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Investing in a Cruel World
Cisco CEO John Chambers says this recession marks the “toughest economic challenge of our lifetimes.” American households have lost more than $13 trillion in wealth. Some have lost everything because of excess debt or fraud. There is absolutely no doubt that the world can be a cold and cruel place. After the collapse of Lehman Brothers in September 2008, millions fled from risk of any kind. Money market funds based on U.S. treasury obligations closed to new investors because of a flood of incoming money. Stock and bond markets plunged. The fear, as we teetered on the brink of an economic abyss, was understandable. But history tells us that it usually is a mistake to panic, follow the crowd and run away from risk. A better strategy is to patiently look for opportunities, ways to recoup losses and build a richer future. Based on my 50 years of investing in good times and bad, I have drafted five key rules for “Cruel World Investing,”
We feel betrayed by the catastrophic bankruptcy of Lehman Brothers, the collapse of AIG, the failure of so many banks and the plunge in home prices. Many Americans are desperate, fearful and terrified. We have awakened to the fact that, when it comes to managing your money, it is a harsh, cruel world. Many are vowing to get out and stay out of the stock market. That is an enormous mistake. In cruel markets, there are more opportunities than there are in inflated or buoyant markets. Irrational selling creates opportunity; irrational buying takes it away. My personal experience says that cruel, volatile markets are in fact “normal.” My experience also says that you can do more than “cope” with rough markets. You can see through them, use them to your advantage and make your fortune. I call it “Cruel World Investing,” a realistic approach to making money investing in individual companies.
Here are three real-life examples of what I’m talking about:
(1) Hong Kong in 1989. In June of 1989, the world watched in horror as the Chinese army killed innocent people in Beijing’s Tiananmen Square. The Hong Kong market crashed. Fear paralyzed Hong Kong banks and investors. I had money invested in Hong Kong stocks. What’s more, I had many clients and subscribers owning Hong Kong stocks. We lost 30% overnight and were faced with the ultimate horror, the possibility of losing everything if the Hong Kong stock market was destroyed.
The answer was research. It was too late to sell stocks. They had fallen in a flash. The only practical strategy was to find out if all was lost. My research turned up some pleasant surprises. Many Hong Kong companies had been worrying about the Chinese for a long time. They had moved assets out of Hong Kong, to safer places. They had cut back on Hong Kong production. In a few cases, they had moved headquarters to other countries. The stocks had plunged in a selling panic, driving prices below the value of the assets outside Hong Kong. By concentrating my Hong Kong holdings in companies with substantial assets outside Hong Kong, I was able to avoid a total loss.
It turned out that the battle for political control of China was ultimately won by the reformers. Hard-line Communist military leaders lost control. By November, the balance of power shifted back in favor of reform. In 1990, the Hong Kong stock market recovered. Banks began lending again. Hong Kong stocks not only recovered, but they went on to produce outstanding gains for several years. But had it gone the other way, I would at least have been able to salvage enough to start over. That is what Cruel World investing is all about – always starting over, rather than giving up.
(2) America’s Great Depression. When we look back at America’s Great Depression, we see two things. First, we see all the companies that went bankrupt and all the investors who went broke. Pessimists use those images to terrify investors. The unspoken but clearly implied message is that, in a Depression, stock market investors will lose everything. That is not necessarily the case. There were stocks that paid dividends all through the 1930s. Those dividends, re-invested, became a source of great fortunes. The second thing we see is that the Depression lasted over a decade. It was not a one-day shock, like Tiananmen Square. There was lots of time to do your research. As long as you were not using borrowed money and weren’t forced to sell, you had time to salvage some cash and buy companies that had a high probability of surviving and recovering. Many stocks soared from 1932 to 1937. From its 1932 low to its 1937 high the Dow Jones Industrial Average rose 372%, the largest five-year rise in history. Investors who held on, did their research and concentrated in carefully-selected stocks recovered most of their lost wealth.
