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June 6, 2016

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How to play risk and opportunity in volatile markets

VOLATILE markets offer the opportunity for big gains and the risk of big losses.

Robert I. Webb, professor of finance at the McIntire School of Commerce at the University of Virginia, said the trick is to focus on the catalysts that spark wild stock gyrations.

In his most recent book “Shock Markets: Trading Lessons for Volatile Times,” co-authored with Alexander Webb, he discusses the triggers of sudden jumps or breaks in prices, using real-life examples.

During a recent trip to China, Professor Webb sat down with Shanghai Daily and shared his views on understanding market shocks.

Q: You’ve said a number of factors, ranging from government actions to central bank moves, can lead to market volatility. So is the market predicable?

A: We certainly don’t contend that we give readers an advantage in predicting market prices in general. But we do believe that when an event occurs, there is an opportunity to react, and sometimes the amount of time a trader has to put on a position can be substantial. Case in point: In his election campaign, then candidate Shinzo Abe argued that he had a plan to restructure the Japanese economy. Of the “three arrows” he proposed, devaluation of the yen was the most important. When the campaign was in full swing, the currency was trading at around 75 yen to the dollar. After the Liberal Democratic Party, which Abe heads, and its coalition partner Komeito won, the currency depreciate to around 90 yen in late December. There was a plenty of time for market participants to get into that trade. Indeed, the yen later depreciated to almost 130 yen to the dollar.

Moreover, the effects of the government-induced decline in the yen were not confined to the forex market. Experience suggests that if a country devalues its currency, equities in that country will rise in value.

Q: China’s equity market is frequently compared to a casino because it seems to be driven by irrational behavior. How can one approach it in a rational way?

A: If you enter a casino, you can still behave rationally. There is a speculative dimension to every market around the world — and a non-speculative dimension. A market participant has to determine which part is dominant at any given moment. If a person is fearful of the casino per se, then one approach is simply to stay out of the stock market and invest elsewhere. But there are a variety of other factors that can push investors and traders to the marketplace. For example, when the interest rate is close to zero or in some cases negative, investors who are close to retirement are effectively being encouraged by governments to take riskier bets because of a lack of alternatives for their savings. I’m not saying that’s the case in China, but I am saying the same type of calculus applies to investor decision-making — namely, how much risk does an investor want to take?

Q: China’s stock market went through a boom-and-bust cycle last year. Chinese investors, especially retail investors who dominate the market, suffered losses. What lesson can we draw from that route and what advice can you offer Chinese investors?

A: Individuals should not invest on the belief that the government will step in to protect private investors. Rather, they should invest on the basis of whether a company represents value for price. They have to make that trade-off decision between risk and expected return.

Is investing in equities worth the risk associated with it? One of the things that happens in the marketplace is that the market tends to aggregate the information that different individuals have. As a result, the market price on average tends to be a fair price. I am not advocating that individuals should place bets without any knowledge of what they’re betting on. They should do their research and make informed decisions. What I am saying is that, to the extent the market price reflects available information, investors who decide they have made a mistake can get out at the current bid price. In a well-functioning market, the bid-offer spread is narrow, and you have that opportunity to get out as well as to get in. You’re not constrained to hold your investments forever.

There is a fundamental rule of trading: Cut your losses short and let your profits run. One of the difficulties of trading is that the rules are very simple, but internalizing them is very hard.


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