When It's Foolish To Sell

Since World War II, there have been nine major crises precipated by political factors, going back to the 1948 Berlin blockade, which raised the specter of another world war.

During each crisis, investors felt confused, uncertain, and panicky. Nothing in their experience, they believed, would help them cope with the ominous world they faced, so they were advised to sell and save their capital.

As it turned out, this advice was wrong: stocks were 16% higher a year later, on average, and 33% higher two years later.

Among those nine crises, the worst - in terms of stocks - was the 1973 oil embargo. After two years, the market was still slightly off. But nevertheless, patient investors profited from the bull market that began in 1982.

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On The Cyclical Versus The Secular

At our recent meeting last week, we happened to comment on the fact that since March of 2000, we have been in a secular bear market, and since the spring of 2002, we have been experiencing a cyclical bull within the secular bear. And this calls for some further comments on the subject.

Bull and bear markets can be either cyclical or secular, with cyclical referring to the shorter term and secular to the longer term. The last secular bear market was when the Dow peaked in 1966, and did not break to significant new highs until 1982, some 16 years later. An even longer secular bear market happened when the Dow peaked in September of 1929, and did not surpass that level until 1954, a period of 25 years.

During the 1966-1982 bear market, there were five separate bear legs with drops of 20% or more and four separate bull markets with gains of 20% or more. These cyclical bull and bear markets alternated. The first leg lasted from February of 1966 until October, and in that time, the Dow fell 25%. It was followed by an up leg to a peak in December of 1968, and investors were rewarded with a 32% gain.

It is easier to achieve a higher percentage gain than it is a loss. If the Dow drops from 1,000 to 500, it's a 50% loss; and if it goes back to 1,000, the gain is 100%. But despite the percentage difference, the investor comes out even.

After the December 1968 high, the next cyclical bear market was in May of 1970, and the loss was 36%. From that low, we saw a 66% gain, which ended in January of 1973. The next leg of the bear market was down 43%, and ended in December of 1974. That low was followed by a very strong 75% gain in the Dow that ended in September of 1976.

Following this high was a 27% down move that ended in February of 1978. The final cyclical bull market segment of the secular bear market ended in April of 1981, with the Dow gaining 38%. The last cyclical bear market ended in August of 1982, with a Dow loss of 24%.

That was the end of the previous secular bear market. From the Dow low of 777, we then began a secular bull market. And for the next 18 years, each year's low was higher than that of the previous year. And as President Ronald Reagan stated while visiting the New York Stock Exchange in 1984, "We're going to turn this bull loose." And that's exactly what did happen!

In the last bull market, people were willing to pay fantastic prices for technology and Internet companies that posted no earnings at all. Thus, when people are optimistic, they will pay very high prices and settle for low yields; when they are pessimistic, they are not interested in either low prices or high yields.

Warren Buffett once compared being in the market to being a business partner with a person who offers to buy your half of the business for twice what it is worth, and later offers to sell you his or her half for half of its worth. So it is always a learning experience to see what it will take to get investors interested -- fair value, or perhaps even less.

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A Trailing Stop Discipline

One of the best ways in which to discipline yourself as an investor is by using trailing stops. This will remove any doubt as to when to sell a given stock.

You set a trailing stop at the time that you purchase the stock, and you monitor the performance of that stock periodically, and if the stock price falls back - either from its newest high or from your entry price - to the trailing stop percentage that you set initially, then there is no emotion involved. You simply sell the stock in question and you never look back.

This is a simple tool to cut your losses and let your profits run, and you will never see great results come to you as an investor by any other method!


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Diversification & Position Sizing

Whenever we speak of diversification, the idea here is to diversify broadly, and be certain that you never have more than two companies in the same line of business in your portfolio.


One of the most important concepts to follow when diversifying the equity portion of your portfolio is to follow a position-sizing-strategy, where you never invest more than 5% of your equity portfolio in any single stock. This way, you will never experience a serious dent in your net worth simply because one stock fell out of bed.

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Five Proven Strategies To Lower Your Investment Risk

1. Buy Quality. In market downturns, dividend-paying blue chips hold up better than up-and-comers. Large caps do betetr than small caps, and value generally does better than growth.

If anything in your portfolio needs to go, look first at your small-cap stocks, unprofitable companies, and other more speculative issues.


2. Diversify Broadly. This has two advantages: First, it increases your chances of holding a big winner; and secondly, it leads to less volatility than holding just a handful of stocks.


3. Asset Allocate. Your asset allocation is your single most important investment decision.


4. Follow a position-sizing strategy.


5. Adopt a trailing-stop discipline.


NOTE: see separate entries for details on points 4 & 5.


