FSO Editorials: "Learning How Not to Lose Money" by Robert B. Gordon 12/24/2002

Learning How Not to Lose Money
by Robert B. Gordon, Sc. D.
December 24, 2002

There are literally thousand of books on how to get rich from stocks and more keep coming despite our severe bear market. I get volumes of junk mail almost daily from the "get rich quick and easy" crowd. There always have been, and no doubt always will be, those eager to profit at my expense. I have yet to read anything claiming to help investors not to lose their money in the many ways that are always available. Have you?

The world’s master investor over recent decades, Warren Buffett, has publicized his two rules of investing:

How does one learn not to lose money? New investors of all ages do not need most of the so-called expert information that floods their eyes and ears almost daily. They do need some specific step-by-step suggestions on how to enter the market with the odds of success on their side. That is what we plan to do in this essay which will depart in some important respects from our earlier essays on investing.

From the many, many hundreds of e-mails I have received in the past year, I have been inspired to continue writing. Readers of both sexes, young and old, are literally crying for objective advice they can believe. The need is enormous. I made a small attempt to help a few really unfortunate individuals in my essay titled "Nowhere To Go for Wise Advice". In this essay we will attempt to start from ground zero and build a base of information which investors in many circumstances can adapt to suit their individual needs.

It would be impossible for any novice investor to start today with less knowledge than I possessed in 1940 when I walked into a broker’s office and bought four common stocks. In growing up during the 1929 boom and crash era, none of my extended family owned any stocks or bonds. The subject of investing was never mentioned. Of course in the Great Depression years there was no extra cash to invest.

My years of college education in engineering and science had given me no information or insights into the mysteries of the stock market. I do not remember the information source for my first stock selections, but I did pick four quite different industries for my first portfolio. I picked them without help from any other person, a practice I continue to follow to this day.

I was totally unaware of the overall stock market status in 1940. I did not know that the Dow average was in a "stealth" bear market, with its level dropping from a high of 200 in 1937 to a low of 100 in 1942. I cannot recall any attempt to read about investing or the history of the U.S. stock market. But I did have one considerable but unrecognized advantage. I had not acquired a lot of the then conventional "wisdom" about investing. At the present time, the biggest hurdle for a new investor is to unload most if not all of the knowledge already acquired. This is especially true for all investors who started investing in the 1982-2000 bull market mania. We present below some examples of current "market wisdom" to be completely erased from your thinking or to be drastically altered to suit a big bear market.

The market always goes up - but hardly ever for a mortal investor. It is true that large institutions have enjoyed positive returns over the past three centuries but even for them there is no certainty for the current century. There is absolutely no historic basis for believing that the market will always go up over any one human lifetime.

In the 20th century there were approximately 3 bull markets and 3 bear markets, averaging about 17 years each. Investors lucky enough to start investing at a major bottom and to end at a major top would probably have made money. But anyone starting near a top and ending near a bottom would have fared poorly. Wall Street’s seductive advertising is always capable of finding and publicizing how a mythical investor might have done well. But the chances of an average unsophisticated investor doing well over his or her lifetime are not very favorable.

Dollar cost averaging is a sure bet. Illustrations of the benefits typically start purchases at a high point, continue thru a few years of price declines and recovery and then end at the starting price. In this example the average purchase price is reduced and some profits are assured. But, with almost all other price patterns, the results will be inferior. If the price continues up, a lump sum single purchase would be better. If the price were to continue down indefinitely as today, the losses would continue to mount and eventual prompt selling at a huge loss.

Broad diversification improves performance. This is either true or false depending on the asset classes involved. This might be true in a bull market depending on the specific assets chosen. But in a broad bear market it is rarely beneficial, since nearly all securities are falling in price. Only careful selection of the few asset classes expected to gain in a bear market will prove to be beneficial. Right now there are just two such equity classes, short mutual funds and precious metals.

Past performance can predict the future. This is utterly useless right now for any time period over 3 years. Mutual funds like to advertise their ten-year performance since that is the only one with a significant positive gain right now. Good performance in the past bull market does not carry over into the current bear market. We are in a new "ball game".

