One of the hardest tasks an investor can ever face, to borrow from Rudyard Kipling, is keeping his head when others are losing theirs.
U.S. stock indices are down more than 35 percent this year, including a 22 percent drop this month alone. On every trading day in October, the Dow has moved lower.
The meltdown has cost stock investors more than $9 trillion this year, far beyond the $600 billion that financial institutions have written off in bad loans at the heart of the current crisis.
“I’m not saying you shouldn’t be scared. But you shouldn’t act on that fear. If your money is invested properly, and if you have a time horizon of three years or more, then you don’t have to do anything right now,” said Ric Edelman, author of “The Lies About Money.”
One useful mental exercise in times such as these is to assume a worst-case scenario and follow it through.
“Assume the entire banking system collapses and then extrapolate. If that happens, what you do with your money is utterly irrelevant. A loaf of bread will be $1,000. Your gold will disappear in three days,” Edelman said.
The scenario is unsettling, and unlikely, he said. Anything less than that, and investors should be looking for opportunities.
“The perfect time to be a buyer is when the last fighter ‘throws the towel in the ring.’ You then have to be standing there to catch it,” advised David Kotok, chairman and chief investment officer of Cumberland Advisors.
Those towels will smell and be full of sweat, but Kotok predicts that a year from now, global markets will be higher.
“You have this once-in-a-lifetime opportunity to buy incredibly high-quality companies,” said Vitaliy Katsenelson, author of “Active Value Investing” and a Denver-area money manager.
Investors shouldn’t sell an otherwise solid investment just because it has fallen in value and they shouldn’t buy a stock simply because it is cheaper.
Value managers who have swept in and bought what they thought were cheap financial stocks have had their heads handed back to them on a platter.
That said, investors got it wrong a year ago when they pushed the S&P 500 and Dow Jones industrial averages to record highs, despite the festering credit problems.
If the markets got it wrong back then, could they be getting it wrong again on the downside?
Banks, weighed down by bad loans, are reducing the credit they offer to hedge funds and others who bought assets with borrowed money.
Stocks can be sold quickly to raise cash. But such selling pushes prices down and triggers margin calls. Investors who get a margin call are forced to come up with cash to pay back the money they borrowed, usually by selling more stock.
As losses mount, investors in mutual and hedge funds are pulling their money, forcing fund managers to sell even more.
“There are some stocks trading at book value or the cash they have on hand,” said Aurora financial adviser Pam Dumonceau. “The problem is they may go lower.”
The painful process is known as deleveraging. But Edelman said it is finite and the global economy is working through the process quickly rather than slowly.
Once those forced sales are done with, stocks should be able to trade on the fundamentals again.
In the interim, look for companies with little debt and enough cash to finance their own operations, Katsenelson advised.
Avoid companies that will have to sell assets into a depressed market, are dependent on outside funding or rely on discretionary consumer spending that is evaporating.
Some investors during the 2000-02 stock downturn loaded up on utilities, which were supposedly safer than high-flying tech stocks.
But those utilities borrowed heavily. When they were forced to unload assets such as power plants all at the same time, they got 50 cents on the dollar.
Likewise, earlier this year many investors piled into commodity stocks, only to find out they had bought at the top.
“If you own individual stock, ask yourself how much is the company worth and what they are trading at,” Katsenelson said.
One company he likes is Microsoft, which had a war chest of $23.6 billion in cash and short-term investments at the end of the second quarter.
Edelman recommends average investors remove the risk of having an individual stock blow up on them by holding a diversified group of mutual funds or exchange-traded funds.
Dumonceau predicts that municipal and corporate bonds will recover before equities do.
“It is still too early to buy stock,” she cautioned.
For the brave of heart willing to step into this market, Katsenelson recommends going in half-steps, a strategy he follows.
Under that plan, someone wanting to buy $10,000 of a depressed stock might only start with $5,000. If it goes up, great. If it goes down, they can buy more at the lower price.
And be patient.
Below are some tips about investing in a falling market:
• Don’t panic, but be prepared for things to get worse before they get better. If an investment is still sound, hold on even if it has moved lower with the market.
• Those with the stomach to buy in this market should move in half-steps. Invest half your allocation and then wait to see how it does.
• For buyers, don’t purchase something just because it’s cheap. Seek out companies that can weather the credit crunch, ones with little debt and high levels of cash on their balance sheets.
• Consider municipal and corporate bonds, which have also fallen in value and could benefit earlier than stocks once the credit freeze thaws.
• It’s hard to know which investment categories will do well at any given time. Hold a broad mix of equities and fixed income, both domestic and foreign.
Aldo Svaldi: 303-954-1410 or asvaldi@denverpost.com
