Fundmastery Blog

Kurt Brouwer September 24th, 2008

When Matt Millen was a tough, hard-hitting linebacker for the San Francisco 49ers, he said it best, “Things are never as bad as they seem when you’re losing and never as good as they seem when you’re winning.”

The stock market has been exhilarating and exasperating investors for generations. At times, making good money is ridiculously easy and, at other times, hanging on to what you have seems impossible. Markets rise higher and higher only to fall further than any sane person could imagine. Is there a way to navigate through these extremes without losing your mind or your nest egg? Fortunately, the answer is yes.

A rising or falling trend in the stock market can last so long that it seems permanent. Witness the long, relatively uninterrupted bull markets in the 1950s and 1960s. Or, a long, nearly-stagnant period from 1970 all the way to 1982, when the stock market lost ground to inflation.

A Decade of Above-Average Returns Followed a Decade of Below-Average Returns

As you can see from the chart below, the 1970s were a terrible decade for stocks.  In fact, the decade of the 1970s had negative real (adjusted for inflation) returns for stocks.  However, the decade of the 1980s and the 1990s were excellent for stocks.

Source: Brouwer & Janachowski, LLC

Now, we are going through another difficult time for stocks, very similar to what happened in the 1970s.  In fact, stock market returns since 2000 have also been negative, adjusted for inflation.  This chart only goes through May 2008, but the downturn has continued and stocks are still doing poorly.

As we saw in the chart above, returns from the stock market are cyclical.  But, no matter how strong a market trend seems to be or how long a given market cycle lasts, it always (and I mean always) carries with it the seeds of its own reversal. A bull market for stocks may seem unstoppable, yet one day it will end and stocks will fall. The worst of bear markets may involve an unending stream of negatives, but it too will end. And when it does, with the benefit of hindsight, we can look back and see the factors that led to the reversal.

A winning investment strategy for stocks or stock mutual funds need not be complicated, complex or, even completely correct. But it must take into account certain, seemingly immutable rules of the road. To be successful, a strategy must be:

• Consistent

• Correct (most of the time)

• Clear-cut

Consistency. Ralph Waldo Emerson rightfully said, “Consistency is the hobgoblin of small minds.” He was right. Consistency, by itself, is of little merit. Consistently wrong or bad is no good. Nonetheless, when it comes to investment strategies, consistency in the planning and execution of your strategy is essential.

Let’s say you have decided upon a course of action that calls for a conservative investment strategy–one that may lag bull markets a bit, but gains considerable ground in flat or falling markets. Nonetheless, you have the good fortune to be in a sustained up market, one that lasts for several years.

During this period, your conservative selections have done reasonably well, but they have lagged behind the more aggressive funds as well as the stock market averages. Finally, in the face of this sluggish performance, you become impatient, dump your laggards and jump on board the aggressive funds that have been doing well. Six months or a year passes and you congratulate yourself–until the stock market tumbles. Your aggressive funds fall faster than the market overall and, suddenly, you are losing a fortune. You give up all your gains from the past few years and maybe more. The slow moving funds you dumped now look quite good and you wonder what ever possessed you to change.

As you can see, making big strategic changes late in the game is dangerous both to your portfolio and to your peace of mind.

Correct (most of the time). No investment strategy is going to be correct all the time, but to be successful you must be correct more often than you are wrong. Going back in time to an earlier crash (see The Stock Market Crash of 1987) Charles Allmon, the editor of an investment newsletter called, Growth Stock Outlook, became bearish about stocks before the 1987 stock market crash, which involved a single day decline of over 22%. During the Crash, his newsletter and a portfolio he managed did very well. Unfortunately, Allmon’s allocation to stocks remained low through one of the longest stock market upswings in history and he and his investors lost out on a huge profit opportunity. Being correct once is just not enough.

For a stock market strategy to work well, it has to have solid logic and good sense behind it. For example, the stock market goes up, on average, twice as much as it falls. Getting out before downdrafts is possible, though not necessarily easy. Getting back in for the ride up is the really hard part. Inflexible formulas and statistical rules seldom conform to reality and they often lead to incorrect decisions.

Clear-Cut. The third and final factor is that your strategy must be clear-cut. If it requires making monthly portfolio changes, reading tea leaves, patterns on stock charts or any other methodology that is not simple and clear-cut, chances are you will not follow it at a critical time. The best investors have simple rules that are easy to understand and follow. They may be nothing more complicated than saving and investing more money every three months without fail–no matter what. Or, putting 20% in foreign stock funds with the remaining 80% allocated to domestic stocks, with 35% in small company stock funds and 65% in large company stock funds. Or, buying nothing but technology funds or growth funds or balanced funds. Take the time to develop a strategy that could be easily communicated to your children, your colleagues or your grandmother in one or two simple sentences. If your strategy cannot pass that test, it may need some refining.

Over time, as your skill and confidence grows, you will develop your own style as an investor. To start developing your own approach, you need to thoroughly understand the financial markets. And to help you do that, we turn to Benjamin Graham, the father of modern security or investment analysis.

Benjamin Graham & Warren Buffett

In 1934, during the depths of the Great Depression, Benjamin Graham co-authored (with David L. Dodd), the seminal work of stock or security analysis, called appropriately enough, Security Analysis (McGraw-Hill 2005). In 1973, during the worst stock market crash since the Depression, he published The Intelligent Investor (Harper & Row).   It is a classic book with a preface by Warren Buffett.  In 2003, a new edition of this classic came out.  It was substantially revised and updated by an excellent journalist, Jason Zweig, and published by Harper Business Essentials. In The Intelligent Investor, Graham gave readers an excellent metaphor for the stock market [emphasis added]:

“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you little short of silly.

If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings…”

We believe (and we’re sure Mr. Graham would agree if he were here) that time spent trying to determine where the stock market is going in the short run is time wasted. Time spent fretting about current market activity is also time lost. According to Graham, the only thing to consider is whether current stock prices are excessively high and therefore you should sell out. Or, that they are so low, you should consider it a buying opportunity. Otherwise, Mr. Graham suggests you should ignore Mr. Market.

The late Ben Graham’s most successful and best-known student is, of course, Warren Buffett.  Yesterday, it was announced that the firm Buffett runs, Berkshire Hathaway, had made a multi-billion dollar investment in Goldman Sachs.  This Bloomberg piece gives the details:

Goldman Chief Executive Officer Lloyd Blankfein is also raising $5 billion from Warren Buffett’s Berkshire Hathaway Inc. in a plan to shore up the firm’s capital base and restore market confidence…

Does Berkshire Hathaway’s purchase of Goldman shares mean a market bottom has been reached? Not necessarily.  However, it indicates that we should pay attention to Mr. Market now because shares of some solid companies are being sold at attractive prices.  Eventually, the rest of the world will figure this out and prices will rise.

Over the past three decades, we have been through many ups and downs in the economy and markets.  We have found that two things remain constant:

• The financial markets always have and always will fluctuate.  And really, we mean all markets, whether in stocks, bonds, real estate, gold, collectibles-you name it.

• The financial markets recover and move on.  At times, the rough patch can extend quite a long time, but ultimately the global economy is growing, and carefully-selected investments will do well despite temporary setbacks.

During these volatile conditions, it does not seem possible to many investors that the stock markets and the bond markets and even the real estate markets will turn up again some day, but they will.

Just remember though, it’s only worthwhile to really pay close attention to the market when Mr. Market is in one of his overly optimistic or overly pessimistic moods.  He seems to be overly pessimistic now and so it’s worth your time to pay attention.  The rest of the time you may want to focus on more important things.

• Investing , Money , Mutual Funds , Personal Finance
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