FOR every action, there is an opposite reaction. Capital markets are no different. We just state it differently. It’s called the zero sum game. Investing in capital markets generates a net result of zero when looking at both parties to each transaction — meaning that for every winner (gainer), there is a loser. We saw that again on Tuesday, February 27, 2007.The tipping pt<$>: Why did this sudden drop in global markets occur? Was it really about a former US Federal Reserve Bank chairman’s remarks? Who knows? Prevailing opinion is that those comments were only one concern voiced by many market analysts over the last year.

No-one can really define what triggers a market sell-off. In some cases, the signals of an overheated or failing economy are there in plain sight, for a significant point in time. In others, as has been discussed endlessly in financial media noisemakers about this most recent event, equity markets had been strong for four years, and possibly it was just time to reap profits by taking money off the table.

Flight to quality (liquidity) and another bond lesson: It is probably true that all investors have some appetite for risk; otherwise they would not be investing, would they? There are two primary reasons for investing:

[bul] To receive an appreciation rate above the risk premium — which is can be defined, for instance, as earning a return above the prevailing market rate of the US ten-year treasury, currently yielding around 4.53%.

[bul] To diversify current asset holdings.

If investors employ careful measured planning to assess the risk they are taking on (and I can’t stress this type of planning strongly enough) they will also have a contingency plan as a fall-back strategy. Some investors aren’t proactive; they just react — falling into the traditional financial behaviour pattern of selling at the low (and buying at the h).

Risk Premium. <$>A careful contingency plan will calculate when to sell any security position as part of your investment strategy on your terms, thereby holding the cash until good value shows its happy face again. The reactive investor liquidates with no plan other than taking the flight to quality where you along with many other global investors vie for the same premium sovereign debt (Treasury bs).

Sovereign debt and government stability. Which bonds of which country are perceived as having the highest credit ratings? It is no secret that OECD country issues generally have the highest credit quality ratings. The absolute top premium requirement for investors seeking (flight to) quality is strong stable government securities because they know that bonds issued by those government bonds are even better than cash in hand.

Contrast those mature stable economies with some other countries where political instability and economic uncertainty may be the only order of the day. While in certain Latin American and Far Eastern countries, for instance, investors are still willing to take on greater investment risk because they are being paid handsomely to do so, at the first feeling of vulnerability, they will liquidate: out of the investments, out of the currency, out of the country.

Tracking historical global market crises and the domino ect: <$>1987 — Black Monday, October 19, 1987, the Dow Jones Industrial Average (DJIA) lost 25 percent of its value, dramatically followed by similar precipitous losses in other trading markets across the world. Potential causes for the decline include program trading, overvaluation, illiquidity, and market psychology, but no real perfect explanation.

1990 — US slides into recession. On Black Monday, the New Hampshire construction company whose finances I managed listened with disbelief as the indexes fell and fell and fell. Two thoughts went through my mind: this event was going to ruin this company and I would soon be out of a job. Both events occurred. By early 1989, New Hampshire, too, fell into a tough recession lasting more than threears.

1994 — The 1994 Mexican crisis was triggered by the sudden devaluation of the Mexican peso in the early days of the presidency of Ernesto Zedillo. The intense currency crisis was stabilised when US President Bill Clinton and other international organisations speedily granted Mexico a $50 billion loan.

1997 — The Asian crisis started in mid-1997 affecting currencies, stock markets, and other asset prices of several Southeast Asian economies. Triggered by events in Latin America, particularly after the Mexican peso crisis of 1994, Western investors lost confidence in securities in East Asia and began to liquidate, creating a domino effect. And later through another business cycle as these economies recovered, investors returned — willing to accept higher risk to gain oversize emerging market returns for both equities abonds.

1998 —<$> The Russian crisis and Long Term Capital Management (LTCM). During this time, possibly triggered by the Asia crisis of the prior year as well as internal political turmoil and negative economic conditions, the Russian government defaulted on their government bonds. Seeking to stabilise global markets, the World Bank and the International Money Fund injected $23 billion into the Russian economy, but still lacking confidence in the outcome, foreign investors closed the proverbial doors, anyway.

Globally, flight to quality increased as investors also sold Japanese and European bonds to buy US treasury bonds. The successful investment climate that LTCM had built, with a reputation based on the development of complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades), came to an abrupt end. Simplistically, convergence became divergence. The firm incurred huge losses as the prices of sovereign debt were driven upwards by investors seeking safety. Ultimately, the Federal Reserve Bank of New York organised a bail-out of LTCM to the tune of $3.625 billion to avoid a wider collapse in the financial markets.

20—<$> 9/11 was probably the most horrific strike aimed at the free market capitalist system. Who can ever forget the television scenes, the first hand accounts, the sadness and disbelief when so many realised that so many would not be coming home from work, ever again?

In the aftermath, the world held its breath in anticipation of the great question. Would the US market trading system resurrect itself after the attempt to dispatch it into oblivion, along with the intellectual capital of thousands of its contributors? Would every investor, everywhere, sell everything? Would other economies collapse, unable to hold their own weight without the investment leader of the free world? Yes, there are those who will disagree with that statement — but for sheer volume alone, US capital markets still dominate — for now.

It did not happen. The entire US capital market-trading conglomerate resumed operations six days after the terrorist attack on New York City. On Monday, September 17, 2001 the Dow Jones Industrial Average dropped 685 points, the greatest in recorded history. But, markets recovered (I tracked this one) and most valuations returned to pre-September 11 in less than a year. The Bear Market blanket was still tucked in tight, but it, too, was on the wane by the eof 2002.

Recovery and its aftermath: <$>So, what’s the lesson here? On a global basis, markets and country economies do recover, most of the time, over time. See the S&P chart of crisis events.

For the individual investor, common sense and logic, not emotions, should prevail. You cannot ignore your portfolio, and certainly, now is a good time to review what you own. If your allocations are comprised of single securities, and you are managing them yourself, you may feel more exposed with more pressure to sell, particularly, if markets continue to slide.

A reminder to revisit basics. <$>Did you pick these securities because the underlying companies have good solid fundamentals: growth patterns, profits, sales, and possibly dividends? If so, feel reassured that just because the market value of these shares dropped, profitable companies are not going to just fold up and go away. Adopt a wait and see attitude during short-term volatility.

If you own single small or thinly capitalised stock on the assumption that these positions may bring you an outsize return, the pressure from market forces in tough economic situations, increasing debt constraints, limited cash flow and dropping share prices, may be enough to bring this type of company down. Now, is the time to review why you bought these investments in the first place.

Anyone who is interested in investing in capital markets should always have two things in place:

[bul] A conservative core portfolio as an income provider and contingency buffer. This means nothing exciting, nothing volatile, but a group of assets managed by an investment expert who will have already anticipated taking defensive positions in anticipation of a market volatilities and crises. That is their job. At least, with a conservative portfolio immunised against adverse market conditions, you will be able to eat.

[bul] A clear mind-set that can afford (and is prepared) to lose value in speculative positions if markets head south — applicable to Northern Hemisphere residents, of course.

If you aren’t able to do that, or don’t feel comfortable thinking about it, then you should not be investing in capital markets. Use this market instability to focus your future investment strategies on including liquidity, long-term appreciation, and balance.

Free markets reign supreme.

Some reference obtained from Wikipedia