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An inevitable consequence of being exposed to equity markets for a prolonged period of time is exposure to Stockmarket crashes. Because of their magnitude and infrequent occurrence, Stockmarket crashes are perceived to be isolated events, brought about by macro economic circumstances that are a function of a unique moment in the evolution of global economics and industrialisation. Once the Economists of the day have performed their postmortem on a crash, a wave of economic reforms are implemented. Regulatory bodies are given greater powers to ensure that the speculators and the corporate cowboys behave themselves in the future. Powerful political, economic and industrial figures have private meetings, supposedly to orchestrate their efforts at ensuring the long-term prosperity of mankind, from which they each emerge stating, that everything is going to be OK. The man in the street forgets all about becoming rich in the Stockmarket and returns to his job, content in the knowledge that he has a roof over his head, a shirt on his back and food on the table.

After a narrow escape from economic Armageddon we collectively adopt the attitude, world leaders and the general public alike, that fiscal exuberance is the route of all evil and we begin the monotonous task of consolidating our debt. Governments balance their budgets and we pay off our credit card debt. As long as the painful memory of the aftermath of a crash lingers there will be little chance of a capitalist orgy that precedes a crash ever recurring. As we look back at history, the crashes of the past appear as punctuation marks in the chronology of global commerce. They pinpoint the hard economic lessons that have been committed to print in the form of university textbooks. Here, they serve as high doctrine to future world leaders and other apprentice keepers of the global economy.

But here's the kicker. Whilst civilisation evolves both economically and industrially, human psychology remains a constant. History repeats itself because we repeat previous actions that are a function of our psychological makeup. Every time there is a repetition in Stockmarket speculation we trot out the well-worn line, 'But this time the circumstances are different'. In the recent technology boom of the 1990s the basis for differentiating current circumstances from previous speculative orgies was the advent of the Internet and other technological marvels. The following table compares the current technological revolution to that of the early 1900s.

I know which list I would rather live without. Some readers will claim that several developments from the early 1900s are from the 1800s. But, although the Internet was originally developed in the 1960s for military use, it has only had a commercial impact on the world since the late 1980s. Likewise, radio was invented in the late 1800s but broadcast radio only came into common use in the 1920s. Technology and industry will always evolve. Human psychology, our needs and desires…are all constant. Circumstances are similar but never the same. Stockmarket crashes are inevitable.
If we accept this inevitability then it is more important to understand the nature of the event rather than the cause of it so that we can develop strategies to cope with the problem of Stockmarket crashes. It's Alan Greenspan's job to work at the futile task of preventing future equity market meltdowns. The following chart of the Dow Jones Industrial Average shows the Crash of 1987.

The crowd of market participants, which the chart of IDT represents, is infinitesimally smaller than that of either of the Indexes but the overall behaviour is strikingly similar. Our reaction to the break in the trend in IDT is one of regret, but little else. In contrast, our reaction to the end of a bull market that has lasted for years is one of mass panic and fear. But a bull market is just a trend, which lasts much longer and is driven by a much larger crowd. We can view the problem as one of having to deal with a trend in an index.

We need to employ risk management that can cope with a break in such a trend. By being in the Stockmarket in the first place we are exposing all of our capital to a trend in an Index. By being caught in a crash with a portfolio of Blue Chip shares we can expect to suffer a loss of up to 50%. It would take approximately 4 years to recuperate our losses at 20% per annum. What's more, this is an optimistic estimate given the lack of confidence, which pervades Stockmarkets during the aftermath of a crash. A more realistic estimate would be 6 to 7 years and even this estimate assumes that we won't encounter a prolonged bear market. One answer is diversification.

Applying the concept of position risk would mean limiting the amount of our total investment capital that we allocate to shares. This is the concept behind diversification across different investment media and it is a sensible measure if we don't have 7 years to spare, rebuilding our capital base. By allocating our total capital across different investment media we will limit our exposure to catastrophic risk in any individual group of financial products such as equities, etc. Other investment media includes real estate, bonds, cash deposits, etc. and are not within the scope of my expertise. There is, however, a wide range of books available that cover these different investment media.

