Five Ways to Outsmart Other Investors

Keith Fitz-Gerald
  SEP 10, 2009 11:45 AM

Why do investors chase hot money and hang on to losers?

 


Back in mid-June, more than 75% of the investors responding to a CNNMoney poll said they were planning to buy stocks -- many of them aggressively.

Of the 41,572 people polled, it now looks like those 31,179 bullish investors kept their word.

The Standard & Poor’s 500 Index has zoomed 15% since those investors were polled (and 53% from its March 9 market bottom).

Let’s face it: A 75% bullish inclination is a disproportionately high percentage. It’s way out of the norm.

What those 31,179 bulls are telling me is, well, we’d better watch out. Statistically, the individual investor excels at making the wrong decision at precisely the worst possible time. I view this survey as yet more evidence that the “herd” may once again be heading down the wrong path.

After the collapse of Lehman Brothers Holdings Inc, investors yanked more than $120 billion out of equity mutual funds. That’s more than the total amount of money investors poured into these funds during 2007 and 2008, a period when exuberance was at its height, according to Money magazine.

And after the S&P 500 hit its March low, most people missed the subsequent rally -- 32% through June 23, when the CNNMoney poll was concluded -- a run-up that could have mitigated their enormous losses.

The disturbing reality is that investors chase hot money and hang on to losers. Most individuals have an awful sense of timing, as well as an unending tendency to act irrationally.

According to a recent Dalbar/IFA study, over-exuberant investors can lose a lot of money. For example, the S&P 500 returned 11.81% a year on average between 1989 and 2008. The “exuberant” gain-chaser scored 4.48% in the same time frame. Factor in inflation and the average investor gain disappears completely, as evidenced in the chart below. You could have done better in a bank savings account!



Hope for the Best, Prepare for the Worst


That brings us back to the two most pressing questions of our time:

1. Whats going to happen next?

2. And what should we do about it?

Although pundits are spewing forth an “improved” outlook for the US economy, history tells us that we’re more likely to see a stock-market correction in the near term.

Over the last half a century, stock-market rallies that follow the horrific declines we’ve seen over the past 24 months are typically followed by a secondary decline of 14% to 50%.

What will happen after that is anybody’s guess.

According to a study by Ned Davis Research, any secular bull market that followed a recession in the last 100 years resulted in gains in excess of 60% during an 18-month stretch. In situations where that rally was actually the catalyst for a resurgent economy, stocks averaged 110% over the next 36 months.

But we also have to remember that the bear market that started all this grew out of the worst financial crisis since the Great Depression. According to longtime investor Jeremy Grantham, the record deficits, stimulus packages, and bailout packages have "reduced to guesswork" any market forecasts (as reported in CNNMoney). That’s probably why Grantham recently warned clients: “If you feel overconfident about anything, take a cold shower and start [analyzing] again. Just be patient. In our strange markets, you usually don’t have to wait too long for something really bizarre to show up." I’ve been counseling readers for more than a year to think long-term. My advice is to preserve your wealth by navigating the near-term chaos. Stifle the knee-jerk urges to buy or sell. If you succumb to the urge to follow the herd, the crowd will inevitably lead you down the wrong path. And probably at the worst possible moment.

Instead, follow these five strategies:

1. Position your portfolio.

Develop a portfolio structure you can live with -- such as the 50-40-10 allocation model my firm recommends in our monthly sister publication, The Money Map Report. That way you can take all sorts of economic contingencies into account, while still maintaining a steady course that emphasizes sound “safety-first” choices, portfolio stability, and high income. How much stability should you be looking for? The 50-40-10 model is typically 30% less volatile than the broader markets. But it can dramatically outperform the broader indices on the upside.

2. Limit your losses.


Invest no more money than you can afford to lose. This sounds simple, but you’d be amazed at how many of the thousands of investors I’ve talked with through the years still don’t get it. They view themselves as “investors,” when they’ve actually become “speculators.” One Texas man I know lost half his wealth during the past two years. When I asked why he’d put so much money at risk, he shrugged and replied: “Because I could.”

Get your strategy in place then pick specific investments that keep you within the guidelines you established. Focus on global stocks with high dividend yields. And make sure you include a healthy dose of energy, technology, and inflation-resistant holdings. Such stocks tend to blossom at the first signs of a real recovery -- just like they have after every other documented economic downturn in history.

And finally, always make sure to manage your risk. Limit speculative positions to 2% to 5% of your overall portfolio value. That way even a total loss in one holding won’t be enough to eviscerate your portfolio.

3. Avoid surprises.

In my talks with audiences all around the world, listeners are often the most surprised to learn that successful professionals don’t wake up with thoughts of how much money we can make each day. Instead, we think about two things from the time we get up until the time we go to bed: What’s the most likely thing that could cause me to lose money today? And how can I avoid that?

In other words, concentrate on understanding what it is that you don’t know. And then make sure to steer clear of that potential pitfall. It’s an approach that helps you make better decisions. Don’t swing for the fences and risk a strikeout each time you come to bat. Instead, make up your mind to go for much-higher-probability singles and doubles. Risk aversion should be your new mantra, especially now. 4. Risk less -- by saving more.

This is actually a neat little trick. Classic market theory holds that to generate bigger returns, you have to have to take on more risk. That’s true -- as far as it goes. But here’s what that adage doesn’t address: By taking some simple steps to save more, you can actually accumulate wealth more quickly than by the increased levels of risk most investors are relying upon at the moment.

5. Don’t let yourself get whipsawed out of the market.


Investors who prepare for only one kind of market are the most susceptible to panic selling. To them, investing is an all or nothing proposition. You’ve got to prepare for both “up” and “down” markets. And you do so with some simple hedging strategies. Hedging, after all, isn’t just for hedge funds. In fact, everyday people just like us can use them very effectively, which is why I encourage you to do so. You see, if you’ve prepared for “up” and “down” markets, you no longer have to actually “predict” what the markets are going to do. Then you can focus on finding quality companies with real earnings, a healthy dose of overseas sales, and high income.

Once these five strategies are in place, you can turn your money loose to do the work it wants do for you. And you can sit back and enjoy beating the so-called “smart” money -- practically no matter what the stock market does next.

As my market analysis demonstrates, success as an investor requires knowing when to act.

But it also requires knowing where to look.

Like under the Eiffel Tower.

The French Oil Ministry has confirmed there is a 40-billion-barrel reserve under that historic landmark -- enough to fuel total US oil demand for 5.2 years, according to the Energy Information Administration.

And a tiny US company is poised to profit from this $2.8 trillion cache of crude. Opportunities such as this are the kind of potential profit plays that my firm focuses on in our monthly affiliate newsletter, The Money Map Report. This publication tracks global money flows, and where those capital flows intersect with some of the most powerful economic and financial trends at play today.

For more information on The Money Map Report, as well as on the oil cache beneath the Eiffel Tower, please click here.
No positions in stocks mentioned.