How to Withstand a Market Meltdown

So how'd your portfolio do in May? For most people, May nicely illustrated the risk part of the risk/reward proposition. Not everything was down -- an acquisition offer pushed up the price of American Retirement (NYSE: ACR  ) , and decent quarterly results helped Baidu.com (Nasdaq: BIDU  ) post strong gains.

But these stocks were the exceptions. The overall market performance was poor for the average company and particularly bad for stocks facing significant headwinds. Investors in DRHorton (NYSE: DHI  ) and Pulte Homes (NYSE: PHM  ) discovered that real estate can go down as well as up. Investors in Newmont Mining (NYSE: NEM  ) and Goldcorp (NYSE: GG  ) learned just how volatile a gold market correction can be. In both cases, the lesson is that when a commodity corrects, the stock prices of producers frequently fall faster than the underlying commodity.

It's not surprising if you find this volatility unsettling. It's frustrating to find out that in a single month, your stock portfolio lost more than you made at your full-time job. And it's nearly impossible to avoid this happening occasionally. The best you can do is position your portfolio to both minimize downside volatility and maximize upside gain.

Upside with less risk
This is where value investing comes in. Value investing involves buying stocks that are trading at less than their fair value. This provides two benefits. First, it provides a margin of safety. If a stock is selling for half of what it's worth, it's unlikely to fall to a quarter of that fair value. Thus, you minimize downside volatility. Second, buying at a discount provides an upside. If the stock simply returns to its fair value, you will make a great profit.

So does value investing actually reduce risk? Well, Warren Buffett seemed to believe so. As early as 1958 -- his second year managing his partnership -- he noted that he expected his results to be better, relatively speaking, in a bear market than a bull market. And the greater than $40 billion personal fortune he's amassed since then makes a pretty convincing case he's right.

The May performance of our Inside Value newsletter service, which focuses on identifying undervalued companies, also supports this argument. In May, the Nasdaq was down 7%; the S&P 500 down 3%. Our Inside Value stocks, on the other hand, were down only 2%.

And it gets even more intriguing when you examine the newsletter's results more closely. The biggest loser was Rent-A-Center (Nasdaq: RCII  ) , recommended in November when the stock was trading in the $17 range. By the beginning of May, the stock had skyrocketed to more than $28. While this provided a nice 60% return to Inside Value subscribers, it also meant that on May 1, the stock was trading pretty close to fair value. In other words, it was no longer a deeply undervalued stock, so it no longer had a large margin of safety to act as a cushion in a market correction.

The second-biggest loser was another stock that had shot up more than 30% within a few months of its recommendation and was trading only 5% below its intrinsic value. If you exclude these two stocks as no longer qualifying as value stocks, then the newsletter's performance during May's hiccup was even better, with a tiny 1.4% loss, less than half the loss of the S&P 500 and one-fifth of the Nasdaq.

Finding the sweet spot
Of course, you can't be truly confident in any conclusion you draw based on evidence from a single one-month period. But the results are encouraging, and the success that other value investors have had during bear markets speaks for itself. So, to find the investing sweet spot where you have both huge upside potential and reduced risk, look for stocks trading below their fair value. And if you want to read about our top value recommendations, you can do so with a free 30-day trial to Inside Value, by clicking here.

Fool contributor Richard Gibbons finds it perverse that a dollar picked up in the road provides more satisfaction than the 99 we had to work for. Richard owns shares of Rent-A-Center but does not have a position in any other security discussed in this article. The Motley Fool has a disclosure policy.


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