Making money in a bull market is not a difficult thing. Knowing what to do when the direction turns is what separates the wheat from the chaff. Markets have indeed turned over and the long-awaited correction seems to be in place. So what should one do? What are we doing?
First things first: never panic. The end of the world has a funny way of never turning out that way. There is indeed life after Lehmann Brothers; Enron and WorldCom did not forecast that all corporations were really frauds; and the stock market has survived recessions, depressions, world wars and terrorist attacks. Not once was panicking a wise decision.
This is much easier said than done, so there are some things that we can do to help – the most important of which is knowing what we own. There are two basic world views on stocks: Some people see them as pieces of paper which are traded the way children trade baseball cards. We see them as what they are, partial ownership in companies. I have no idea how scared people in the first camp must be when the Dow Jones opens for trading down more than 1,000 points. That must be terrifying.
We, however, know what we own. Apple’s business did not collapse Monday morning at 9:30 am Eastern Daylight Time. We realize that this is just a big mistake on the part of irrational traders, many of whom are no longer human beings but computer programs, and this overreaction will be corrected shortly. Having this faith is much easier done when one knows what she owns.
It also helps to have a plan – knowing that there are risk controls in place in your portfolio and professionals ready to act when necessary. This is why we discuss with our clients how much pain they can tolerate. It is much better to focus on risk when things are going well and we are not caught up in the emotion of the moment.
Not panicking is of utmost importance, but it is not the only important issue. Secondly, one must understand that not all losses are created equal. There are short-term trading losses, in which the market moves down because the mood has turned negative. Nothing has changed in the underlying businesses of companies whose stocks are being beaten up; it is just the mood of the market. This is the classic opportunity for long-term investors. The prudent thing to do is wait for some sign of a bottom, then add to the position.
Then there are mistakes. Of course mistakes can happen in any market environment, but they are often easier to see in a downturn. Here one must again fight irrational thought. Tax law in our country says that one cannot write off an investment loss on his taxes unless he has realized the loss: in other words, sold the investment. Many people, including several financial advisers, believe this means that one has not lost anything unless he sells. That is simply not true.
A loss is a loss. If the investment in question is sound, then one can expect to gain it back, and usually much faster than people appreciate. However, as Warren Buffett learned early in his investing career, one does not have to make it back in the same way he lost it. Many times investors are better off realizing the loss so that they can rebalance and better take advantage of the next leg up.
In summary, the steps of navigating a downturn are: Don’t panic. Know what you own and have a risk control plan. Then, be honest about the loss. Where your investments remain strong, use it as an opportunity; where there is weakness, cut losses and look for new opportunities made possible by lower prices. Remember the words of Benjamin Graham, and be greedy when others are fearful.
Chuck Osborne, CFA