A bear market can be hard on your psyche. It's depressing watching the value of your portfolio fall day after day.
Even worse, the negative emotions bear markets stir up can influence our actions. Unable to handle the pressure, investors often sell right when the market hits its lows. Or, paralyzed by fear, they are too scared to buy any of the bargains that become available when the market drops.
But there is a way around this psychological barrier. Doing so can improve both your mental state and your investment returns. It just requires a little unconventional thinking.
What can you lose?
"Invert, always invert." Channeling the mathematician Carl Jacobi, that's the advice of Charlie Munger, Warren Buffett's business partner. In other words, whenever you're stuck on a tricky problem, try looking at it from another direction.
Most people approach stock investments by thinking about how much money they can make. They're dreaming about becoming millionaires from a stock going to the moon. When analyzing an investment, they're entirely focused on the upside.
Value investors, including Munger, prefer to think about the downside first. If you can find a stock with a huge margin of safety, then you're unlikely to lose money. Buying stocks at a discount provides a safety net. You have to make a big mistake in your analysis of the stock or business has to degrade significantly before you have any risk of losing capital over the long term.
And if the downside is taken care of, you'll get the upside for free. The margin of safety means that you're buying stocks for substantially less than their fair value. You can achieve excellent returns just by selling value stocks after they rise to the price levels where they should be trading.
Beyond just a theory
That's the theory. What does it mean in practice?
First, when it comes to growth stocks, you shouldn't simply extrapolate historical trends. In the past few years, Google
Second, for any stock, understand all the events that could potentially disrupt the company's business. For Merck
Third, when investing, you should look for anything that will limit your downside risk. Real estate investment trusts like Vornado
The Foolish bottom line
If you know that your stocks are trading below their fair value, it's far easier emotionally to deal with a correction. After all, you know that over the long term, stocks tend to return to their fair value, so any losses are temporary. That's a huge psychological boost, and will help ensure that you don't dump great stocks at the worst time.
Even better, after you train yourself to look for value, you will come to see the falling market as an opportunity. You will find attractive stocks at these times, and will have the courage to buy them while they're cheap. In fact, as you might expect, recent volatility has led to some excellent stocks becoming bargains. Our Inside Value newsletter focuses on the undervalued stocks that we think have both the biggest upside and the least risk -- we've found quite a few stocks that have substantial upside potential from here. You can find a free 30-day pass here.
Fool contributor Richard Gibbons yearns for a rich cheese fondue on a cold winter's night. He owns shares of CryptoLogic, but does not have a position in any of the other stocks in this article. CryptoLogic is a Motley Fool Hidden Gems recommendation. eBay is a Stock Advisor selection. Baidu is a Rule Breakers pick. The Fool's disclosure policy frets.