(3) The 1970s were also rough on investors. Bonds collapsed when inflation and interest rates skyrocketed. Stocks collapsed for the same reasons. Gold was king. The Swiss franc was the best haven for cash. But you had to be nimble. Gold rose sharply, to $850 an ounce in January 1980, only to fall sharply thereafter. I lost heavily in the 1973-’74 stock market crash. So did Peter Lynch, in his first years managing the Magellan Fund – which fell 54% in a year. The 1970s were very rough. In 1976, I was in my office in Zurich, Switzerland. A trader whom I respected a great deal came into my office and pounded on the table. “John,” he said, “you must buy gold!” Gold had fallen to barely $105 an ounce. I was confident that he was right. The problem for me was insufficient funds. I was still struggling to recover from the 1973-’74 market plunge. I was researching a U.S. defense stock, Loral, a turnaround situation. My theory was that the U.S. would expand government spending on military electronics. Because of Vietnam, defense spending was under attack. But electronics, I reasoned, would survive the cuts and benefit. I decided to buy the stock. Believe it or not, in January 1980 it was a tie game. Gold and Loral returned almost exactly the same results. But unlike gold, the stock market kept growing. Better yet, the gain was enough to put me in strong financial position to launch my newsletter in 1980. I had survived the 1973-’74 crash and had more than fully recovered.
From these true stories – Hong Kong in 1989, the Great Depression of the 1930s and the 1973-’74 market crash and recovery – you can already see a few lessons. In all three cases, research proved to be essential to survival and recovery. There is a common saying, investigate before you invest. That sounds good, even logical, but investigating shouldn’t stop when you buy a stock. In fact, buying a stock should be a starting point for continuing, intensifying research. The second rule was to accumulate savings from income (or stock dividends) and plan a return to the market.
Does common sense and research always keep us out of bankrupt companies? No! Even with the best research and decades of experience, you still can get caught in a stock where the company goes bankrupt. In my 50 years as an active investor, that has happened only a few times. Recently I held too many bank stocks including IndyMac, which was taken over by the FDIC after an unexpected but devastating run on the bank. I got caught owning Global Crossing, all the way down to bankruptcy, but I knew that was a high-risk investment. Therefore, I also knew there were no guarantees that I would not lose. I had seen cases in the past where betting an entire company on a new idea turned a small amount into a fortune. When AT&T laid the first intercontinental telephone cable, the entire company was at risk. Laying cable in the North Atlantic is by itself highly risky. AT&T won and investors made fortunes. Global Crossing took similar chances but they lost. The key here is that when these high-risk investments work, they turn small amounts of money into a fortune. You don’t have to invest a lot in such high-risk stocks to enjoy life-changing gains. You don’t have to put your whole portfolio at risk.
FIVE “CRUEL WORLD SURVIVAL RULES”:
1. Save part of your income. First, accumulate six months living expenses in cash.
2. Study the markets, the economy, and especially the companies in your portfolio.
3. Always have a “Plan B.” After you have accumulated a substantial portfolio, keep enough in cash to start over, if the worst happens.
4. Be alert when a stock flies high. Sell some or all if valuations rise so high they don’t make sense.
5. Manage your risks. Rather than diversify for its own sake, focus on your risks, stock by stock. Accumulate stocks with different risk characteristics. Invest smaller amounts in risky stocks, and larger amounts in safer stocks.
CRUEL WORLD INVESTING RULE #1:
SAVE MONEY! LIVE BELOW YOUR MEANS
When you are working and earning, keep your spending levels BELOW your income levels. Put something away out of every paycheck. When I give this advice, I often hear people say they can’t save because “the cost of living is so high.” But I also see immigrants from Mexico, Cuba and Asia who live far below their very low incomes. They save 35% of their income until they can invest in a business, real estate or stocks. If they can do it, so can we. As our income rises, too many Americans allow their spending to rise even faster. That is a formula for financial disaster. Even in retirement you should live below your means. Having a financial cushion provides a high degree of security for senior citizens.
