LIVING OFF DIVIDENDS & PASSIVE INCOME

Following the decline in the US markets and a show of no-confidence in Bush’s Economic Recovery Plan, global markets crashed in unison.

According to Yahoo! Finance:

Britain’s benchmark FTSE-100 slumped 5.5 percent to 5,578.20, France’s CAC-40 Index tumbled 6.8 percent to 4,744.15, and Germany’s blue-chip DAX 30 plunged 7.2 percent to 6,790.19.

In Asia, India’s benchmark stock index tumbled 7.4 percent, while Hong Kong’s blue-chip Hang Seng index plummeted 5.5 percent to 23,818.86, its biggest percentage drop since the Sept. 11, 2001, terror attacks.

Canadian stocks fell as well, with the S&P/TSX composite index on the Toronto Stock Exchange down 4 percent in early afternoon trading. In Brazil, stocks plunged 6.9 percent on the main index of Sao Paulo’s Bovespa exchange.

In Tokyo trading, exporters got hit hard, partly because of the yen’s recent strength against the dollar. Toyota Motor Corp. lost 3.3 percent and Honda Motor Co. sank 3.4 percent.

Shares of Bank of China dropped 6.4 percent in Hong Kong after the South China Morning Post newspaper reported that the bank is expected to announce a “significant write-down” in U.S. subprime mortgage securities, citing unidentified sources. In Shanghai, the bank’s stock declined 4.1 percent.

India’s the benchmark Sensex index fell 1,353 points, or 7.4 percent – its second-biggest percentage drop ever – to 17,605.35 points. At one point, it was down nearly 11 percent.

Since the start of the year, Japan’s Nikkei index has declined 13 percent, while Hong Kong’s blue-chip index is down more than 14 percent. Even China’s Shanghai index — which nearly doubled last year — has fallen 6.6 percent over the same period and nearly 20 percent from its all-time closing high on Oct. 16.

The world is definitely getting smaller and the smart thing to do is invest internationally for global exposure. However, don’t expect these different stock markets to be non-correlated. In the event of an economic downturn, all non-correlated markets converge as selling pressures force the liquidation of all assets.

This was how Long Term Capital Management (LTCM), which was led by Nobel-prize-winning professors, went bankrupt. When the Russian government defaulted on their bonds, all emerging market bonds tanked. Because LTCM was leveraged to the tune of nearly a trillion dollars and couldn’t meet its margin calls, Federal Reserve Chairman, Alan Greenspan, had to step in to prevent a meltdown in the US financial system. For a fascinating and very informative history behind this, check out When Genius Failed: The Rise and Fall of Long Term Capital Management. Its one of my favorite books. Readers of the book would have realized that the fancy-schmancy Residential Mortgage Backed Securities and Collateralized Debt Obligations that hedge funds were leveraging 5-to-1 and 20-to-1 would come crashing down and they did in the form of the subprime meltdown.

The reason all these global markets are correlated is because of excessive leverage employed by financial institutions. When you lose 10% on an investment and you’re leveraged 5 times, you face a 50% loss of principle. In this case you have to liquidate your winners to meet your margin call. Unfortunately, this sometimes precipitates in a global panic to bail on investments as the selling causes further losses, which initiates further selling.

The lesson to learn is that its extremely difficult to beat the market and rather than be over-leveraged, its better to have 20% of your assets in cash (like Warren Buffett) so you can take advantage of over-sold conditions and undervalued investments.

Don’t believe that you can achieve risk-diversification by investing in non-correlated assets.

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