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Avoiding Big Losses Is Key To Investment Success

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
April 26, 2005

IN THIS ISSUE:

1.  Risks Are An Inherent Part Of Investing

2.  Recent Market Decline Illustrates These Risks

3.  Lesser-Known Investment Risks That We See

4.  How To Determine Your Own Risk Tolerance

5.  Take Our “Confidential Investor Profile” For Free

Introduction

The recent sharp drop in stock prices reminds us that there are always risks in the investment markets.  This week, I will discuss some of the obvious risks in stock market investing, but also several types of risk that many investors never think about.  So read this one carefully.  This is an educational E-Letter that you may want to share with your adult children and others.

There are many different types of risks involved in investing, and investors should only commit their hard-earned capital after they have identified all of the risks and are sure they are comfortable with them.  Unfortunately, many people invest in programs and strategies that tout the potential for high returns, but they frequently fail to fully evaluate the risks associated with those types of investments. 

Other investors follow the “herd instinct” investment strategy where they do what everyone else is doing.  That is exactly what happened in the mid-to-late 1990s when millions of investors decided to jump on the high-tech and dot.com bandwagon, only to see the Nasdaq plunge over 70% in the bear market that followed.

Unfortunately, many investors also followed the herd and bailed out of stocks near the bottom of the bear market and never got back in.  As a result, they missed the markets’ strong recovery in 2003 and 2004.  Following the herd instinct can lead to a double whammy.

Then there are investors who are so inundated with conflicting information that they get “analysis paralysis,” and simply do nothing and sit on the sidelines.  There is so much investment information out there today, and much of it is indeed contradictory, so it’s easy to be confused.  That’s why you need information you can trust.

In this week’s E-Letter, I will expand on the discussion of investment risk that I started in my April 5th E-Letter, and explain why I think this is the most important element to successful investing.  Avoiding large losses should be objective #1 for all investors.  I will also discuss some of the lesser-known risks of investing that you don’t often hear about.

At the end, I will tell you how to determine your own risk tolerance level (not everyone is the same).  I will give you access to our Confidential Investor Profile questionnaire that will allow you to determine your own personal risk tolerance level at no charge to you.

Recent Market Activity Showcases Risk

Stock market volatility so far this year has been brutal!  Take the Dow Jones, for example.  The Dow started the year near 11,000 and then plunged to below 10,400 by the end of January. Then it shot back up to near 11,000 again in February and March.  And in the last few weeks, we’ve seen the Dow plunge back down to near 10,400 again.  The Nasdaq was even worse – it’s been hammered over the same period.

As the market dropped earlier this month, the financial news shows were full of talking heads discussing how and why the stock markets were acting the way they did, and what investors should do about it.  From what I have observed, they had no idea how to answer either question, but that never keeps them from blathering on with opinions and advice.

No matter what the cause, the market’s recent action underscores the inherent risk of investing in the stock market.  It also shows the danger of the buy-and-hold strategy, especially one that recommends investing in unmanaged “index” mutual funds.  Sure, the markets will rebound eventually, but that will be of little consolation to investors who bailed out due to the recent high volatility.

In my April 5th, 2005 Forecasts & Trends E-Letter, I illustrated the relationship between losses and the amount of return you have to earn just to get back to where you started.  I received quite a response from readers indicating how this table opened their eyes to the risks they were taking.  Because evaluating risks and avoiding large losses is so important, I have reproduced that “break-even” table below:

Amount of Loss
Incurred

Return Required
To Break Even

 

 

10%

11.1%

15%

17.7%

20%

25.0%

25%

33.3%

30%

42.9%

35%

53.9%

40%

66.7%

45%

81.8%

50%

100.0%

60%

150.0%

70%

233.3%

 

To demonstrate the point of this table, the S&P 500 index plunged approximately 45% during the bear market of 2000-2002.  Buy-and-hold index fund investors who suffered that 45% decline will have to earn a total cumulative return of over 81%, just to get back to where they were in March of 2000.  Even though we are in the third year of recovery after the bear market, this lost ground has not yet been made up.  As of the end of March 2005, the S&P 500 was still over 16% below its peak. 

For Nasdaq investors, the situation is much worse.  Those who rode the market all the way down, over 70%, will require a return of over 233% just to get back to even, and the Nasdaq Index is nowhere near that point now.  This further illustrates that it is critical to avoid incurring large losses in the first place.  If you can keep losses to a minimum, then you spend less time having to make up for lost ground.