Market timing does not work. This is a big fat lie. The ability to time both short and long market cycles is what separates successful from unsuccessful investors. In several previous essays, we have given examples of simple moving average techniques that do a great job. Many mutual funds have put up barriers to discourage trading. But the growing number of exchange-traded funds (ETFs), that trade like stocks, provides an easy way to trade whenever needed.

Elliott Wave timing can be a great help to both new and experienced investors when the strengths and limitations of the method are fully understood. We have discussed the use of Elliott Wave techniques in many prior essays. New readers should scan the titles in my archive at www.freebuck.com and read further on this important subject.

Let us rebalance your portfolio. This common mutual fund sales gimmick is usually just another way to diversify into more slightly different asset classes. It will have negligible benefits in a bear market environment. However, periodic re-balancing the assets in an intelligently selected bear portfolio (as described in several of our essays) can improve the probability of success over time.

Buy the stocks you know best. These oft-repeated words of a well-known fund executive are usually given along with other platitudes like "the market always goes up". Buying any one stock on the basis of familiarity with its products is probably about as effective as throwing a dart into the stock page. Evaluation of individual stocks is best left to those few professionals who seem to know how to do it. We much prefer to buy mutual funds whose assets are carefully chosen for the current and expected market conditions.

Asset allocation at various ages. Conventional wisdom advises investors to be quite speculative in their youth and very conservative in their old age. My full 62 years of experience says that this so-called wisdom is based on a major fallacy. The proper answer is that asset allocation should be based on your level of investing skill and experience, not on your calendar age. In my carefully considered opinion, an investor should be very conservative until he or she learns to handle their assets capably. From that point on, investors should decide how they wish to manage the risk level of their assets for the rest of their life. We will discuss this type of life plan in detail later in this essay.

Before starting to develop an investment program, a prospective investor has to do four things:

None of these tasks are simple or easy, but they may be doable after reading this essay. We will start by listing some typical problems for any investor of moderate means:

We are now near the end of the third year of what is already a severe bear market with the prospect of at least several more years of decline to some sort of an initial bottom. We then foresee many years of market underperformance before a new bull market arises.

The fact that the future is not bright should not discourage any investor. It should strengthen their resolve to manage their assets and learn by experience how to do it well. Learning how to invest during a bear market will teach lessons that will greatly enhance the chances of long term success. For those investors who started in the late bull market and whose experience was unsatisfactory, we will suggest a way to wipe the slate clean and make a fresh start.

We will now present our suggestions in chronological order for building a successful lifelong investment program. The required steps are identical for neophytes and for all investors wanting to make a new start

For investors subscribing to the Elliott Wave International services, determining where we are now, where we came from and where we are going is quite straightforward. For others it may mean going to a library and viewing old stock market charts. But for everyone with a serious interest there is much information freely available on expert Internet web sites such as: prudentbear.com, financialsense.com, freebuck.com, safehaven.com and cross-currents.net.

Since our market climate is now relatively well known for some years ahead, we will consider only the current bear market environment in our later remarks. However, younger readers and the children and grandchildren of others need to remember that financial markets are seldom static. Having up-to-date information on the stock market’s immediate past and present is a prerequisite for successful life-long investing.

Selecting asset classes that are the best available for the current and expected market environment is the most important step for successful investing. We will list some asset classes that may be useful in a bear market environment:

Fixed Dollar instruments:
Money Market funds holding 100% U.S. Treasury bills
Certificates of Deposit in a bank rated A+ or A by www.weissratings.com
Short to Medium Maturity Government Bonds:
U.S. Treasury notes and bonds
Foreign Government bonds in their currencies
Mutual funds specializing in the above.

Precious Metals:
Gold and Silver coins or bullion
Precious metals mutual funds
Gold and silver mining stocks

Short Mutual Funds:
Fully managed funds
Reverse index funds
Leveraged reverse short index funds

Tangible Asset Stocks:
Coal and oil resources
Timberland resources
Prime Real Estate

Many of the fourteen sub-asset classes can be broken down even further. A large portfolio should consider holding most if not all of them. A very small portfolio could be started with just two of the classes.