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A Snapshot of Americans' Finances

The nation's apparent dearth of saving was underscored recently with publication by the Federal Reserve Board of its triennial Survey of Consumer Finances (SCF). The survey, which was based on 2004 data from 4,522 families, found that, while soaring housing prices had added to the net worth of American families since 2001, only about half of all families had saved regularly, and the fraction of families with retirement accounts fell. American families may have benefited from bubbly home prices in many parts of the country, but that is a thin reed for longer-term financial security.

The SCF is a rich data set, but the following findings seem to stand out as the most important:

1) Little more than half of all families (56 percent) saved at all in 2004 (other than passively through increased home equity). Not surprisingly, the percentage of families that saved rose with family income (81 percent of families in the highest income decile reported that they had saved, as compared with 34 percent in the two lowest deciles).

2) Even fewer families (41 percent) save as a matter of priority. The remainder view saving as what is "left over" from income (by accident rather than by design) at the end of the year.

3) The net worth -- the difference between families' assets and their liabilities -- of the lowest two income deciles is minuscule, with a median of only $7,500. The median is the halfway mark; half of the families in this group had a lower net worth, and half had a higher net worth. Moreover, most of that net worth is in the form of home equity.

Among all families, median net worth changed little from 2001 to 2004, increasing from $91,700 to $93,100. (All figures are in constant 2004 dollars.) It fell a sharp 24 percent among one demographic group -- families headed by persons with less than a high school diploma. Broken down by age, however, net worth fell only among households headed by persons in the 35-44 age group. In contrast, it rose sharply among those closest to retirement, the 55-64 age group.

4) Retirement and liquidity dominate among the main reasons Americans save. The fraction of families citing retirement as their most important reason for saving increased sharply in the past decade, from one-fourth of families in 1995 to one-third in 2004. This likely reflects the twin trends of an aging society and the reduced availability of employer-funded pensions.

5) With housing prices on the rise, savings in the form of home equity has become an even larger portion of household wealth. By 2004, the median value of home equity in primary residences was seven times the median value of financial assets ($160,000 as compared with $23,000), whereas in 2001 it was only four times as large. The median value of financial assets actually declined during the three-year period, reflecting the slump in the stock market from record highs and accentuating the importance of home-ownership in the typical family's balance sheet.

6) Renters, meanwhile, without the benefit of rising home prices, continue to own little. The median value of financial assets owned by renters, who constitute as much as one-third of all families, was a mere $3,000 in 2004, as compared with $4,000 in 2001. Renters tend to be younger, which helps explain their small financial assets.

7) Few Americans seem to be on track to enjoy any semblance of financial ease in retirement. The nation's retirement system is often said to be a three-legged stool: Social Security, employer-sponsored retirement plans, and private saving. Even with its long-term actuarial imbalance, Social Security may well be the healthiest of the three, relying as it does on the general taxing power of the Federal government and the nation's expressed will to support the elderly. The other two legs are now visibly shaky.

8) Few families own stock outright (21 percent), although many (50 percent) hold equities indirectly in IRAs, 401(k)s and other retirement accounts, and still others (15 percent) own them in the form of non-retirement mutual funds and other pooled assets. Bonds, in contrast, are very tightly held: only 2 percent of families hold them directly. Direct holdings of any significance are almost exclusively among top-income and elderly families. However, many families across the income distribution hold bonds indirectly in mutual funds, IRAs, etc.

9) Americans routinely break the first rule of investing: diversification. Among outright holders of equities, 60 percent had stock in three or fewer companies - among them their own employers. The lesson from the experience of employees of Enron and other failed companies apparently has not yet sunk in.

10) The SCF does not point to overwhelming debt burdens, to judge by the ratio of total debt to total assets (15 percent) and the ratio of scheduled debt payments to income (18 percent). Both ratios increased only slightly from 2001 to 2004.

Not all that much comfort lies there, however, given that two of the factors that helped keep these ratios relatively steady -- sharply rising home values and falling interest rates -- have largely run their course. Now, families face the risk that home equity values will level off or fall as the economy keeps advancing cyclically and interest rates continue to rise. And while families kept their debt-service payments under control from 2001 to 2004 partly by refinancing their mortgages at lower interest rates, some will now face higher payments as the rates on adjustable-rate mortgages increase.

Conclusion

Public polls reflect growing concern on the part of Americans that their saving is inadequate, especially their saving for retirement. They cannot have failed to notice the wide attention given in the past few years to Social Security's long-term actuarial deficit and to Corporate America's shedding of its pension liabilities. Failure to act against the background of these warnings signs could push retirement out for many and even put it out of reach for many others.

Rising home values buffered many families from the impact of lower stock valuations in the 2001-2004 period and have helped offset the lack of other saving. But it is questionable whether most Americans will be able to finance a comfortable retirement by continuing to rely mainly on large increases in the value of their homes.

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