In recent weeks, investors have witnessed a dramatic acceleration of the greatest bear market meltdown since the Great Depression. The Standard & Poor’s 500 closed at 683.38 today (March 6, 2009), more than 56% lower than the record closing high of 1565.15 on October 9, 2007. This exceeds all of the major bear markets since the 1930s, including the 1973-74 bear market and the dot com meltdown early this decade.
In this type of environment, it is natural for investors to have concern about the safety of their portfolios. Many investors have taken massive losses that are not likely to be recovered soon, if ever. How can investors sleep at night given this massive wealth destruction? Is it possible to determine if the drop in your portfolio is a permanent impairment or if recovery can be expected?
I do not pretend to have all the answers, but I sleep very well at night and I do not worry about large scale permanent wealth destruction in my actively managed portfolio. This is not because the quotations of what I own have held up well. Like nearly all other investors, the market value of my portfolio has dropped substantially in this bear market. Here are some of the ways in which I have successfully coped with the market meltdown.
Know Your Temperament
Successful investors need to have a temperament that permits independent thinking and analysis and does not allow the opinions or actions of others to dictate their own actions. There are many very successful people who have sky high IQs but do not have a temperament suitable for actively managing a portfolio. There is no shame in this and it is perfectly acceptable to simply take a passive investment approach and delegate management to others (preferably through a low cost index mutual fund). Individuals who require constant validation of their actions and opinions by their peers are simply not well suited to actively manage money.
Know Your Investments
Successful investors know their investments. They do not make investments based on talking heads on television, by reading newsletters, or by taking “hot tips” from their neighbor. The problem is that knowing your investments takes significant time and effort. Not everyone has the time or inclination to perform the necessary due diligence required to actively select investments.
At a bare minimum, an investor considering the purchase of a share in a business must review the company’s most recent 10K, as well as all 10Q reports released since the latest 10K. It is often necessary to review other SEC filings. Going beyond the primary sources, investors must research the company through business and trade periodicals and other secondary sources. Those who wish to be even more thorough often read the SEC filings of the competitors in the industry.
This is all massively time consuming! I have to admit that I have not always followed my own advice in this area. When I have not, my results have been predictable. I have had “good luck” with certain investments where I did not conduct due diligence, but I have had at least as many disappointments. My results have been far better on investments where I took the time to conduct adequate research.
Knowing your investments does not end after you buy a security. Although it takes less time to “maintain” knowledge of a company after the initial work is done, it is necessary to follow the business closely on a consistent basis. It is fine to go a month or two without checking the quotation of a security you own, but it is not fine to ignore the investment entirely. Successful investors do not focus on quotations but focus intensely on the business results of their investments.
The Market Is Your Servant, NOT Your Boss
If you have the right temperament and you know your investments, then the stock market is your servant and not your boss. Most value investors know Ben Graham’s parable of “Mr. Market”. Mr. Market is a manic-depressive who serves up all kinds of quotations for what you own on different days. On some days, he is giddy with optimism and offers you a high price and you can choose to buy or sell. On other days, he is depressed and marks everything down.
Knowing the value of what you own by itself is not enough to make Mr. Market your servant. You also need the right temperament and the conviction to act based on your knowledge rather than being dictated to by the market. Having the right temperament without the right knowledge, or the right knowledge without the appropriate temperament can both lead to disaster because you will make Mr. Market your boss rather than your servant.
Understand Intrinsic Value
I have to admit that I watch the prices of what I own on a regular basis. This is probably a mental defect, but it also occasionally provides opportunities to take advantage of Mr. Market’s mood swings. What keeps me out of trouble is that I never listen to Mr. Market’s opinion on the value of my holdings. I really don’t care what the market thinks. Instead, I keep a spreadsheet of the intrinsic value of my holdings based on my estimates. I adjust the intrinsic value of my holdings up or down based on business fundamentals, not what Mr. Market is telling me on any given day. I use the market’s quotes to my advantage and buy or sell when the quote is out of line with my valuation. This can only be done if you have a sense of the intrinsic value of your holdings.
Don’t Invest the Rent Check!
We have all read about retirees who cannot afford to pay their rent or mortgages due to the market decline. These people should have never invested their rent money in the stock market. Always keep between three to five years of expenses in liquid assets. Not only will this avoid the need for forced sales at low prices, but it will also allow you to have the intellectual detachment to perform analysis of the situation and make intelligent decisions.
No one can make intelligent decisions if they do not know where their next rent or mortgage payment is coming from. The stress would make it impossible. It makes no sense to put yourself in a situation where you must liquidate long term holdings for short term consumption needs.