Why You Should Fear the Future

Remember when everyone was quoting Baron Rothschild, saying, "Buy when blood is in the streets"? Well, this is it. We're in the Wall Street equivalent of Kill Bill meets Jurassic Park. It looks like it's all over but the spurting.

Warren Buffett knows how to play this game. He's buying, and he says that in five or 10 years, "we'll look back on this period and we'll see that you could have made some extraordinary buys."

But when the market drops 9% in a day, it's hard to react logically, like Buffett -- and not, say, curl up into a quivering, whimpering ball. Here are five ways to achieve your goal.

1. Be afraid -- be very afraid
Instead of looking at how much you can make by buying a stock, examine all the ways that you can lose. Bruce Berkowitz, who manages the Fairholme Fund, swears by this strategy. He tries to think of every possible scenario that can kill a company -- and if he can't find any, then he'll buy. As of the fund's most recent quarterly report, he owned major stakes in a variety of industries, such as construction materials giant USG (NYSE: USG  ) , health insurer WellPoint, oil producer Canadian Natural Resources (NYSE: CNQ  ) , and insurance conglomerate Berkshire Hathaway (NYSE: BRK-B  ) .

Even ridiculously paranoid scenarios deserve consideration. A year ago, it was inconceivable that a handful of the nation's biggest banks would go out of business and that credit markets would essentially freeze. But just because it was inconceivable, that doesn't mean it couldn't happen -- and it did.

In this environment, where no one is lending, you should be especially paranoid about debt covenants and maturing debt. Even if a company is profitable, a large debt maturity that it can't roll over could drive it into bankruptcy. With economic conditions as they are, companies are making moves they wouldn't have considered if the market were better, like MGM Mirage (NYSE: MGM  ) cutting hundreds of managers, Las Vegas Sands (NYSE: LVS  ) laying off thousands of workers, and even growth-market Macau heavyweight Melco Crown (Nasdaq: MPEL  ) offering unpaid "sabbaticals" to many of its employees.

2. Avoid black boxes
Be suspicious of companies you don't understand, or whose financials are opaque. In fact, unless you understand the business model, don't buy it at all.

Sure, Goldman Sachs and Morgan Stanley may have survived the purging that took down every other investment bank in this country. But unless you fully understand their portfolios -- which seems almost impossible right now -- it's difficult to be confident that their businesses are rock-solid.

The same sort of reasoning applies to private equity companies like Allied Capital, bond insurers like MBIA, and retail banks with labyrinthine liabilities such as Citigroup. If you can't assess the risk, you can't be confident in the investment -- especially when blood is flowing like water.

3. Invest only money that you don't need soon
Assume that the near-term market will remain volatile -- even after it smoothes out. That approach will prevent you from investing money you need in the near term, and thus protect you from losses you can't sustain.

Think of it this way: Suppose that you do find one of Buffett's extraordinary buys, and you're brave enough to pick it up. Then you're set, right? Well, not entirely. You can still lose if you're forced to sell. Remember, Buffett isn't saying these stocks will become 10-baggers tomorrow, or even next year. He's talking about five or 10 years.

So when you buy, don't buy with money you'll need soon, and definitely don't use margin. If you're forced to sell at a bad time because of a margin call, you could lose money, even if you've successfully identified a stock that goes on to become a 10-bagger.

For instance, immediately after the 9/11 tragedy, you could have bought Coach at a cheap $27.50 per share. But a few days later, it traded down to $21. If a margin call forced you to sell at that price, then you would have missed the stock becoming an 10-bagger over the subsequent five years. Ouch.

4. Ease in
And all of that means you should be suspicious of how your chosen investments will perform initially. When the market's this volatile, don't put all of your money into a stock all at once. Instead, put a portion in when you see an attractive opportunity, but save some cash to buy more if it falls.

Some people buy in thirds on the way down, so that they have two chances to average down without becoming overexposed to the stock. I recommend buying enough so that you'll be happy when your stock goes up, but little enough that you'll also be happy if it falls significantly and you can buy more.

5. Buy at a discount
Of course, the whole reason you're trying to buy when there's blood on the streets is to capitalize on stocks trading at big discounts to their fair value. Those discounts can propel your portfolio to extraordinary returns -- the bigger the discount, the bigger the potential return. Plus, a good understanding of a stock's intrinsic value can give you the confidence to hold in today's volatile market.

But make sure you're buying shares that are actually cheap. Many companies are trading at prices far lower than they were a year ago -- but that doesn't mean they're cheap. JA Solar (Nasdaq: JASO  ) had fallen a lot by August, but it was still expensive.

The Foolish bottom line
The streets run with red ink, so if you can handle the volatility, it really is a great time to invest -- but invest suspiciously and fearfully. It will do your portfolio good.

Our Motley Fool Inside Value team has turned its skepticism on this bear market and found many companies we consider exceptionally attractive right now. That doesn't mean they'll skyrocket tomorrow, but we do think they'll prove to be extraordinary buys at today's prices. You can read all about our top picks, including our best bets for new money now, with a free trial. Just click here to get started -- there's no obligation to subscribe.

This article was first published on October 3, 2008. It has been updated.

Fool contributor Richard Gibbons was praying that the killed Bill wouldn't be the bailout one. He owns shares of WellPoint. Coach and Berkshire Hathaway are Motley Fool Stock Advisor recommendations. WellPoint, Berkshire Hathaway, and USG are Inside Value picks. Melco Crown is a Global Gains selection. The Motley Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy eats velociraptors for breakfast.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 06, 2009, at 4:31 PM, td4900 wrote:

    I like the article. However, I much prefer the CANSLIM theory advanced by Wm. O'Neill. I also think that the average investor should stick to his or her own strengths and leave the investing to money managers who will follow the strategy that best suits the individual.

  • Report this Comment On January 07, 2009, at 2:02 PM, mloren1357 wrote:

    This year we learned that especially the professional investors lost big. Us little guys need to reexamine the time tested- not necessarily valid premise: hold long term. There are probably extraordinary times that we need to be sitting on the sidelines if only for a few weeks or months. I don't think this is a timing issue. It is a fear factor that we have been through and I can't see that 2009 is going to be "clear sailing". We don't have the resources of a Warren Buffett who can loose 20 or 30% of billions of dollars. If I loose, I wouldn't be able to make it up so easily as Buffett. The market is basically unpredictable. Even diversification was of little value, unless you had lots of cash as a large part of the portfolio.

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