Uncommon Risks That You Face

I think we can all agree that your first priority in investing should be to avoid large losses.  The second thing you should know is that if you invest in the stock market using Wall Street’s “buy-and-hold” strategy – and if the market goes down you are certain to lose money.  As noted above, the S&P 500 Index lost approximately 45% in the bear market of 2000-2002, and the Nasdaq Index lost much more.

Since I assume that everyone reading this is well aware of the risk that the market can, and does, go down from time to time, I will focus on some of the other risks associated with investing that you may not have thought about.  Some are very basic risks, and some are esoteric, but all have an influence on investors’ behavior.  Some of the most frequently encountered “uncommon risks” in my experience include the following:

1.  Political Risk:  Whenever I write about politics, we always get responses from some readers who would prefer that I stick only to investment and economic topics.  The truth is that I write about political issues not only because it interests me so much, but also because politics can have such an impact on the economy and the investment markets.

In last week’s E-Letter, I discussed the downside risks of the unchecked spending by Congress and the Bush administration, and there are many other potential political risks out there.  In addition to running up huge deficits, politicians can and do pass laws and take other actions that directly influence the investment markets.

It is widely believed that the Great Depression was brought about by well-intentioned protectionist legislation that made an already bad situation a lot worse.  You might think that will never happen again, but as I pointed out in my March 8th E-Letter, our exploding trade deficit has some in Congress talking about new protectionist legislation.

Democratic Senator Charles Schumer of New York has already introduced a bill that would place a tariff on all Chinese goods until they agree to revalue their currency.  A recent editorial in USA Today by Democratic insiders James Carville and Paul Begala calls for Democrats to “…reform trade laws that encourage corporations to ship jobs overseas,” and “Above all, we should place middle-class jobs and middle-class values at the heart of our economic policy.”  Sounds like protectionist rhetoric to me.

Another political risk lies with the Federal Reserve.  The Fed Chairman and the Governors are political appointees.  The Fed’s decisions can move the markets in a variety of ways.  Obviously, the level of interest rates has a direct effect on the trends in the equity and bond markets.  Even mere comments spoken (or not spoken) by the Fed Chairman can move the markets abruptly.

Unfortunately, political risks will always be there; we can’t always know them in advance or eliminate them; and there will be times when they affect the investment markets negatively.  Having all of your money in a buy-and-hold investment strategy means you will lose money when politics sends the markets lower. 

Other risks, however, are more personal and controllable.  The remainder of my discussion will focus on these risks.

2.  Goal-Related Risks:  First century philosopher Seneca said, “If one does not know to which port one is sailing, no wind is favorable.”  Many investors have portfolios without a long-term plan, in that they are not geared toward meeting a pre-determined set of financial goals.  In my November 23, 2004 E-letter on the basics of financial planning, I discussed how setting specific goals is the very first step toward financial independence.  Unfortunately, there are many investors, including some experienced ones, who have not taken this first step.  As a result, they risk not investing appropriately.

Another goal-related risk is having goals that are totally unrealistic.  During the go-go 1990s, many investors believed that the stock markets would produce returns of 20% (or more) per year indefinitely, which was a part of the herd mentality back then.  In the late 1970s and early 80s, investors thought bank certificates of deposit and fixed annuities would always have double-digit yields.  As we know now, both assumptions were clearly wrong.

If your expectations for portfolio returns are too high, there is a very good chance your financial goals will not be met.  And more importantly, this can lead to saving too little money to meet your retirement goals.  Unfortunately, this can also lead to investing in securities and strategies that are far too risky in order to try to “juice” the returns.

Another goal related problem is taking too much risk when you don’t need to.  This is why it is so important to have a defined financial plan.  The flipside of investing too aggressively, and exposing yourself to large losses, is investing too conservatively and losing purchasing power to inflation, thus raising the odds of not meeting your investment goals and the risk of outliving your assets.  There are investors in both categories.

3.  Emotional Risks:  This type of risk is probably the one I have encountered most frequently in my 28 years in the investment business. Emotions on the part of investors are often irrational, so a clear, well-reasoned approach won’t necessarily seem like the best course – especially if large losses have occurred in the recent past.  In the discussion that follows, I will address three different emotional risks, and afterward point out the consequences that can come from them.

