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10 Ways to Solve a Down Market

It's been an ugly summer. And with a slowing housing market, high oil prices, political uncertainty, and suggestions of inflation, it could get uglier. What's an investor to do?

A first step
Stop. Breathe. Markets have fallen before. They will do so again. In a full-fledged bear market, you may be lucky enough to see 20%, 30%, or even 50% paper losses in some of your holdings. Yes, I used the word lucky; Mr. Market makes a habit of throwing out excellent companies with the trash, and the worse the downturn, the greater the chance that real bargains will emerge.

Does the market matter?
Investment success -- at least the way I define it -- comes from buying shares in a quality company for less than the company is worth and then holding for the long term, trying not to short-circuit the miracle of compound growth in the meantime. Whether the S&P 500, Dow, or Russell 2000 is making new gains or lows is largely irrelevant; only my individual holdings and the related personal scorecard matter. In other words, no matter the market direction, no matter the trajectory of individual stock prices, the strategy remains the same.

So here's my personal bear market strategy, distilled into a handy-dandy David Letterman Top 10 list.

Down market "to-do" list
1. Resist the very human urge to "Do Something!" Instead, practice what Charlie Munger calls "Sit-on-Your-[Behind]" (ahem) investing. Perhaps you believe you can sell and then wait until the dust settles before you re-enter the market. This is a recipe for late entry, because you'll never realize the turnaround is real until it's already well under way. Being too cute with entry and exits can kill your returns. Don't play that game.

2. Forget the past. In a bull market, this admonishment applies to a company that has risen in price such that foreseeable future growth and performance are already built into the price, yet investors keep buying the stock. But it applies equally in bear markets. Investors extrapolate the recent past of companies that have gotten pummeled and stay away. No one wanted Alderwoods Group (Nasdaq: AWGI  ) when it rose from the ashes of bankruptcy -- yet it has more than tripled since its 2003 lows.

3. Valuation matters. Review the value of each of your holdings. Start with your largest, and work your way down. To the best of your ability, answer the following questions:

(a). What is a fair value for this company? Have I been conservative in my valuation process?
(b). How far above, or far below, fair value is the current trading price?
(c). At what price will I add shares?
(d). At what price would I sell my shares?

4. Prepare a shopping list. What do you want to buy? At what price would you buy? Going back to the prior point, make sure each of your current holdings are on your list. Surely, if you own them, you must like them, right? I'd love to own Quality Systems (Nasdaq: QSII  ) again -- just not at a price greater than $30.

5. Add new money. Since you've got valuation down and a shopping list prepped, probably the most important lesson we can espouse during a market downturn is to always, always, always, keep adding new money. It's easy to say "What's the point?" when everything is continually hitting new 52-week lows. We haven't had a real bear market for a few years, but it will come. And it will end. Your returns will be enhanced at the end of it if you've continued buying cheaper and cheaper companies.

6. Consider buying a share or two of Berkshire Hathaway (NYSE: BRKb  ) . Berkshire is likely to do very well in a market downturn as the short-term crowd flees to quality. A great many very smart people have made the case that Berkshire offers compelling value at the moment; I don't disagree with them. You'll not get a 25-bagger in five years, but you might get a double and sleep easier aligned with the world's greatest investor.

7. Diversify. I argue for Berkshire because it offers diversification at a reasonable price, given the myriad wholly owned businesses under its umbrella. If you're a small-cap investor, diversification is imperative. Making a few large bets on small caps that might turn sour could impair your portfolio and, moreover, your appetite for stocks, for years.

8. Embrace dividends. In The Future for Investors, Jeremy Siegel calls reinvested dividends "The Bear Market Protector and Return Accelerator." In that light, consider adding to your dividend-payers, particularly those that understand the concept of returning value to shareholders. Automotive safety system powerhouse Autoliv (NYSE: ALV  ) currently pays 2.7% and has raised its dividend by 27% annually over the past five years. (It has also repurchased nearly 17% of the outstanding shares in the same period.) Or how about Johnson & Johnson (NYSE: JNJ  ) and its strong cash flows and more than 40 years of rising dividends? Even hard-hit reinsurer Montpelier Re (NYSE: MRH  ) , with its modest dividend, gets a worthy nod, given its bolstered capital and strong pricing environment.

9. Further your investing education. My recent bedtime reading has been Bull! by Maggie Mahar. If that's not manly enough, how about Creative Cash Flow Reporting to feed your inner valuation geek?

10. Be patient. Investing is a decades-long sport. Short-term volatility -- up or down -- is often just noise; learn to ignore it. If you find yourself agonizing over every 5% loss, cut down on checking your portfolio. Get out of the house and away from the computer. Take your significant other to a movie. Throw water balloons with your kids. Remember to enjoy life.

The Foolish bottom line
Perhaps all of this sounds cavalier, but it's really not intended as such. In fact, I sympathize; it can be agony to watch the price of a favorite company hit new 52-week lows daily. Been there, done that. But the best advice remains to ride out the dark times and add new shares of quality companies as you go. We never know when the market will roar ahead or plunge. A continued focus on what you're trying to accomplish -- significant long-term wealth -- will help you ride through the dark times.

This article was adapted from the May 30, 2006, Hidden Gems Daily column. For free, full, and unfettered access to every aspect of our small-capMotley Fool Hidden Gemsinvesting service -- including research, recommendations, and discussion boards -- click here. Our picks are beating the market by 15 percentage points. You're not under any obligation to subscribe.

Fool contributor Jim Gillies owns shares of Berkshire Hathaway, Montpelier Re, and Autoliv. Alderwoods Group andMontpelier Re are Hidden Gems recommendations. Johnson & Johnson is an Income Investor recommendation. Quality Systems and Montpelier Re are Stock Advisor recommendations. The Fool has adisclosure policy.

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