The Mistake Everyone's Making Now

It's bleak news as far as the eye can see. The credit market is still locked up. Banks are having trouble judging other banks' exposure to bad debt, so they simply aren't lending money to each other. Home prices have been dropping at a record pace. And all this turmoil is having an effect on the economy, with most retailers reporting dour results.

In the face of all this bad news, it's tempting to sell and wait for better times. When your portfolio falls by 15% in a month, a Treasury note's safe 3.9% annual return starts to look pretty good.

But that can be a huge mistake.

The safest way to lose money
While Treasury notes may ensure that you don't lose money in the short term, they can also ensure that you do not have enough money for retirement. In fact, it's likely that in real terms, you'll actually lose money in T-notes.

Recently, T-notes have been paying about 3.9%. From this, you have to subtract taxes, which lowers your return. But that's not all. Recently, inflation has been ticking up at an annual rate of 4.3%, eroding the value of both your principal and interest. Add it all up, and it's clear that if you take into account inflation and taxes, T-note investments are a time bomb that will cost you purchasing power.

So, you've reduced your risk by guaranteeing that you'll lose money.

Maybe you'll claim that T-notes are just a short-term hedge, and you'll buy back into the stock market when the volatility is over. But by the time there's nothing but blue skies, there's a good chance that the market will have rallied, and you will have missed out on a large chunk of the profits.

Lower-risk investing
However, there is a strategy to both reduce risk and achieve huge profits in the stock market. And the strategy actually works best in a choppy market like we have now.

Just buy stocks for much less than they're worth.

The reasoning is simple. If you pay $30 for a stock that's worth $50, it's much more likely that the stock will jump to $50 than fall to $20. So you've reduced your downside risk. At the same time, you still have a huge upside, because you can be confident that the stock will eventually return to its fair value. So buying undervalued stocks helps to ensure that you buy low and sell high.

Some cheap stocks
Right now is the ideal time to look for bargains. Just look at how cheap some of these stocks are:

Company

Five-Year Average P/E

Current P/E

Autodesk (Nasdaq: ADSK  )

50.4

26.3

eBay (Nasdaq: EBAY  )

77.2

24.4

Humana (NYSE: HUM  )

23.0

10.6

International Paper (NYSE: IP  )

32.0

14.3

Marriott (NYSE: MAR  )

40.6

16.9

Yahoo! (Nasdaq: YHOO  )

85.1

34.7

Data from Capital IQ, a division of Standard & Poor's.

These are all big names that aren't directly tied to the current housing and debt woes. They all have significant competitive advantages in their niche. Sure, these businesses may feel the effects of a potential recession, but it's likely that they will survive any short-term turbulence. Yet they're all trading at significantly lower valuations than they have been for the past five years.

These stocks can be bought more cheaply now than they could have been in the past (though the P/E is a rough measure of value). But if you wait for everyone to be happy with the economy, it's likely that you'll miss out on much of the upside. That's why, in a market like this, you should be particularly active in identifying undervalued opportunities.

The Foolish bottom line
What's more, these stocks -- while cheap -- aren't even the best opportunities in the market. Our Motley Fool Inside Value newsletter focuses on finding the cheapest stocks that have the best potential for extraordinary returns.

We've identified several hugely undervalued stocks that we believe will outperform in 2008's choppy market. If you're interested in checking them out, we offer a free trial.

This article was first published Jan. 8, 2008. It has been updated.

Fool contributor Richard Gibbons sat in the house all that cold, cold, wet day. He does not own shares of any company mentioned in this article. eBay is a Stock Advisor recommendation. The Fool's disclosure policy is jolly.


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