Most of the new clients that have come to me in the last few years lost a lot of money in the bear market of 2000-2002, when losses of 30-40-50% or more were common.  The first thing they usually say is that they want to “make it all back as fast as possible.”  Unfortunately, trying to recover large losses in a short period of time is a recipe for financial disaster.  As the break-even table above shows, coming back from a loss of 30-40-50% requires a very large return and all the risks associated with huge returns.  Coming back from such a loss can take years, and for older investors, it may never happen.

This underscores my point that objective #1 in any financial plan should be to avoid such large losses in the first place.

On the opposite side of this spectrum, we also hear from investors who lost big in the markets and will never, ever invest in equities again.  While large losses are traumatic, these investors should take time to see how they were invested and determine if a more reasoned approach to the markets might make more sense.  Stuffing money into a mattress or investing in CDs is not likely to build the nest egg they will need for a secure financial future.

With some investors, there is also the issue of “bragging rights” with their peers.  During the go-go 1990s, it became fashionable for many investors to brag about how their latest tech stocks were going through the roof.  Of course, you never heard much about their losers, which were many as we went through the bear market.  Some investors also get hooked on having the latest “trendy” investments in their portfolios, whatever they may be.  This can also be disastrous.

For example, “hedge funds” have been the rage in the last several years.  As with all alternative investments, there are some good hedge funds and there are plenty that are not good.  Many hedge funds incurred large losses in the bear market of 2000-2002.  All hedge funds and alternative investments have their own set of inherent risks and unfortunately, most investors are not qualified to assess those risks.

The consequence for investors who get caught up in emotional risks is that they make themselves vulnerable to another big risk of becoming prey for less than scrupulous investment operators.  There’s an old adage in the direct marketing business that says the two best sales approaches are fear and greed, both of which are strong emotional triggers. 

It is one of the big frustrations of my job to see so many investors who won’t agree to a well-diversified portfolio of investments, but will eagerly jump into an investment scam that promises the world but delivers disappointment.  Remember, if something sounds too good to be true…. just say no.

4.  Fee Risk: There are many well-known firms in the financial industry that continually preach that you should only invest in funds and products with the lowest fees.  They tout studies that show that, on the average, low-fee investments do just as well or better than those with higher fees.  The clear purpose is to move investors toward index-type funds that have low fees, but also have no protection from severe swings in the market.

To say that the average high-fee fund doesn’t do any better than index funds is like saying that on the average, pro baseball players don’t have any better batting averages than Little Leaguers.  If you average them all together, that may be true, but professional team managers and owners don’t worry about averages.  They go after those players who have shown the ability to beat the averages season after season, even though they cost a lot more money.

The same thing goes for the money management industry.  If you package all of them together, the average doesn’t look very impressive. However, there are some money managers and funds that have shown the ability to add value over and above their fees for many years.  Firms like mine spend lots of time and money searching out these managers and funds to offer to clients, and sophisticated clients will gladly pay higher fees where the manager or fund can be shown to add value.

In case you doubt me on this, look at the hedge fund industry.  This is an arena where only sophisticated, high-net-worth individuals can participate, and where some of the best money management talent in the world is located.  However, it is also where money management fees are far higher than those found in the mutual fund industry.

I am not saying that high fees automatically guarantee superior performance, since they do not.  What I am saying is that you should not automatically reject investment products just because they have higher fees.  Each investment must be analyzed in detail to determine if the manager or fund is adding value over and above the level of fees charged.

5.  Diversification Risk: We all know the risk of not being diversified.  However, there is an associated risk of thinking you are diversified when you are not.  Many investors believe that diversification means that you buy a lot of different mutual funds.  However, they frequently don’t look below the surface to see how the funds are invested.  We often receive statements from prospective clients whose existing portfolios show a number of different funds, all of which have the same core stock holdings.   That’s duplication, not diversification.

Another diversification-related risk is not being diversified among the various investment strategies.  Since the “Modern Portfolio Theory” of investing has become so popular over the last 10-15 years, most investors know that they should diversify among the various asset classes such as large cap stocks, small cap stocks, bonds, international, etc.  However, very little is said about diversifying among the various investment strategies

Buy-and-hold is still the conventional strategy, even though it’s a guaranteed loser in a bear market.  If you have read this E-Letter for long, you know that I prefer “active” or “tactical” investment management strategies, and in particular those that have the flexibility to move out of the market and/or “hedge” their positions if market conditions turn ugly.

In short, the buy-and-hold mantra has been pounded into investors’ consciousness by mutual fund families and brokerage firms largely because it is in their best interests to do so.  Yet, there are other valid investment strategies that should also be part of your overall portfolio.

