For those of you who eschew any kind of discussion about the general direction of the stock market, cover your eyes. For those of you who have been kneeling for years at The Motley Fool's altar of long-term buy-and-hold, brace ye for the looming sacrilege. The Motley Fool's editorial message has always been that people shouldn't concern themselves with the ebbs and flows of the stock market. I'm here to tell you that I believe we've gotten it exactly wrong.
What makes me speak such foulness? Simple: March 2000 to October 2002.
In those two years, the Nasdaq fell 4,000 points, roughly 80%. The S&P 500 was cut in half. I've had good friends tell me how their 401(k)s were decimated. I can't tell you the number of times people who held Yahoo!
Could all of this pain have been avoided? From a macro perspective, probably not. The bubble of irrational exuberance was going to burst, either very quickly or very slowly. It just happened to take two-and-a-half years to unwind. The only way the pain would have been avoided was if we all didn't bid these shares up to the moon to begin with. Alas, I digress.
My intent today is not to be preachy about what might have been, but to equip those of you willing to listen with the tools to handle what's to come. I said before that I believe the Fool has gotten it wrong all these years by telling people to ignore the gyrations of the stock market. To be fair, the spirit of the Fool's message has always been that it's not possible to predict future stock price movements by examining past stock price movements. In that regard, I agree. I don't believe that past prices help predict future prices.
I do believe, however, that the stock market discounts future fundamental information. I'm not alone. The Federal Reserve and various other governmental agencies use the S&P 500 as one of many leading economic indicators. It is a widely held belief that significant increases or decreases in the market averages portend certain economic behaviors. Why?
A pseudo self-fulfilling prophecy takes place through something called the "wealth effect." When the stock market goes up, people have more money, either on paper or in their bank accounts. The euphoria created by these overflowing coffers makes people willing to spend money on things more freely. Luxury items do well, travel to exotic lands does well, second home purchases take place, and 70-inch Sony Grand Wega XBR HDTVs are bought. Woo-hoo!
Because people are spending so freely, corporate America rakes in and reports big profits, thereby sending the stock market even higher, making people feel even wealthier! In this regard, the stock market's ebbs and flows do have some predictive value for the economy at large. Implicit in this virtuous/vicious cycle is the idea that some of the wealth created is not real, but only perceived. Because of this, in strong bull markets, stock prices will usually rise to levels that aren't based in reality. When, then, do we believe what the market is telling us?
There are only two times when the market's movements do not reflect future economic reality. Can you guess those two times? If you said, "At the very top, and the very bottom" give yourself a big gold star. The market is only "wrong" at the top and the bottom.
As individual investors, we obsess over these words, as does the media. Don't want to buy at the top, right? Can't sell at the bottom! The problem is, we don't know that a top is a top until it is. When the Nasdaq sat at 5,132 and Sirius Satellite
I'll say this one time: Stock prices almost always move in advance of news being announced. Learn it, love it, live it.
Our problem, as individual investors, is that the fundamental bad news usually doesn't get announced to us until it is way too late and our stocks already have been cut in half. How many times have we seen a stock fall 20% to 40% on no news at all, only to learn a month later that earnings shrank or a contract fell through? More importantly, how can we manage our risk and avoid taking such nasty losses?
There are lots of ways in which you can manage your risk and avoid the catastrophes. These ideas can be applied to individual stocks or to your portfolio as a whole.
1. Pick a number. In doing your fundamental analysis of any company, you should be able to identify a valuation, or at least a fairly tight range of valuations, for what you think the company is worth. As simple as this sounds, when the company reaches the value you assign, sell it. Too many people outsmart themselves and don't sell fully valued businesses. Don't be afraid to bail.
2. Stop the losses. One of my favorite ways to manage risk is to set a trailing stop-loss on the stocks I own (after the Fool's mandatory 30-day holding period for employees, of course). While opinions around Fool HQ differ about the effectiveness of stop-loss orders, they've been a good friend to me in helping me avoid absolute beat-downs in stocks I've owned. For a slightly different view on stop-loss orders, check out Bill Mann's excellent piece The Illusion of Liquidity.
3. Diversify. One of the oldest tricks in the book, eh? While I obviously believe that people should diversify their stock holdings, that won't generally help you when the stock market gets creamed. I'm talking about diversifying your investable assets across various asset classes. This is especially important as you get older and capital preservation is much more important. While you would have hated to hold stocks from 2000-2002, you'd have loved being in bonds and other high-yielding income investments. If that kind of safety and peace of mind appeals to you, then you need to get a freebie issue of The Motley Fool Income Investor newsletter.
The bottom line, folks, is that you will likely feel the most euphoric about stock prices at the very top, and the most depressed at the very bottom. In other words, you'll be exactly wrong at the worst possible time. Manage your risk and be prepared to take advantage of things when the market is precisely wrong.
Questions, comments, or ideas? Email me.
David Forrest doesn't own any of the stocks mentioned in this article. He's been a guest analyst for Tom Gardner's Hidden Gems recently, sotake a free trialand find out which stock he likes the most right now. The Fool has adisclosure policy.