FOOL ON THE HILL
With the major market indices trading at a fraction of their old highs, many investing mistakes have painfully come to light. Luckily, this is a prime learning opportunity to become better investors for the next time we find ourselves in such an economic environment.
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It certainly has not been the best of times of late to be an investor. As of this writing, the S&P 500 is down over 20% year-to-date. The Nasdaq Composite Index is down nearly 40%. This is on top of last year, when the S&P fell more than 10% and the Nasdaq gave up roughly 40%. Since breaking the 5,000 level in March of 2000, the Nasdaq Composite has shed approximately two-thirds of its value. This "bubble pop" -- or "bear market," or "correction," or whatever you want to call it -- has been brutal, with the vast majority of investors seeing the value of their portfolios drop precipitously. Instead of just taking our lumps and moving on, however, times like these offer good opportunities to make mental bookmarks and learn important lessons. Whether you made an investing mistake yourself, or merely watched a friend or family member make one, mistakes can happen to the best of us. Heck, I bought Yahoo! (Nasdaq: YHOO) in January just above $40! But the good thing about mistakes is that there are no better educational tools. We can tell our kids to not put their hands on a hot stove, but the lesson won't take until they actually do it. It's the same with buying stocks: Investors may know some of the dangers of thinking short-term or overexposing themselves to certain sectors, but until the consequences of such actions are felt or observed firsthand, the dangers are often cavalierly dismissed. With the pain of this market environment still fresh in our minds, I thought it would be helpful today to spell out some of the lessons investors should always remember. Though there are many lessons to be learned, below are five that stick out in my mind. The economic cycle still spins The anemic economy of this year, however, has proven that the economic cycle is alive and well. Economic activity continues to ebb and flow like it always has, and perpetual, continual growth is anything but a given. Though over the long-term the economy should continue to move forward, there will inevitably times where it first takes a few steps back to recoil and consolidate previous gains. Today it appears we're in one of those transient backward-moving times. As investors, it's important to take this into consideration when buying into industries that are economically sensitive and have highly cyclical earnings. Take, for instance, the airlines: American Airlines parent AMR (NYSE: AMR) may have looked darn good in 1999 when it had trailing earnings of over $7.50 per share and a price-to-earnings ratio in the low single digits, but how does it look now that it is staring at billions in losses? Yes, the terrorist attacks have made the situation much worse for the airlines, but AMR and its peers were already reporting copious amounts of red ink. The lesson remains that companies that operate in the red when the economy is poor certainly may look "cheap" when the economy is booming, but that discount is warranted. It's also worth remembering not to consider the current situation as the permanent status quo with cyclical companies. Short-term investing is gambling Folks that invested their tuition money, housing down payment, or funds needed to retire this year back in 1999 learned the painful lesson that the stock market, like the economy it tracks, does not always go up in the short term. It's always a good idea to think about asset allocation to make sure your life situation won't force you to buy high and sell when the market is vacillating low. (For more information on getting help with your asset allocation, please check out TMF Money Advisor.) Diversity is key No matter how well you know an industry, it's prudent to own stocks across multiple industries to contain losses should the floor fall out from underneath a particular market. Playing with margin is playing with fire A person buying stock with half their own money and half margin debt would be completely wiped out if the market fell 50%. (Remember, the Nasdaq is now down nearly 70% from its 2000 high, so don't think it can't happen.) There is also the nasty margin call: Lenders can call in a loan when the equity backing it up falls below a certain point. Investors who get these calls must either pony up more money or sell some of their stock at inopportune times. Most just part with their stock, which corners them into a situation where they are buying high and have no choice but to sell low. The bottom line is that using margin debt is like drinking alcohol or casino gambling -- a little bit in thoughtful moderation is O.K., but over-indulging can be disastrous. Most investors are probably better off leaving it alone. There are more important things than investing If you obsess over your investments or are concerned about your stock-selecting skills, let me suggest putting a greater portion of your assets in a whole-market index fund. They not only give you diversity across a great number of companies and industries, but are "no-brainer" investments that can save an enormous amount of time for the better and more important things in life. There are many additional lessons to be learned from this depressed market environment, but these stick out in my mind. If we take this opportunity to learn from our -- and others' -- mistakes, we will be much better investors and more prepared when we find ourselves going through more difficult economic situations down the road. Paul Larson still owns a stake in Yahoo!, but he's not exactly sure why. You can see what else Paul owns online thanks to The Motley Fool's progressive disclosure policy.
With unemployment essentially nil, nary a recession in nearly a decade, and the stock markets soaring, we were in economic utopia for much of the late 1990s. It was easy to believe the good times were going to last indefinitely -- or at least that a recession was far, far away.
We've said it thousands of times, and I'm going to say it again. When investing in the stock market, it is advisable to use only money you won't need to touch for several years -- hopefully, several decades. In the short term, the stock market is nothing more than a crapshoot, but in the longer term, the odds for success are heavily weighted in your favor.
It's always a good idea to diversify your stocks across several different industries to minimize the chance that unforeseen events will decimate your portfolio. Imagine, heaven forbid, someone that had the majority of their portfolio in airline stocks before the events of Sept. 11, or that someone had most of their portfolio in Internet retailers, B2B, or fiber optics stocks when each of those industries had their day in the spotlight.
Many investors are tempted by the siren song of margin debt -- money borrowed against equity in a portfolio that is used to buy more stocks -- in order to boost their overall returns. While margin does indeed increase returns when stocks are rising, it can also greatly exacerbate losses when stocks fall.
The final lesson was brought home to many of us on Sept. 11. While money and investing are important parts of society and our lives, there are more important things we should appreciate, including our friends, family, health, and the good fortune to live in such a time and place of enormous prosperity.
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