6.  Relationship (Trust) Risk: This one bothers me the most because it can be so devastating to future working relationships with clients.  Many times we have investors come to us as clients who have had bad experiences with prior Advisors or brokers.  When we inquire about their prior experience, they usually say that they trusted this person to do what was right for them.

As discussed above, most mutual fund families and large brokerage firms tout the buy-and-hold strategy, which is a guaranteed loser in a bear market.  Aside from that, the financial services industry has its share of unscrupulous brokers and Advisors who will take a client’s money and invest it where it generates the biggest commission, rather than what is most suitable for the client.  And others their clients into the latest “hot” investments (which typically lose a lot when they go cold) even if they are not suitable for the client.

Since many investors are not familiar with the markets or terms like asset allocation, risk tolerance, etc., they place their trust in someone they think will do what is best for them.  Sadly, this trust is often misplaced.

Quality Investment Advisors won’t operate solely on the trust of their clients.  Instead, they strive to determine the appropriate financial goals and risk tolerance for every client, and then insist that the client understands them as well.  You should insist on nothing less when seeking professional management of your money.

How To Determine Your Risk Tolerance

There are a number of ways to determine your personal risk tolerance.  Some Advisors use face-to-face conversations to get a feel for how conservative or aggressive a client may be.  Others use extensive questionnaires that ask a variety of investment-related questions.  Most, however, use a combination approach like we do at my company. 

One of the first things we do is have the investor complete a confidential questionnaire that provides a profile of his/her investment goals, expectations and risk tolerance.  Our questionnaire is specifically designed to ask certain questions in different ways in order to help us be more certain about the investor’s experience, objectives and risk tolerance.

In our conversations with the investor, we discuss any similar questions that were answered differently, or if there are “disconnects” between one answer and another.  Once we have this information, we use sophisticated software that evaluates the answers and produces a risk tolerance score.  It is this combination of discussions and the questionnaire results that allows us to make suitable investment recommendations to our clients.

Interestingly, many investors who come to us are surprised when we tell them their risk tolerance score.  Some find that they are really more conservative than they thought, while others find that they are more aggressive than they thought.  Most find that their old investment strategy did NOT match their risk tolerance level, one way or the other.

Many of you reading this have never had your risk tolerance level evaluated professionally.  As you will read in the following section, I will tell you how you can take our confidential investment questionnaire to get your own risk tolerance score, with absolutely no cost or obligation.  You might be very surprised.

Conclusion

By now, I hope you have a better appreciation for the variety of risks that can and do influence your investments.  I have discussed risks that you can’t do anything about, such as market risk and political risk, as well as a number of risks that are under your control.

Clint Eastwood is famous for saying, “A man’s gotta know his limitations.”  The same is true of investors, so the first step in managing risks is to determine your own risk tolerance. 

There are a number of websites on the Internet that offer free risk tolerance analysis, but I do not recommend them.  The biggest risk of using Internet questionnaires is that you never know where your personal information will go from there.  And, as I said above, a combination of one-on-one discussions AND the questionnaire results is the best way to go.

For those of you concerned about the privacy of your personal information, go to my website and download our Confidential Investor Profile.   We have a very strict, public privacy policy at my company to protect your personal information: My company will never sell, rent, give or otherwise make your personal information available to any other company or organization.  We never have, and we never will.

Simply CLICK HERE and you will go directly to our Confidential Investor Profile.  You can complete the questionnaire and send it to us (fax 512-263-3459 or mail).  When we receive your completed questionnaire, we will give you a no-obligation analysis of your answers.  Of course, we would love to talk with you at length about your investments, but if you only want your risk tolerance score, that’s your call.  We don’t hassle anyone!

So, I invite you to take the Confidential Investor Profile free of charge and with no obligation.  You may be surprised at how you score, and it will be valuable information for you to have.  If you have questions about how to complete the questionnaire, or would like to talk to one of our experienced Investor Representatives about how your current portfolio is invested, give us a call at 1-800-348-3601, or e-mail us at mail@profutures.com

Very best regards,

Gary D. Halbert

 

SPECIAL ARTICLES

Hillary in trouble over fund-raising scandal.
http://www.nypost.com/postopinion/opedcolumnists/45233.htm

Democrats should learn from Tony Blair.
http://www.nytimes.com/2005/04/22/opinion/22friedman.html?

An IRS cover-up in the Clinton era.
http://www.opinionjournal.com/editorial/feature.html?id=110006594


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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