Long-term Profits on Bear Stock Market

Keith Fitz-Gerald writes: During a two-year stretch every 20 years or so, the Standard & Poor’s 500 Index can be expected to lose 35% or more of its value.

In 1974, according to research by Ibbotson Associates, that truism manifested itself as a 37.25% downdraft. It was even worse in 2002, when investors received a 41.65% haircut.

As bad as those downturns were, they were a mere shadow of the poleaxing investors received in 1932 - during the depths of the Great Depression - when the U.S. market plunged 80%.

But uncertainty breeds opportunity - and in the financial markets uncertainty can bring with it some of the biggest profit opportunities you’ll find. Investors who are able to strike a balance - managing their risks as they capitalize on the opportunities the uncertainty creates - will position themselves for some potentially handsome long-term profits. To help you strike this balance, I’m breaking out my market-survival kit - what I like to refer to as my “Three Keys to Success in Volatile Markets”:

  • Control what you can; manage what you cannot.
  • Always remember that it’s harder to get out of a trade than it is to get into one.
  • Ban wishful thinking from your investment analysis.
Let’s take a look at these one at a time.

First, there’s a reason I say to “control what you can, manage what you cannot.” Financial markets can - and often do - fall much more frequently than we’d care to admit, and often for reasons well beyond our control (even though we’d like to believe otherwise).

What this means, in very plain English, is that big declines are part of the investing landscape and that we need to be prepared for them - not just some of the time, but all of the time.

When investors read this rule, their initial thought usually is that it’s meant as a warning - telling them to avoid big losses. The reality is that this rule was put in place to ensure big gains.

Time and again, history demonstrates two key facts:

  • The biggest stock-market returns go to investors who put capital into play when the markets are at their worst - think of the profits reaped by investors who took the plunge in 1932, 1942, 1982 and 2003.
  • And that the worst returns go to those who invest when markets are highest - think 1928, 1969, 1999, and 2007.
The trouble is that - as sound and clear as this bit of market wisdom actually is - it runs completely counter to what investors’ emotions tell them to do (or not to do) in their quest for profits.

That brings us to volatile-market success key No. 2: It’s harder to get out of a trade than it is to get into one.
Few things are as intimidating as selling an investment, particularly when it’s one we “love” to own. Once again, the “why” of this reality really doesn’t matter, although psychologists who study this sort of thing suggest we hate being “wrong” more than we hate losing. Of course, that’s why “the crowd” is wrong much more often than it’s right.

And that (at least partially) explains why so many people would rather go off the cliff with the herd than step aside when it’s appropriate to do so. It’s easier to be wrong with the crowd than to risk going against what “everyone” believes to be true.

When push comes to shove, there are all kinds of rational decisions we should be making, but don’t, because of how we’re hardwired inside.

We’ve all made the same mistake and held on to an investment when we shouldn’t have - all too often riding what should have been a small loss into a very big one, because we couldn’t bring ourselves to sell, even though we intuitively knew that was the right move to make.

That last point is precisely when we repeatedly counsel investors to instill a kind of structured discipline in their approach to investing. The best way to do this is through the use of so-called “trailing stops” at all times. Not only can they keep small losses from turning into big ones, trailing stops can also lead to significantly higher portfolio returns over time by making sure you lock in at least a portion of your gains on a profitable position.

Some experts, such as Investor’s Business Daily’ s William J. O’Neill , advocate rather tight stop-losses, or trailing stops, of 7% to 8%. Others, like my good friend Alex Green - the Oxford Club investment director and author of the new book, “ The Gone Fishin’ Portfolio “ - suggest 25%, depending on market conditions. Even the “Wizard of Wharton,” Jeremy Siegel , agrees with their use, and notes in his best-selling book, “ Stocks for the Long Run ,” that there is “no question” [the use of trailing stops] even with transaction costs, avoids large losses while reducing overall gains only slightly .”

Finally, I tell investors to ban wishful thinking from their analysis for a simple reason - it clouds their judgment.

In March 1994, Money magazine published a list of the “Eight Investments That Never Lose Money.” Back then, as now, the stock market had dropped, interest rates were rising and the dollar had cratered.
By the end of that year, six of the eight “can’t lose” investments were, well, losers - and in the red.
So, what are some concrete steps you can take to incorporate these three snippets of wisdom into your investments? Let’s take a look:

  • To control risk that would otherwise swamp your portfolio, invest in a good balanced fund and make it the cornerstone of your entire investment portfolio. Our favorite, hands down, is Vangard Wellington (VWELX). Since 1929, this powerhouse has captured more than 80% of the stock market’s returns, but with nearly 50% less risk, thanks to the 60/40 split it maintains between stocks and bonds.
  • Mandate the use of a 25% trailing stop (or some other percentage that fits your ability to tolerate risk). But use the stops. That way you’ll keep small losses from becoming large ones and probably capture more than a few big gains in the process.
  • Concentrate on what the markets are actually doing rather than what you think they ought to be doing. And remember, as Warren Buffett so eloquently said, “it’s better to be approximately right than precisely wrong.”
Especially in today’s markets.

Author: Keith Fitz-Gerald
Source:
http://www.marketoracle.net/Article6019.html

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