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In the looming hot summer, we are feeling the heat of the stock market. In April, the Hang Seng index (HSI) surged by 3,200 points or about 13% (from 24,900 to 28,100), the highest single month gain since May 2009. Trading volume also reached a record high with an average daily turnover of HK$200 billion.

Market sentiment was very bullish in April. People were talking about the advent of a new era for the local bourse that has been stimulated by the participation of mainland China investors via the Shanghai-Hong Kong Stock Connect, the mutual market access channel between Hong Kong and the Mainland.

Nevertheless, the market lost some momentum in May and June. The HSI dropped from its recent peak of 28,500 points (recorded in late April) to around 27,000 points (mid-June).

Apparently the market has also become more volatile and fluctuation was much more obvious than earlier this year. For example, the Hang Seng Index fluctuated around 1,200 points on April 9, and moved more than 900 points on May 28. Besides, there were many days that intraday fluctuation (ie the difference between highest and the lowest points within the trading day) was above 500 points in the period, not to mention the volatility of individual stocks, in particular the small-caps.

Staying calm and being aware of the risks could help you ride out what may be quite a roller-coaster ride in weeks and months to come.

Stop, pause and reflect if the following scenarios are relevant for you:

1. The market was thrilled with some positive news about a newly listed small-cap stock that is trading at a premium to the IPO offer price. In the media, stock commentators also recommended this stock. My instinct tells me not to miss this chance of making a quick gain from investing in this stock. Should I follow the herd?

Market news on individual stocks or potential favourable government policies to specific sectors that may stimulate stock prices, can turn out to be rumours. Even if the news is factual, such information is subject to different interpretations by different investors, in particular under volatile market conditions. Share prices may correct sharply and quickly at any time. So market news-driven investment decisions could be very speculative and could involve high risks.

Though everyone wants to make profits, the reality is that the higher the potential gain, the higher the potential risk. This is true for all investment products and in all market circumstances.

Even in a bull market, share prices will fluctuate and there will be corrections along the way. It is just a matter of time. Also, it is never easy to catch the right timing for market entry or exit. You may incur significant loss if the share prices suddenly plunge.

Share prices of individual stocks can be very volatile, in particular the small-caps and stocks with shareholding highly concentrated in a small number of shareholders* (in this scenario, the share price could fluctuate substantially even with a small number of shares traded). Think carefully if you have the ability to withstand the potential losses. Also as a rule of thumb, you should understand the fundamentals of the company you have in mind and the risks of what you are investing in. Stay cautious and don’t invest in something that makes you sleepless at night. Do not follow blindly the tips from market commentators.

*Investors can refer to the SFC website for the list of companies with high concentration of shareholding.

2. I am offered a loan at a preferential interest rate from a finance company and can use the money for investing. Should I borrow the money to buy stocks?

You may find it easy to get money via borrowing (eg cash advance from credit cards, personal loans or even mortgage loans etc) to increase available funds for purchasing stocks, but you should be aware of the consequences of the potential downside of this scenario.

Consider the following case:

James has a stable job with a monthly income of HK$20,000. His friend told him that the share price of Company X was predicted to go up due to its good business prospects reported in the media. A few days later, James found that the share price of Company X did increase by almost 20%. He then decided to borrow HK$100,000 to buy Company X stock, aiming to sell the stock once the share price went up by another 10%. He believed this was a smart investment decision as the interest rate of the loan was low compared to his expected quick return of trading Company X stock. However, it turned out that the share price plummeted immediately after James bought the stock. Even worse, the trading of the stock was suspended and Company X was subject to regulatory investigation.

You may consider this just an unfortunate or rare case. But borrowing money to bet on short-term gain in the stock market is very risky. Apart from the potential investment loss, you have to pay interest and other fees related to the loan. And in the worst case, if the stock was suspended from trading, you could not sell the stock until it resumed trading. Your investment is locked in but you still have to repay the loan and interest. You might then incur multiple losses.

3. I can easily open a margin account with my brokerage firm. Should I make use of margin financing to invest in stocks?

Margin trading is a common way of borrowing to invest. But beware it can magnify your gain as well as the loss. In this scenario, investors use their existing stocks as collateral in their margin account, to borrow money from the brokerage firm to buy more stocks. If the stock prices drop to a level that the value of the collateral in your account is not enough to cover your margin position, you will have to add more money to your account or else your stock collateral will be sold by the brokerage firm (ie the margin call**) to make up for the shortfall. In the worst case, you would lose more than your original capital.

So always consider carefully your financial situation and the high risks involved in leveraged investing. Know more about margin trading.

**The brokerage firm may not be obliged to make a margin call or otherwise tell you that the value of the securities held on your account have fallen below the specified lending ratio. Your brokerage may sell your securities at any time without consulting you.

4. My friends said trading CBBC can make huge gains within a short period of time. Should I try to invest in CBBC?

Structured and derivative products such as CBBC (ie callable bull/bear contracts), warrants, futures, options or equity-linked investments are complicated instruments. Due to the leveraging effect, a small change in the price of the underlying assets can result in significant price movement of the structured/derivative product. While some of them (eg options and futures) can be used as a hedging tool to manage risk, these products can also be a high risk instrument if they are used for trading purposes. In general, structured/derivative products are only for sophisticated investors who understand the product and can afford the potential losses.

Equip yourself with useful investment techniques:

1. Diversification:

Avoid putting all your money into a single investment or a single type of investment (eg stocks or properties). An investment portfolio with diversified asset allocation based on your investment objective, time horizon and risk tolerance can reduce risk and help you achieve your investment objective over the medium to long term.

Diversification can be achieved through holding different classes of assets such as stocks, bonds, funds, insurance saving plan and properties in your portfolio. You can also adopt a diversification strategy within one asset class, such as stocks. For example, compared to investing in a single stock, an exchange-traded fund which invests in a basket of stocks can help to achieve diversification in the stock market. Besides, the performance of different sectors may not be correlated closely to one another, eg the utility sector may not be impacted by a rise in interest rates as much as the financial sector. Investing in different sectors can therefore be a way of spreading your investment risk.

2. Stop loss strategy for stocks

Make use of stop loss strategy to protect your investments from possible significant losses. You can limit your losses by placing a stop loss order with a broker to sell a stock if its price drops to a certain level (ie the stop loss price specified by you). Alternatively, you can set a predetermined percentage, such as 15% below the purchase price, as the cut loss level. The stop loss strategy is a risk management tool that helps you manage the downside risk.

3. Dollar cost averaging

You may also consider dollar cost averaging (DCA) to smooth out short-term market fluctuations. DCA works best for long term regular investment (like MPF) but the principle can still apply in other scenarios. For example, if you plan to invest a lump sum amount in a stock (say HK$150,000), you can spread the purchase over three stages, eg invest HK$50,000 on any designated date in three consecutive months. This technique reduces the effects of short-term market fluctuations on investments by averaging out the costs of your investment over time.

Last but not least, you should always know your investment objectives, horizon, risk tolerance, projected financial resources and fully understand an investment product before making a purchase decision.

Last update: 15 June 2015