They include:

Anyone can be a Millionaire, Sean O'Reilly (Pan McMillian)

Getting started in Bonds, Sharon Wright (John Wiley & Sons)

Building wealth through investment property, Jan Somers (Herron Books)

How to make your money last as long as you do, Margaret Lomas (Wrightbooks)

Going back to the Stockmarket though, we face another problem with respect to Index trends. As well as a break in an upward trend we also have to contend with the possibility of a sustained downward trend, more commonly known as a bear market. The following chart of the All Ordinaries Index shows the relatively brief bear market that occurred during 1994. Australian equity funds and many superannuation funds reported negative returns during this period. Reporting a positive return for the calendar year of 1994 was considered exceptional. The Index fell 20% over 12 months.

If we are to trade with the prevailing trend and not open any new positions when the broad market is trending down then we will find ourselves being sidelined during periods such as 1994. To prevent this from happening we need to have the ability to profit in bear markets. To do this we need to 'Short sell' ordinary shares which is to sell shares that we don't own with the intention of buying them back later, at a cheaper price.

The best way to explain the science of short selling is to use an analogy. The following example illustrates how we can profit from selling an item before we buy it.

Example:

Imagine that you rented a brand new TV from Acme Rentals.

The rent is $100 per annum.

You sell the TV to Fred Nurk for $600.

1 year later you buy the TV back for $400 making a profit of $200.

You then return the TV to Acme Rentals and pay the $100 rent.

Your net profit after the rent of $100 is repaid is $100.

Unfortunately it is illegal to sell goods that you don't have clear title to and so we can't profit from short selling tangible goods that we can rent. However it is possible to rent shares and sell them into the market with the intention of buying them back later and returning them to the lender. To short sell ordinary shares we definitely require the services of a full service Broker as online discount Brokers don't facilitate short selling. The bad news is that we have to pay rent on the shares that we short sell and our Broker is going to want an amount of money placed on deposit just in case something goes terribly wrong, i.e. share prices start rising. The cost of renting shares usually includes an upfront fee plus an interest payment that is commensurate with fixed deposit interest rates, calculated and payable on a daily basis.

Brokers usually request that clients have a separate 'Short selling' account with a balance equal to or greater than 30% of the value of the shares that they wish to short sell. By short selling we unavoidably become exposed to leverage as we can short sell $100,000 worth of shares that we don't own with a deposit of only $30,000. I recommend that a deposit of 50% be used for short selling as it is a comfortable distance away from the Broker's margin and will reduce the likelihood of a request for more funds from the Broker. This added safety cushion also allows room for the rental that is deducted on a daily basis from the short selling account. There are a range of other conditions that apply to short selling but they vary from Broker to Broker and therefore there is little point in going over them here.

Now to the good news. If we're caught in a crash and our total capital is reduced from $100,000 to $50,000, we will have suffered a 50% loss to our capital base. The cruelty of mathematics is that to recuperate this 50% loss we have to double our $50,000 back to $100,000 that is a 100% gain. Hence, to recover from a 50% loss we require a 100% gain. But when we short sell this cruelty of mathematics is eliminated. A fall of 20% equates to a 20% gain for us, based on our original position, and if the share were to rise by 20% then we only lose 20% on our original position. At the end of the day the pro's and con's of short selling virtually eliminate each other with the added mathematical complexities being the only real barrier for most people.

However there is also the psychological discomfort for some of us of obtaining financial gain through someone else's loss. If you fall into this category or find the science of short selling difficult to comprehend then don’t do it. The Stockmarket is not a place where anyone should be operating outside his or her comfort zone.

Hedging

For those of us who want to concentrate our efforts, and capital, in the Stockmarket and not in other investment media, we can use hedging to eliminate the risk of a crash. In order to hedge our portfolio against a crash we need to ‘Short’ at least 30% of our total capital. The following example assumes that we have a total capital base of $100,000.

