Learn to Invest Money: Protect Your Stocks During Turbulent Times, Part I (May 18, 2006)

By J. Shin Kim

This is a special article in response to the global market’s recent correction.

In the U.S., the Dow is down 4% , the Nasdaq about 6%, and the S&P 500 about 5% in a week. European stocks posted their biggest drop since May 2003, and the FTSE 100 in the UK had its biggest 2 day loss in 3 years. On the other hand, in Asia, as of May 11th, the HK Hang Seng index was up 22%, the South Korean index up 55%, the Australian markets up 31%, and China was up 50% before these markets also corrected with the global market correction in the past 7 days.

In addition, the U.S. is allocating $2 billion very soon to shore up its borders, major conflict still is going on in Iraq and Afghanistan, and Venezuela has increased the top royalty rates on oil to 33% from 16.67% after raising this rate from just 1% in October, 2004. In Bolivia, Evo Morales has followed his friend Chavez’s lead, and nationalized his country’s oil and natural gas resources. In Mexico, political unrest, according to subcomandante Marcos, is the worst since 1994 as it nears its next Presidential election. In Iran, the threat of nuclear confrontation with Israel and the United States looms, and returning to the U.S., record trade deficits that won’t turn around any time soon, a falling dollar, and another bad expected hurricane season (due to global warming) is what lies ahead.

So What is an Investor to Do?

Well, sad to say, but I don’t believe the worst is over. The temporary bounce we received mid-week was not the bounce I believe that has yet to come. I still believe that we will see a sharp, steep bounce sometime soon in response to the oversold market. But following that, I still believe that we may see the worst to come. Why? Just read the paragraph above. So in response, I have been shifting significant portions of my client’s into several areas for protection. If you had remained fully invested in these markets before they started tanking I would not recommend panicking and selling out now.

The biggest mistake individual investors make is panicking on market corrections and then buying back in after the market bounces back significantly. That’s the worst thing you could do. Sell low and buy high, but yet millions of investors will make that mistake in response to this weeks actions. But yet if you are mainly invested in Europe and the U.S., you need to rebalance your portfolio now because you will be punished for such short sightedness in the remainder of 2006. In fact, if you liquidated a good deal of assets before the plunge, I would look to buy partial (but not full) positions in some stocks now as a good deal of stocks are on sale right now. It pays to be brave when others are afraid (I think Warren Buffet said that).

Recently a new client transferred over a large portfolio and I immediately liquidated as much as I could, luckily liquidating before the second big drop in the global markets this week. His previous advisor did not own a single stock on the Brazilian, Canadian, London, Australian, Chinese, Mexican stock market. Not even one ADR either. Every single stock he owned was listed on the NYSE or S&P 500. These are the types of portfolios that will get punished over the remainder of the year. I recently read an article about a big producer at another American firm that recently shifted 70% of all his client’s assets into China, but all through Chinese mutual funds. I hate mutual funds, and the thought of owning mutual funds in emerging markets (but that’s an article for another time). People should always own stocks, not mutual funds. Mutual funds are the lazy way out and you’ll get punished for being lazy. It’s just not the way to benefit from these rapid growth markets.

So where should your money go? Due to all the political unrest, I’m looking at the defense sector. Due to continued globalization and the threat of new epidemics, I’m also looking at the healthcare and pharmaceutical sector. And due to all the geopolitical unrest, I’m looking at precious metals. Geographically, I’m looking for continuing opportunities in China of course, as well as some in Brazil, Australia, the U.K. and Canada. And the only U.S. companies I’d invest in other than the defense sector would be companies that have very wide global expansion initiatives. But I can’t discuss all of these ideas, so I’ll discuss one of my favorites –Precious metals.

PRECIOUS METALS

I’m not really sure but large investment firms by and large seem to ignore year after year, precious metals such as gold, silver, palladium, and others. However, in turbulent times, this asset class is one of the most valuable.

It’s not that the news doesn’t report on it. In fact, every night, in financial news reports, the closing price of commodities including gold is reported. However, at the end of the day, very few people ever seem to benefit from investing in the stocks (and not the commodities themselves) that benefit the most during precious metal bull markets.

LESSON #1: The average person does not understand the upside of investing in metals because it has never properly been explained to them

Many myths surround metals that cloud the truth about their value as an investment vehicle. Several of the most widespread myths include the following:

(1)Gold, silver and metals are risky speculative investments.

(2)The best way to buy gold and silver is to physically own the commodity.

(3)Gold is only an investment accessible to the extremely rich.

The definition of speculation according to Webster is the following: “the assumption of unusual business risk in hopes of obtaining commensurate gain”. Speculation is one of the most incorrectly used terms in investing. Investors in general stay away from trying to profit from bull markets in precious metals because of its speculative stigma. However, what is never explained to most investors is that the great majority of risk can be mitigated by employing intelligent analysis and intelligent buying and selling strategies.

