Investments–Rule Number One

January 10, 2008 by  


By Bob Wood, MMNS

One of the greatest investors of our time, Warren Buffett, is also famous for sharing his simple rules for making money in the stock market. To him, Rule Number One is: ‘’Don’t lose money.’’ I’m constantly amazed at how few investors have taken time to consider why this great investor considers this rule the most important part of his investing strategy.

To Buffett, protecting what you have is at least as important as trying to grow it. I am sure that far too many investors think that they must be invested in the stock market at all times, regardless of stock valuation or economic conditions. But I am as sure as I can be that what hurts investors more than anything else is their staying in bad markets for too long. Secular bear markets like the one we are enduring in the domestic markets now are the killer of investor hopes and dreams.

Currently, Buffett is famously sitting on a pile of cash rumored to be somewhere between 40 and $50 billion. And this is not the first time he has protected mountains of cash for which he could find little use in the stock market.

In 1969, he closed out his investment partnership, sending money back to investors and bemoaning the fact that there was little to buy with their money at prices that seemed fair. Sure enough, the stock market slipped into a nasty bear market in 1972, and the 1973-74 bear cycle saw prices in the Dow Jones Industrial Average fall roughly 40%.

While other investors were counting their losses, Buffett was piling millions back into the stock market; that mountain of cash was now available for scooping up what he saw as bargains. The rest is history, of course, since we now know that this buying opportunity is largely responsible for the great wealth Buffett has accumulated. Had this great investor remained fully invested in the stock market during the cyclical bear market that did so much damage to other investors, he most likely would have had little cash and less desire to dive into the stock market at what became “the low point” of the decade.

Buffett has said on several occasions that he doesn’t really concern himself with economic conditions in general. He simply looks to buy assets at fair prices — and nothing more. With today’s stock market selling at multiples similar to those of 1969, it is not surprising that he once again is holding a huge amount of cash.

Of course, a careful observer will see many other similarities to 1969 in today’s bigger picture. The U.S. is again involved in wars overseas – wars that offer little hope of victory. War costs in terms of both human life and national treasure continue to mount in nauseating ways. Another glaring similarity is high inflation, as seen in the rising price of energy.

We also find ourselves firmly in the middle of a secular bear market. The long-term bull market in stocks, which began shortly after the end of World War II, came to an end in 1964. By 1969, it was obvious to Buffett that the stock market downturn was no short-term event.

Investors today can also see clearly that the stock market, as evidenced by the S&P 500, is lower today than it was at the end of the last secular bull market in early 2000. This provides a clear sign to today’s investors that the current bear market is of the secular, or long-term, variety.

The idea held by many — that an investor can remain fully invested during a secular bear market — is a sure sign that rational thinking is not part of the process for far too many investors. In today’s stock market, we see record trading volumes, making it appear as though the long-term bull market never ended!

Part of the problem for many investors is that losing money in the stock market occurs in subtle ways. A case in point is that today’s Standard & Poor’s 500 is about 7% lower than it was at the bull market peak in early 2000.

Those investors who have hung in there, remaining with the ‘’stocks for the long run’’ argument might think they are close to even too. But even if we accept the government’s lowball numbers for inflation as running close to 3% per year since early 2000, the investor who stuck with the domestic markets is well behind where he started in terms of the buying power of his investments.

The big problem is this: most investors, even professional mutual fund managers, tend not to outperform indexes such as the Standard & Poor’s 500. But even the rare investors who have been able to match returns of that major index over the past eight years still find themselves about 30% poorer than they were in early 2000.

What will happen to today’s investors should the current secular bear market endure as long as secular bear markets have tended to last over time? For a more extreme example, look at the Japanese stock market as shown by its major index, the Nikkei 225.

That index topped out at about 39,000 on the first day of 1990. Today, it remains more than 60% below that previous peak 18 years ago, before inflation. Even if the investor in that market had managed to break even in nominal terms over the past 18 years and his account today is at the same level as it was 18 years ago, he would still need 70% more money to buy what his investments would have bought then.

The average investor there would need 1.7 million Yen to buy what 1 million Yen would have bought in 1990. But with the Nikkei down over 60% since then, he has a mere 400,000 yen to do the job with, or thereabouts. In other words, he can now buy about one quarter of what his investments would have bought 18 years ago!

Yes, this represents an extreme example, and conventional wisdom insists that it could never happen to us. But I wonder what kind of reaction I would have heard back in 1990 if I had suggested to a Japanese investor that his home stock market would be 60% lower in 18 years than it was on that day?

I also wonder how many investors in America in 1928, at the height of the Roaring 20s, thought that both the stock market and overall economy would reverse course and deal them brutal losses? The Dow Jones Industrial Average peaked at 381 in 1929. It hit bottom at 41 in 1932. How many then would have accepted the premise that the stock market could possibly fall that far?

While I remain a Bear — or a realist, as I prefer to be called — in today’s markets, I am in no way suggesting that domestic stock markets will fall to that degree in the coming years. But I am about as sure as I can be that the best case scenario in the coming few years is that the stock market will be no higher than it is today.

What I am suggesting, however, is that at some point in the future we may well find a wonderful buying opportunity much like the one Warren Buffett took full advantage of in 1973 and 1974. What concerns me is that too few investors will be holding enough cash to take advantage of that opportunity!

The time to invest in the stock market is when valuations are low and investor enthusiasm is even lower. A recent example of this type of situation occurred in the summer of 2002 when the Standard & Poor’s 500 fell almost 50% lower and the NASDAQ was 80% lower than they had been at their peaks in early 2000.

How many investors do you know who have been sitting on cash, ready to load up on stocks at prices much lower than they have been in previous years? Only those investors who have paid sufficient attention to Buffett’s Number One Rule for making money will have the ability to do just that.

That time will come again, at some point in the future, when the skeptical realist who sat out the worst of the bear market will be able to walk into a scarcely populated stock market and take full advantage of the bargains that will abound.

I have every intention of being one of them.

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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