Investing 101
The First Step
Decide what asset classes are in your comfort zone.
What does that mean?
Peter Lynch, the legendary manager of the Fidelity Magellan Fund said this a long time ago: "Stock markets sometimes decline. If you do not understand that is going to happen, then you will not do well in the stock market".
That means that if you’re going to start contemplating suicide when your stock portfolio loses fifty percent of its value, then stocks are NOT in your comfort zone.
How frequently does the market lose fifty percent of its value?
In October 1929 the DOW fell about 16% from its high. During the depression that followed the DOW continued to lose value until it bottomed out in 1932. At that point the DOW had lost 90% of its value.
The market took twenty-two more years to get back to its 1929 high.
But that’s ancient history and things like that don’t happen anymore, right?
The Japanese Nikkei crashed in 1989 and lost 75% of its value – More than twenty years have gone by and the Nikkei has not yet recovered HALF its 1989 value. And that’s without considering the ravages of inflation.
During the US bear market of 1972 to 1974 the S&P 500 lost 44% of its value.
During the three-year bear market that ended in the last half of 2003, the S&P 500 lost more than 40% of its value. The NASDAQ 100 lost more than 80% of its value.
During the bear market that bottomed out in March 2009, the S&P 500 lost 56.8% from its peak on October 9, 2007 to its low on March 9, 2009. Most other global markets lost considerably more.
If you can honestly say that you are financially and psychologically able to deal with declines like that, then stocks are an appropriate asset class for you. But let’s be honest about this. What were you doing at the end of a typical bear market?
Some investors were in denial and refused to even look at their portfolios.
Some investors looked at their portfolios, but didn’t do anything.
Some investors panicked and sold at or near the bottom.
Some investors were buying at or near the bottom.
Once again: What were you doing?
If you were buying at or near the bottom, then chances are pretty good that:
You had a strategy
You had the discipline AND the money to implement your strategy
If you were NOT buying at or near the bottom, then the information that follows may be of interest.
Before I continue, I’d like to mention one other point: Sun Tzu, a Chinese general, wrote The Art of War almost three thousand years ago. His book is still studied by military strategists today. Sun Tzu wrote:
"If you know your enemy and if you know yourself, you need not fear the result of a hundred battles."
That’s good advice.
So, how much in stock?
And, how much in bonds?
There are many ways of answering those questions, but I’m going to help answer them by asking another one:
How much of a loss can you tolerate before you panic and run?
That’s a tough one to answer. I am fond of saying that you will never know your limits until you exceed them. None of us are teenagers so I am going to assume that you have exceeded your limits once or twice in the past. That makes it possible to answer the question. Not easy, but at least possible.
Once again, how much of a loss can you tolerate before you panic and run?
Determine the net worth of all your liquid assets. That includes stocks, bonds, and cash in taxable and tax deferred accounts, but NOT your house or any other illiquid assets.
Let’s assume your liquid assets total an even One Million Dollars. It is important to put a dollar value on the total amount because you should be asking yourself how much, in dollars, you could lose before you panic and freeze, or worse, panic and run.
If we were twenty or thirty years old then it would not be possible to answer that question with assurance. But most of us are on the wrong side of fifty or sixty, and many of us are retired. That means it has taken a lifetime to accumulate one million dollars and it means we should have a pretty good idea how we would feel if we lost one or two or three hundred thousand dollars. It also means we do NOT have a great deal of time or energy to recover from a disaster.
Let’s play a little game: Think about a loss, in dollar terms, that you could handle. File it away in your memory banks. Write it down if you don’t trust your memory.
Let us assume we have carefully thought about the question and examined the financial and psychological consequences of losing “X” amount of dollars. Let us assume that we have decided that we could tolerate a loss of $250,000.
Even though the US dollar lost about ninety percent of its value during my lifetime, two hundred fifty thousand dollars is still an enormous amount of money. According to the US Census Bureau, the median net worth of a non-Hispanic White household in 2000 was $79,400. And that includes home equity. Median net worth was $7,500 for Black households and $9,750 for Hispanic households.
Regardless, if you have decided that you can tolerate a loss of $250,000 and if you recognize that the US stock market more or less regularly loses almost 50% of its value, then you should own no more than $500,000 worth of stock.
Is everyone with me on that?
Let’s review:
Your net worth is $1,000,000
You own $500,000 worth of stock and the market loses 50% of its value, which it more or less does on a regular basis.
Your net worth has been reduced by $250,000 or, in percentage terms, 25%.
That is an enormous reduction.
What are you going to do now?
Option 1. Refuse to look at your portfolio.
Option 2. Panic and run.
Option 3. Buy more stock.
If you chose not to look at your portfolio or, even worse, chose to panic and run, then it should be pretty obvious that you are not psychologically equipped to own stock.
Know your enemy - Know yourself
If you know yourself well enough to recognize that you are not psychologically equipped to successfully own stock, then that is an extremely important epiphany. You could restrict yourself to fixed income assets or you could hire a professional. The problem with hiring a professional is that the fees professionals charge will generally negate the advantage of a stock portfolio. Think about that last statement carefully. It is extremely important so I am going to repeat it: The fees professionals charge will generally negate the advantage of a stock portfolio. If you cannot remember that, then write it down and paste it on your bathroom mirror.
Regardless, after all this some of us may still want to own stocks because, after all, we have been told, over and over, that stocks return more than anything else. If you still want to own stock, then go to the Asset Allocation page for a few simple portfolios that are almost impossible to beat.