ALBERT HERTER

‘CHAOTIC YEAR SHOWS KEY CONSTANTS OF INVESTING,’ by James B. Stewart at SmartMoney via fidelity.com. (BTW: I HAVE NEVER EVER BOUGHT ON MARGIN!!!)))

In Uncategorized on September 10, 2009 at 11:55

As the one-year anniversary of Lehman’s collapse approaches, many have been focusing on how everything seems to have changed from investors’ reduced appetite for risk to consumers shunning conspicuous consumption.

Somewhat to my surprise, I’ve concluded that what’s most surprising isn’t what has changed but what hasn’t.

The collapse of Lehman Brothers last September marked the beginning of the most severe financial crisis of my lifetime drawing comparisons to the 1929 crash and other events that led to the Great Depression. Without benefit of hindsight, of course, there was no way to know this. The Dow Jones Industrial Average  actually rallied last year on news of the government’s takeover of Fannie Mae and Freddie Mac  in the misguided belief that the rescue would resolve the crisis. With benefit of hindsight, investors would have sold their entire stock portfolios and reinvested in March when stocks bottomed.

The problem, as I’ve often stressed, is that no one has the benefit of hindsight. Buying only at market lows and selling at peaks is impossible. My approach to investing tries to enhance long-term returns by buying lower when stocks are relatively cheap and selling them higher when they’re expensive. It relies on an analysis of years of market data and provides a discipline and a framework for rational decision-making, which is exactly what I believe is needed at times of financial shocks and near panic.

Putting such a system into practice, however, isn’t easy. It certainly wasn’t during the past year before stocks turned up in March. Investing money in the market and watching its value erode is discouraging and functions as a kind of negative conditioning. Yet disciplined investing calls for buying when stocks are cheap — notwithstanding the fact that they may get even cheaper. Last year’s events have convinced me that the ability to do this depends on two very basic principles: keeping enough in cash and other safe, short-term investments, and avoiding leverage.

I feel the main reason I was able to avoid panic and invest rationally was that I didn’t put money in risky assets that I couldn’t afford to lose. By risky I mean anything where the principal value is subject to large fluctuation including stocks. I had enough of my assets in cash, money-market funds and relatively short-term certificates of deposit (CDs) to meet expenses. Having this gave me the peace of mind to pursue more aggressive strategies with money I could put at risk. The value of my stock portfolio on any given day this past year was interesting and at times distressing, but it never threatened my day-to-day well being.

Of course, low-risk assets tend to be low-yielding ones since risk is correlated with reward. A few years ago, two-year CDs were still yielding fairly high returns but no longer. Investors must accept that there’s a portion of their assets where safety is paramount not total return.

I’ve always been leery of leverage perhaps because I grew up in a relatively conservative Midwestern community that still looks askance at borrowing. Only once have I owned stock on margin, and the experience was so stressful that I quickly paid off the margin loan. I’ve never undergone a margin call, and I have no desire to experience it.

Of course, I recognize that leverage can greatly magnify gains. You could make the argument that, if I’m only investing money I can afford to lose, why not swing for the fences? The simple answer is an emotional one: Leverage also magnifies losses, and I’m not comfortable with that level of volatility. The rational answer is that margin calls force investors to sell into weak markets. That’s the antithesis of the Common Sense approach, which is to sell higher and buy lower. I want to make that decision not leave it to a creditor.

Yes, avoiding leverage means forgoing some high returns. But so what? I’m not a professional money manager. I don’t care whether I beat the Standard & Poor’s 500  in any given year. That doesn’t mean I don’t aim to do well. I have long-term goals tailored to my circumstances, and I hope to meet them. But as individual investors, we don’t need to measure our performance by quarterly and annual benchmarks. Investing isn’t an athletic contest even though some commentators treat it like one.

Since so many have been comparing the current crisis to the Great Depression, I’ve been mindful of how various investments performed back during the greatest economic contraction of modern times. The headline has often been the 89% peak-to-trough decline in the Dow Jones Industrial Average. Less attention has been given to the market’s subsequent recovery. Investors who had the courage to invest realized handsome long-term gains. And that’s something else that hasn’t changed: Over the long term, stocks still outperform every other investment class.

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