The Only Way to Profit From the Recovery

Let's face it: It's been a terrible year to be in stocks for the long term. And since that's predominantly what we practice and preach here at The Motley Fool, by virtue of the transitive property, I can say that it's been a pretty terrible year to be a Fool.

Indeed, we've had longtime members question our mettle, and we've been inundated by requests to offer more guidance on how to play defense. But this article isn't about The Motley Fool. It's about you, and how you can make sure you're in position to make money when this terrible market environment turns around.

The perils of recency
There was and is a reason why we Fools are predominantly holders of stocks of high-quality businesses for the long term: It's a time-tested strategy that works.

Warren Buffett learned that lesson early in his partnership with Charlie Munger, and it's helped other successful investors, such as Chuck Akre, the team at Dodge & Cox, and Phil Fisher achieve market-beating returns over time.

It may not seem true today, but that's only because your brain has a bias toward recency -- it thinks that whatever has happened most recently will happen next. And in a market like this, that means your brain is busy scaring you into thinking the market can do nothing but drop -- or veer wildly.

There will definitely be times like these, when stocks drop dramatically and test your mettle. But if you remain disciplined, practice dollar-cost averaging, and allocate your invested assets between stocks and bonds in a way that respects your time horizon (more on that in a minute), you will succeed over time.

As Buffett has said, "The most important quality for an investor is temperament, not intellect."

The turnaround you won't see coming
When stocks recover (and they will recover), they will do so dramatically and without warning. For evidence, look at this table of market downturns from Brandes Investment Partners, which was recently reproduced in an outlook from the superior investors at West Coast Asset Management:

Source: West Coast Asset Management.

Will you make back all of the money you've lost this year over the next two? It's unlikely, given that the market would have to nearly double from here to get back to its October 2007 high.

But it is likely that if you pull out of the market, you'll miss out on the recovery. And if that recovery resembles the magnitude of those we've seen before, missing out will add many years to the process of building back your wealth.

That's not all
What's more, as this table of data from the 2000-2003 market downturn shows, you can make up ground even more quickly if you own high-quality businesses:

Return data courtesy of Capital IQ.

By simply holding some of these stocks, you could have come out ahead. If you continued to add new money to these stocks while they were down, you would have further accelerated your recovery process and ended up coming out way ahead.

What's the point?
I've heard from many investors recently who are sick of the market and just want to get out. That's a dangerous move -- because the only way to profit from the recovery is to make sure you still have money in the market.

But it's an equally dangerous move to keep all of your money in the market in the hopes that a recovery is imminent and you'll profit from it. While a recovery is coming, no one knows when it's coming. So, make sure you:

1. Have an emergency fund in place that you keep in a liquid, inflation-protected asset, such as a TIPS exchange-traded fund.
2. Make sure your bond exposure is in the proper ballpark. One handy rule of thumb is to make sure the percentage of your portfolio allocated to bonds is the same as your age. For example, if you're 40, you should be 40% in bonds.
3. After confirming Nos. 1 and 2, continue to dollar-cost average into high-quality companies without trying to time the market.

If you do all three of these things, you'll put your portfolio in a position to profit from the recovery -- and you should be able to sleep at night.

If you'd like some help finding high-quality companies, consider joining Fool co-founders David and Tom Gardner at our Motley Fool Stock Advisor investing service. You'll receive two top stock picks each month, as well as market updates and further asset-allocation guidance. Click here for more information.

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This article was first published on Feb. 13, 2009. It has been updated.

Tim Hanson does not own shares of any company mentioned. American Express is a Motley Fool Inside Value recommendation. The Fool owns shares of American Express. The Fool's disclosure policy is an ambassador for awesomeness.