Thoughtful Reflection Leads to Successful Investing

Eric Fry By Eric Fry
Macro Strategist

Market Trends

When I read recently about a woman who tried to board a commercial flight with an “emotional support peacock,” I thought to myself, “Wow! That’s pretty crazy!” But after enduring the last several days of wild stock market gyrations, I’m now thinking that having an emotional support peacock might be a darn good idea.

A word of warning: Don’t try substituting the peacock with an ostrich. At the moment when you most need emotional support from an ostrich, it will simply stick its head in the sand.

With or without the assistance of an emotional support creature, we investors must try to figure out what, if anything, we should do differently. For most of the last decade, we didn’t need to do much more than buy stocks… and keep on buying them.

Words like “sell-off” seemed to disappear from the investing lexicon. They became as archaic and unfamiliar as “haberdasher,” “davenport” and “icebox.”

But then… Wham! Just like that, the Dow tanked about 2,000 points from an all-time high… and “sell-off” became a very relevant word once again. Some investors seized the moment to familiarize themselves with a few other long-forgotten terms like “margin call” and “bear market.”

So now what? What are we investors supposed to do with this thing called a sell-off?

History provides some clues, but not all of them are comforting.

For example, contrary to what many professional investors may be advising at the moment, history does not say “Don’t panic.” Rather, the lessons of history convey a slightly different message.

That message is “Panic… a little.”

In other words, don’t simply plow additional capital into stocks because “the market always goes up over time.” Instead, take a step back. Reassess your personal financial situation and then act.

Based on a thoughtful assessment of your risk tolerance and investment time frame, you might choose to cash in some of your holdings and reduce your exposure to stocks.

Or you might reach the exact opposite conclusion. If you are investing over a long-term time frame, for example, you might want to use the current sell-off to add to your stock holdings.

Faithful readers of Energy & Resources Digest may be aware that most of my most recent musings have conveyed a cautionary message. I have been warning since late last year that the U.S. stock market had entered dangerous territory.

For example, three weeks ago, I remarked, “According to a wide variety of market gauges, the U.S. stock market’s valuation is so extravagant that it could be a cast member on Rich Kids of Beverly Hills… That is not a promising augury. When extremely high equity valuations combine with extreme investor complacency, good things rarely happen.”

Within a few days of that observation, bad things started happening. Stocks fell and investors rediscovered emotions like fear.

The market has stabilized somewhat, but it is likely to remain volatile for a while longer. In fact, it could resume falling and develop into a full-fledged bear market. That possibility doesn’t mean we should run for the hills… or hide in a bunker with bars of gold and cans of tuna fish.

But it does mean that we investors must honestly re-evaluate our true risk tolerance and investment time frame.

If we are close to retirement, for example, or anticipate an imminent need for liquidity, we should maintain a small exposure to volatile assets like stocks. However, if we are investing over a long-term time horizon, I would repeat the observation I made several weeks ago, before the market began tumbling…

The starting price matters when making an investment. That’s why buying U.S. stocks at their current lofty valuations could be a risky bet.

But the lessons of history are not all doom and gloom. For long-term investors, history provides a much more hopeful and optimistic lesson: Time covers a multitude of investment sins, like the “sin” of buying richly valued stocks just before a major market top.

For example, even if you had purchased a stock like Wal-Mart or McDonald’s exactly one day before the crash of 1987, your investment would have soared more than 400% over the ensuing 10 years.

Or if you had purchased Amazon or Apple at the very peak of the dot-com mania of 2000, you still would have fared quite nicely over the next 10 years. Despite suffering immediate and enormous mark-to-market losses of more than 80% on both stocks, your investment in Amazon would have doubled over the next 10 years, while your investment in Apple would have soared more than 800%!

If you still held those positions today, you’d be sitting on a 1,500% gain on your Amazon stock and a gain of more than 3,700% on your Apple stock. And remember, those are the results you would have achieved from investing in these stocks at the very top of the dot-com mania.

Investing in winning companies is much more important than investing at the lowest levels of a bear market. That said, investors should not be careless about the prices they pay for stocks. Buying low is certainly better than buying high.

So one very easy way to avoid “top ticking” is to dollar cost average your investments that is, to invest over time. Instead of buying your position in a stock all at once, you would buy a fixed dollar amount of that stock every month until you had completed your intended investment.

That sort of discipline can be very helpful because it removes emotion from the equation.

No matter your personal risk tolerance, and no matter your investment time frame, corrections are never easy to endure. So be sure to establish a realistic investment program that anticipates short-term setbacks along the way to long-term success.

Good investing,

Eric