Therefore, these investment opportunities should not be rated speculative but more accurately explained as moderate risk, high return opportunities. If you don’t perform intelligent analysis and intelligent buying and selling strategies, then investing in large company stocks, typically described as the “safest” of all investments, can become highly speculative as well. Large companies such as energy conglomerate Enron went belly up and investors lost every penny they had invested in this company. Stocks and bonds invested in “safe” companies such as Ford and Hyundai became risky this year when accounting scandals were uncovered that placed these company’s credit ratings on shaky ground.

Bonds are always described by financial consultants as “safe” investments and financial consultants will buy bonds for the overwhelming majority of their clients if they are over 60 years of age. But right now, bonds are probably one of the riskiest investments you could own. Bond prices go down as interest rates climb higher. Most likely interest rates will head higher from here, so that means the face value of bonds will decline. Bond prices are linked to U.S. dollars. The dollar is incredibly weak now and will possibly even become significantly weaker. And then there is credit risk. Accounting scandals are uncovered everyday.

And in case you’ve forgotten the “high quality” accompanies accused and investigated for fraudulent activity, in 2001 and 2002 alone, these companies included Adelphia, AOL Time Warner, Arthur Anderson, Bristol-Myers Squibb, Citigroup, ImClone, General Electric, JP Morgan, Lucent, Parmalat, Freddie Mac, Duke Energy, Dynergy, Enron, Global Crossing, Halliburton, K-Mart, Merck, Qwest Communications, Reliant Energy, Tyco, Worldcom, and Xerox to name a few. All were accused of falsifying their financials to make revenues or cash flows look better than they actually were. More recently, Ford, AIG, and Hyundai come to mind.

Think about how many more people would invest in an opportunity if they knew it was a moderate risk, high return opportunity versus a high risk, high return opportunity. To give you an example of exactly what I mean, let’s consider the following situation.

Opportunity A: Invest $10,000 in company ABC. Risk of investment: Low. Maximum upside: $1,000. Maximum downside: Capped at $1,500 by using a stop-loss of 15% (means that the stock automatically sells if it loses 15%).

Opportunity B: Invest $10,000 in a gold mining company. Risk of investment: Above average. Maximum upside: $25,000 to $100,000. Maximum downside: Capped at $4,000 by using a stop loss of 40%.

With Opportunity B, a greater downside risk exists but it also possesses a much much greater potential upside. Now even if we factor in the greater risk of Opportunity B, estimating that the downside loss scenario is twice as likely to happen (40%) when compared to Opportunity A (20%), the risk-adjusted numbers now look like this.

Risk-adjusted loss, Opportunity A: $1,500 * 20% = $300

Risk-adjusted loss, Opportunity B: $4,000 * 40% = $1,600

So on a risk-adjusted basis, for an additional risk of $1,300, you gain upside of $24,000 to $99,000 on potential return. Most people, if presented with an investment correctly in this manner, would take advantage of several Opportunity B type investments because of its much better risk/ reward equation. It wouldn’t be wise to engage in many opportunities like this, but several wagers such as these are more likely to pay off than not.

Myth (2) is also a reason most average investors don’t invest in gold and precious metals. Many people believe that one must physically buy gold and silver bullions to benefit from rising gold and silver prices and don’t want to deal with the hassle of safekeeping and buying bullions. However, now there are gold and silver ETFs (Exchange traded funds) that basically mimic the price of gold and silver. But even so, I still don’t believe it’s the best way to benefit from the uncertainty in the markets and in the geo-political sphere.

Owning gold and silver coins, rare coins that are in demand, is much better than owning physical gold or silver or the ETFs, because rare coins always appreciate in price over time and are often worth many many more times the cost of the actual gold and silver in the coins. So a gold coin that is worth $2,000 in underlying gold may sell for $8,000 or $10,000. This probably is the single best way to capitalize on precious metal bull markets, NOT buying actual gold or silver or the gold or silver ETFs. The second best way is to buy gold mining companies. Gold and silver mining companies often appreciate many more times the cost of their underlying asset during precious metal bull markets so are often a much better alternative to profit from a bull market in metals.

In the second part of this article, I’ll review the final two lessons about investing in precious metals.

© 2006 Global Market Opportunities

This article may be freely reprinted on another website as long as it is not modified, changed, or altered and as long as the below author byline is included along with the active hyperlink exactly as is.

J. Shin Kim is the founder of Global Market Opportunities. He has over thirteen years of experience in finance and private wealth management with two Fortune 500 companies. To learn more about how to identify small and micro cap stocks that consistently and significantly beat the market indices, click the following link, Learn to Invest Money and Achieve Financial Freedom.

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