Example

A Stockmarket crash has occurred, causing all shares to fall 50%

We have $70,000 in long positions and $30,000 deposited in our short selling account

We have short sold (Shorted) $60,000 worth of shares, i.e. our $30,000 deposit represents 50% of our shorted positions

Our $70,000 of long positions is now worth only $35,000 (i.e. a 50% loss)

We can buy back the $60,000 worth of shares that we have short sold for $30,000 because these shares have also fallen in price by 50%

We lost $35,000 on our long positions and made $30,000 on our short positions.

Conventional hedging techniques usually involve the use of derivative products such as options and futures that act like an insurance policy. Whilst they prevent losses in the event of a fall in equity prices, they will lose value if the market doesn't fall. In the event that the market doesn't crash, the exponents of this form of hedging treat their losses as an insurance premium. But we can actually profit from both sides of the market at the same time when we hedge by short selling ordinary shares that are already trending downwards. We also avoid the added complexities that come with trading derivatives such as time decay and liquidity problems.

Downward trending shares

The sentiment that drives equity markets up is not the exact reverse of the sentiment that pushes share prices down. Bulls run on greed whilst bears are driven by fear and these emotional forces are not mirror images of each other. Therefore, given this lack of symmetry, we need to use a slightly modified set of tactics for trading the sharemarket on the short side.

The most noticeable difference is that the bears act with greater impetus but in shorter bursts than the bulls. Historical examination of Stockmarkets supports this observation, as global markets will rise for much longer periods than they fall but they will fall with greater speed. However human beings, in the majority, are optimists and they will react swiftly when a glimmer of hope appears on the horizon. Therefore short-term factors that affect opinion have a greater influence as they will work in harmony with people’s optimism to lift share prices. We must also resist the temptation to short sell shares, which are falling very rapidly because they carry a greater chance of a sudden trend reversal and increased risk.

When analysing shares using 'Multiple Moving Average' charts we will discover that volatility is harder to avoid and that the regular pullbacks in the short-term group of averages is more pronounced. We must place added importance on avoiding volatility when selecting shares for shorting. Looking at the following chart of Ausdoc we can see that the short-term group of averages are on the bottom and a pullback in price activity is, technically speaking, a pull up in price activity.

Ausdoc, pictured above, has been falling steadily over time. But even Ausdoc is capable of a sharp reversal if the right catalyst appears in print such as a take-over announcement, etc. Therefore we must be more vigilant in monitoring and executing our stop losses when trading short. Short selling is a more intense activity, requiring more effort with downtrends being typically shorter than most uptrends. The main differences between shorting and conventional buying and selling can be summarised in the following recommendations.

We must by highly disciplined in executing our stop losses when trading short.

We must 'Short' at least 30% of our total capital in order to be hedged effectively.

Always use a 50% deposit for 'Short Selling'. An example would be:

'If our deposit is $20,000 then we can short a maximum of $40,000 worth of shares'.

We must never use the value of short positions when calculating our total capital as they are leveraged. We must always use the current balance of our 'Shorting Account' plus the current profit or loss from our open short positions.

If you short sell during a Stockmarket crash and make a lot of money, don't go dancing down the street singing, 'Happy days are here again'. You're likely to get run over.

If you have a problem comprehending any aspect of 'shorting' then it is best forgotten about altogether. In order to train up for short selling though, we can start out by paper trading. The risk that we face from a Stockmarket crash is referred to as catastrophic risk. It is a very real and ever present danger to all market participants. But if we attempt to short sell before we are ready then a Stockmarket crash will be the least of our problems. There is no doubt however that our perspective will shift dramatically as former adversity, i.e. the Tech Wreck of April 2000, can be turned to our advantage as shown in the following set of charts.

Developments - Early 1900s	Developments - Late 1900s
Motor car	The Internet
Flight	Satellites
Radio	Mobile phones
Telephone	Space travel
Moving Pictures	Computers