on more than one occasion. It all started with his trading bets in currencies like the US dollar and Deutschemark. Given his research on various economies, Keynes had bet on dollar appreciation and deutschmark depreciation. In a short span, his net positions yielded him good profits. However, to his dismay the profits got eroded and his account incurred huge losses when deutschemark began a three month prolonged appreciation rally which eventually gave birth to this quote.

Share Market can remain irrational longer

Just how irrational is the market?

It depends upon who you ask and more importantly, what their invested position is at the time. The discussion is rather focused on whether you are an investor or speculator and to what extent one is leveraged.

In finance, leveraging generally refers to creating more assets by using borrowed funds, with the view that the income from the asset will be more than the cost of borrowing. This process always involves the risk that borrowing costs will be more than the income generated from the assets one is invested in. Leverage can be created through options, futures, margin and other financial instruments. For example, say you have Rs10000 to invest. This amount could be invested in 10 shares of Reliance stock, but to increase leverage, you could invest the Rs10000 in two futures contracts of 100 shares each. You would then control 200 shares instead of just 10.

Implied Volatility

Investing versus Speculation

One should clearly understand nuances of online trading in financial markets and have a clear view of investing versus speculation: Investing is an activity of forecasting the yield of an asset over the longer-term; speculation is the activity of forecasting the psychology/short-term price trends of the stock market.Investors with a long-term view have been tested time and againas assets keep showing divergences in shorter time frames. Moreover, investors who are highly leveraged in any asset class would not be able to sustain any significant adverse movement. For that matter, Keynes too realized this after having a short stint of trading history and reverted to short-term trading signals/parameters for online trading rather than entering leveraged positions on long-term views.

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The devil lies in over-leveraging

Keynes gives a very clear message to the market participants through this quote and his experience. Over-leveraging remains the biggest devil for investors as financial assets have historically illustrated a tendency of irrational moves for significant time durations. Taking the lessons from financial history, it isimperative for investors to structure balanced and diversified portfolios abstaining from high-leveraged positions.Let us elaborate on the portfolio mentioned above where an investor takes positions in Reliance futures contract to understand the perils of over-leveraging. Assume that an investor having a capital of Rs10000 bought two contracts of Reliance Futures of 100 shares each at a market rate of Rs 1000. In this instance, a price fall of just Rs50 will wipe out the entire capital (200 shares * Rs50 = Rs 10000) of the investor.

Over-leveraging – the root cause of sub-prime crisis in 2008

The way over-leveraging can cause significant damage to an investor’s portfolio; the same applies to a corporate. No one had thought in the wildest of his dreams that the effects of over-leveraging can be so disastrous until one of the top investment banks in the US,Lehman Brothers, went bust in 2007.  In order to multiply their profitability, Lehman Brothers borrowed more and more money and kept investing in real estate related financial products. By August 2007, the bank’s leverage ratio (debt to equity ratio) is believed to have gone as high as 44 to 1, while its competitors like Goldman Sachs and Morgan Stanley had leverage ratios in the range of 20s.As a result, Lehman Brothers went bust at the outset of failure of these real estate related products and thereby led to widespread contagion in financial markets, resulting in a full-blown financial crisis in 2008.

The world has a lesson to learn from the financial crisis of 2008. Let us make sure that none of us repeat what Lehman Brothers did in 2007 to safeguard our capital and avoid bankruptcies.

So beware of over-leveraging and remain happily invested!

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