CRUEL WORLD INVESTING RULE #2
STUDY THE BASIC CONDITION OF THE U.S. AND GLOBAL ECONOMIES THEN, MAKE UP YOUR MIND, AND STICK TO YOUR PLAN.
This rule is especially important today. Economists and market experts alike are sharply divided on the outlook for jobs, the economy, stocks and bonds. Some see high unemployment and slow growth as the new reality. Others think we will work our way through the challenges and achieve sustainable economic growth. These experts have more detailed information about the present than we do but they still don’t know any more about the future. That is why experts with the same information can come to two entirely different forecasts. Always listen to both sides. Then form your own opinion about what the future holds. But when making your personal investment plan give respect to the opposite possibility. Be prepared for the possibility that the worst or best case might turn out to be the real case.
CRUEL WORLD INVESTING, RULE #3:
PLAN FOR CRUEL MARKETS. ALWAYS HAVE A BACK-UP SURVIVAL PLAN.
I am often criticized for being too optimistic. Yes, I am ordinarily optimistic, but that is because optimism has been a winning attitude for most of the last 50 years. But I am more than an optimist. I am a “paranoid optimist,” always worried about what will go wrong next. From my first job, and throughout my career, I always had a “Plan B,” just in case I was fired, or the job situation became too difficult. I never was fired, but I believe that being prepared gave me the courage to do things that more complacent people would not do. I took risks on the job, risks that paid off handsomely. As you grow older cash is an important part of any back-up plan. Have at least six months living expenses in cash at all times.
CRUEL WORLD INVESTING, RULE #4:
BE ALERT TO A RAPIDLY RISING STOCK. PLAN TO SELL SOME SHARES.
What would you say to a 50-year-old Enron or Lehman Brothers employee who lost everything in his 401(k) account? Don’t tell him he “should” diversify; it’s too late now. Or is it? In truth, he’s lucky to learn this painful lesson so early. What if he were already retired? In the early 1990s, an elderly couple came to my office. He had retired in the early 1980s when interest rates were sky high. He followed the popular strategy of the time. He sold all stocks and invested the cash in short-term CDs and government bonds. All was well until interest rates fell sharply. By 1990, the couple was in financial trouble. They no longer could afford vacations and were worried about rising real estate taxes and the cost of home and car insurance. They asked for my advice. I told them that the only chance for recovery was to take a chance in the stock market. They cringed, admitted their fear, but finally agreed. Half of their cash was invested in conservative stocks. Two years later, they could smile again. With all its ups and downs, the stock market restored enough wealth for them to live out their lives in financial security.
CRUEL WORLD INVESTING RULE #5:
START ALL OVER AGAIN – AND MANAGE YOUR RISKS.
I would give Enron or Lehman Brothers employees the same advice. The only chance for recovery is to buy stocks, even though that includes the risk of investing in another company that goes bankrupt. A 50-year-old Enron or Lehman Brothers worker, suffering the aftershocks of the loss, shouldn’t feel hopeless. Start small. For example, start with a monthly contribution to a low-cost, no-load index fund. Wealth accumulation develops faster than you might think with a monthly contribution. Month-by-month, things may appear to go slowly. But when the stock market makes one of its periodic upward moves, your wealth will increase sharply. When the amount in the index fund has increased to more than $10,000, withdraw part to invest in specific stocks. A 50 year-old still has a chance to retire in style by 65.
CONCLUSION: EVEN IN A CRUEL WORLD,
STOCKS ARE STILL YOUR BEST INVESTMENT
If you are young and working to build a substantial portfolio, stocks are your best bet. If you are middle aged, stocks are your best choice. Even after you have secured a substantial portfolio and are ready for retirement, you need stocks to fuel growth to offset the inevitable rise in your cost of living.
The cold, cruel world has always been with us. Our challenge is to meet these reversals head on, by saving and working hard to make this a better world, for ourselves and our families.
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