Investor, heal thyself

7/28/2008


It doesn’t take a doctor — or an MBA — to know that the stock market has been ill.

The bounce since July 15 is a good sign, but only time will tell whether the ailment is cured. Market declines can make investors queasy — and desperate for a remedy.

We have no quick cure for you but can offer a piece of advice for anyone in search of financial healing: First, do no harm.

That precept, a core teaching in medical school, serves as a warning to doctors that sometimes the best thing to do is … nothing. The risk of some medical treatments can outweigh their potential benefits.

Standing still is harder than it sounds. In the face of danger, human instinct often directs us to fight or flee. And all too often, our investments suffer the consequences of quick and instinctive actions. With that in mind, here are three common “cures” that will just make your portfolio sicker.

Take a sedative. It’s tempting to just sell all your stocks and ride out the storm in a money-market fund. The low volatility of cash can make you feel better for a time. But unless you know precisely when to get back into the market — and you won’t — limiting your portfolio to cash exposes you to another type of disease: long-term underperformance.

From 1926 through 2007, large-company stocks have returned an annualized 10.4%, and small-company stocks have been even stronger at 12.5%. In contrast, risk-free Treasury bills delivered an annualized 3.7% return, barely outpacing inflation. Cash and bonds are likely to continue underperforming stocks in coming years.

Hair of the dog that bit you. Sometimes investors figure a troubled stock can’t go any lower, so they buy a lot more at the “bottom,” just in time to see the market plumb new depths. Value investors are particularly susceptible to this trap. Just because a stock is down from its highs does not make it a good value. At the end of June 2007, Morgan Stanley ($39; NYSE: MS) traded at less than 11 times trailing earnings. Today, the brokerage giant’s shares are down 54% from the June 2007 close but trade at 227 times trailing earnings.

To avoid this dangerous treatment, follow the Forecasts’ cash position, presented every week in the Market Commentary. And if you want to double down on a depressed stock, stick to those on the Buy List or Long-Term Buy List.

New medication. The best approach for long-term investment success is finding an investment strategy that works, and sticking with it. The Forecasts’ strategy, which revolves around a combination of quantitative analysis using our Quadrix® system and fundamental analysis of individual companies, has substantially outperformed the market since 2000. We’re outperforming this year as well, though losing less money than most isn’t as much fun as making money.

Our system is designed to get you through rough patches, with portfolios that can outperform regardless of the direction of the stock market. If you are cruising on a direct route to your destination, do you turn off onto a side road every time a storm comes up? Of course not. Resist the temptation to veer from your financial objective.

The Greek physician Hippocrates wrote, “Healing is a matter of time, but is is sometimes also a matter of opportunity.” Time takes care of itself, and health is more than the absence of illness. More than 100 years of history has taught us that eventually, the market will turn — and sharp declines like the one seen since early June can represent opportunities to make money. Patiently exercising a sound investment strategy is the best way to take advantage of the recovery.


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