Friday, August 31, 2007 - Surviving a market correction - Surviving a market correction

A great article by Don McDonald, who works with Paul Merrimans company, Merriman Berkman Next, Inc. Its exactly what I would have said had I wrote it!!

Investing is about behaviour, enjoy this great article.

Written by Don McDonald
Wednesday, 29 August 2007
When it comes to investing, you can count on two things. In the short run, the value of securities will fall, while over the long haul they tend to rise. Understanding these basic truths should make investing a simple process. Except for Wall Street, it might be. More on that later. If you invest in the stock market, there will come a time when you unexpectedly lose money. There is no way to know in advance when stock prices will fall as they did this August. Anybody who could reliably predict the market’s short-term ups and downs would be wealthy beyond belief. Such a person certainly would have no reason to give such information to investors like you and me. (Remember this next time you’re watching CNBC’s gurus confidently predict the market and prescribe what investors should do immediately.)

On the other hand, I am confident that if you remain invested long enough, you will eventually make money in the stock market. But in the meantime, this means you must take risks if you want to make your money grow. Investments that entail little or no risk are doomed to provide little or no gain. Government-guaranteed savings accounts pay less than the rate of inflation. The guarantee applies to the number of dollars, but not to these dollars’ purchasing power.

Wall Street brokers would like us to believe that only they have the rock-solid advice we need in order to get ahead. They spend a fortune on advertising to convince us that they know which stocks to buy and when to buy them. Now and then they even claim to know when and what to sell, but that advice usually comes only after a stock has fallen precipitously.

Brokers favor products with high commissions and fees, sometimes ensuring a loss of principal on the first day an investment is made. Rarely do brokers take the time to try to build a diversified portfolio designed to meet an investor’s long-term needs and address the topic of risk. Do you ever recall a broker asking you how much money you were willing to lose?

In my years at a brokerage firm that is now part of Morgan Stanley, I cannot recall a single instance where Wall Street set its own interests aside to do what was best for a client. I don’t recall any training session or class devoted to teaching us how to help clients build portfolios to weather bear markets.

One of the best ways to weather bear markets, of course, is to stay put. But that’s not necessarily what brokers want their clients to do. Portfolio turnover is profitable for brokerages, which make money on commissions when we buy and again when we sell. I remember well the rallying cry during the weekly cold-calling sessions I attended: “Churn ‘em, burn ‘em!”

Wall Street likes to boast that it has found ways to reduce risk while increasing returns. The returns to brokerage houses usually materialize. But for investors, it’s often a different story.

Once upon a time, a home buyer needed real income to get a mortgage – and needed a down payment to buy a house. Then Wall Street got involved. Brokerage firms created complex securities of mortgage pools, supposedly to benefit everybody. Suddenly the standards were relaxed, and just about anybody could get a home loan. The effect of these efforts is the root of today’s credit crisis.

This isn’t the first time Wall Street has created a series of complex mortgage-backed products that blew up in investors’ faces. In 1994, the collateralized mortgage obligation (CMO) market collapsed, costing businesses and governments billions of dollars.

Eventually the current panic and the stock market’s reaction to it will wane. The economy will grow again. Stock prices will start to rise again, as excess fear gets washed out of the market. This is what happened after the bear market of 1974-1975, again after the crash of 1987 and again after the bear market of 2000-2002.

The investors who will do the best job of weathering this and future storms are those who have built diversified portfolios knowing they are bound to lose money along the way and who can stick with it. If you cannot tolerate any losses, you must expect to get low returns.

I think the best way to stay within your comfort level is to put the right percentage of fixed-income investments into your portfolio so that it is not likely to sustain calamitous losses. Fortunately, this isn’t terribly hard to do if you can be honest with yourself about the losses you can tolerate. Paul Merriman’s article “Fine-tuning your asset allocation” tells you how to do that. However, don’t count on doing this with the help of a brokerage firm. This is not what they do.

Once you have set up your portfolio properly, my advice is to ignore as best you can the short-term moves in the market and the news about them. Resist the temptation to abandon your careful strategy and buy into something new that you hear about on the radio, see on the TV or read about in the press.

The investors who consistently make money are those who remain consistently invested. Keep the big picture in your mind: The economy of the world has steadily grown over time and is likely to continue to do so. Smart investors diversify globally in low-cost equity funds and keep volatility at a comfortable level with the right amount of high-quality fixed-income funds.

If you do that and manage your emotions properly, your chances of long-term success are very high.