Fear, Uncertainty, Doom[Fool on the Hill] April 14, 2000

An Investment Opinion

Fear, Uncertainty, Doom

By Bill Mann (TMF Otter)
April 14, 2000

I heard an amazing thing this morning on television. A professional money manager opined that the current drop in stock prices should be good for the mutual fund industry because individual investors and do-it-yourselfers were likely to take this as a keen reminder that the market is not evergreen, that it is easy to lose money in equities. That really makes my blood boil.

Let me get this straight. The Wise have somehow come out of the recent market drops OK? Because that's what he's saying, that the average individual investor cannot handle his or her own financial future, that it is best left to the professionals.

Does he hear some maudlin ululations of the individual investors that I do not? Obviously there is a lot of pain out there right now. Obviously the stock market is a much less fun place for most in this type of atmosphere than it was, say, in December. But even a cursory glance at the mutual fund returns both in the long term and in the immediate short term tell a different story. Over a five year period, according to data from Morningstar, 90% of all actively managed mutual funds trail the performance of the S&P 500 Index. And in the short term, the vast majority of all equity mutual funds have been crushed over the last three weeks, dropping in concert with the market.

So stocks are dropping like stones. We have lost all of the gains in the Nasdaq Composite that we have had since December 1, 1999. That, if you are counting, is 86 trading days worth of losses, and we're now down nearly 30% from the all-time high hit in March. But that is not a very large amount of time, in the great scheme of things. I am not belittling the pain out there, and we'll address that in a moment, but on average if you had a portfolio of stocks in December, and you have the same portfolio now, you're in the same place, financially. Interestingly, both the Dow Jones Industrial Average and the Standard & Poor's 500 indexes crossed the level we sat at in the beginning of December as well. Particularly for newer, less-experienced investors, let me make the point that the amount of time we're talking about is minuscule in the course of time we should look at for investing.

That said, some people out there have been shattered by the rapid losses, their portfolios hit particularly hard. There are a number of reasons for this, but I imagine that the largest among them has been overconfidence. Overconfidence in one's own abilities, analytical skills, and, perhaps most importantly, risk tolerance. Over the last six months, the Economist reports that the level of margin debt taken on by Americans has increased by 50%.

There's a real danger here. Margin becomes quite dangerous when market volatility increases. Margin debt is secured by assets, and must, at most brokerages, be no more than 40% of the value of the assets. People who tried to juice up their returns during the go-go times of December through early March by buying speculative stocks with other peoples' money have had a terrible wake up call. As their assets shrunk in value, their debt did not. The ensuing margin calls, in which their brokers, from which the money was borrowed, required these investors to either put up cash to meet securitization requirements, or sell stock to pay down the debt.

People who had no additional money were forced to sell, and sell at the worst possible time, when the stock prices are low. In this way, dependence upon margin can completely wipe out an investor if the market suddenly drops.

Let's say, for example, as of March 10 our fictitious investor Moe Aggressive had a portfolio consisting of $60,000 in Nasdaq 100 Trust (Amex: QQQ) and then bought another $20,000 of VerticalNet (Nasdaq: VERT) on margin. The net value of his account would be $60,000 (80K-20K of debt), and his margin level would be 25%. In the interim, the QQQ price has dropped by 27%, so his holding is now worth $43,800. VerticalNet, meanwhile, has dropped 82%, from $148 down to a current level of $28. The asset bought by Moe's $20,000 margin is now worth $3782. But Moe's margin level remains at $20,000, and that's what he still owes. Unfortunately, his current account balance of $47,582 fails the broker's limit for margin, so he gets hit with a margin call. He can sell the VerticalNet and meet mergin requirements, but that would still leave $16,200 in debt, for an asset he no longer has. To cover this debt, he has to sell some of his other stock. To be precise, he must sell 37% of his QQQ to rid himself of the debt. This leaves him at a final market value of $27,600, down from $80,000, with no chance to recoup either the sold QQQ shares or the VerticalNet.

Moe's experience is, unfortunately, not uncommon right now. I hope those who have overextended themselves find a way to get out without getting hurt too badly. A lot of people are learning some very painful lessons right now as they see their paper profits, and then some, disappear.

So what are the lessons?

1. Margin debt is not your friend

Margin is a useful short-term device, when used in moderation. Being fully margined, however, is not Foolish, because the market can, and will, turn on a dime.

2. Keep the long-term perspective

This has happened before, and it will happen again. We often tend to think of the market as something that has been relevant to individual investors since, oh, maybe 1995, if even that long.

3. Increased risk is not synonymous with increased return

The more risk you take on, the more return you should expect. But sometimes you beat the risk, and sometime the risk beats you. Do not fear taking on risk, but respect it for the damage it can do to your long-term returns.

4. Buy the best companies

Right now 95% of all companies are down for the day. Over the long term, however, history has told us that the direction of the market is up. Some companies will not survive. The ones that do will reward you in the long run. Your task, should you choose to accept it, is to find those companies that will continue to grow. If your portfolio is comprised of a collection of Rule Makers, Rule Breakers, Gorillas, Blue Chips, whatever you want to call the best, you have hit a bump in the road. If you are holding more speculative issues, you may have hit a cliff. Buy the best, and don't be afraid.

5. And most importantly, "Be the ball, Danny."

Apologies to Caddyshack, and a safe, relaxing weekend to Fools everywhere. Monday is another day, and we will be back.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion Boards