Please notice what is missing from the above list, practically everything being heavily advised for sale by the Wall Street establishment - all past and prospective losers in the bear market. They continue to promote dividend-paying blue chips, small caps etc., asset classes which have much further to drop in this big bear market. Read what the masses are now being sold according to a recent e-mail from Zacks:

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In this section, we will suggest a basic framework for creating and managing one or more portfolios planned NOT TO LOSE in the long run. The "secret" is based on my firm belief that investors can and should learn to be their own investment advisor. In my proposed "learning not to lose" method, the investors cannot fire themselves, but must stick with the job until they have become a confident and successful investor.

Here are the steps required to learn how to invest safely for the long term. Follow these steps faithfully for a number of years and you will end up with a number of portfolios with a high probability of making, not losing money. It is impossible to guarantee success but each investor will learn through their own efforts which portfolio combination(s) are gaining and not losing. Then by a simple process of retaining the best portfolio(s) and selling any under performers, the investor ends up owning 100% winning portfolios:

The simple process described above in step 3 is called portfolio rebalancing and is the subject of several of my previous essays which contain some very concrete examples of its advantages in the long run. I am sure that some readers, who have been investing for many years, will see little value in my simple suggestion. Their problem may well be that they expect investing to be complex and difficult but in principle it can be very simple. Think of how Warren Buffett accumulates his billions - by buying profitable companies at the right price and letting them grow. We propose to profit by buying the right assets for this market and letting them grow. A number of portfolio examples will explain the broad possibilities.

From our view of the foreseeable future stated earlier, we are presenting these portfolios to conserve assets with moderate growth for the balance of the current bear market leg which is expected to continue into 2004 and perhaps longer. Elliott Wave experts predict the full bear market may last for decades with intermittent rally phases that may appear as new bull markets.

Each of the four example portfolios use minor positions in precious metals and short funds. When either or both of these volatile sectors show indications of poor performance, then it will be time to re-allocate assets. We have deliberately allocated high percentages to the stable MM and bond sectors to provide a stable core that will help the portfolios weather normal market volatility. The suggested program of rebalancing of assets will further promote stable returns.

A Small MM/Bond Portfolio
     50% U.S. Treasury Money Market fund
     25% U.S. Treasury Short/Medium bond fund
     25% Foreign Government

This portfolio will be quite stable and will be in a protected hedge from any future decline in the U.S. currency relative to others. The prices of the bond funds may drop somewhat if interest rates rise but any such effect will be minimized by the periodic recommended rebalancing process. Under these circumstance, money would be switched from the MM to the bond fund(s) and provide higher growth. During any future rally in the price of either bond fund, rebalancing transfers would go the other way, returning money to the MM funds.

A Small Precious Metal Portfolio
     70% U.S. Treasury Money Market fund
     15% gold coins or bullion
     15% silver coins or bullion

This portfolio could be started with a $1,000 MM purchase and a trip to the local coin shop and purchase of a number of small coins with no numismatic value. The value of the coins will surely be volatile, which is why we suggest a small percentage to start for a new investor. This portfolio would be a relatively safe way to learn about the great volatility of gold and silver. Over any two year period there would be at least several re-balancing opportunities that could contribute to the final growth. This is the result of transferring profits from the gold and silver to the safety of the MM fund when their prices are high and, when their prices dip at some future time, transferring dollars back from the MM. The rebalancing does not always improve the growth but it always provides stability and peace of mind in volatile times.

A Bond/Precious Metal Portfolio
     30% U.S. Treasury short/medium bond fund
     30% Foreign Government
     25% Gold and Silver coins or bullion
     15% Precious Metals mutual fund

This portfolio combines stable income from the bonds with volatile growth possibilities from the precious metals. We use the 60/40 ratio just as an example. Every investor should set the ratio at a comfortable level, going as high as 90/10 for risk averse investors.

A MM/Short Fund Portfolio
     80% U.S. Treasury Money Market fund
     10% Reverse Index short fund
     10% Fully managed short fund

In this portfolio, we chose to balance the short bear funds with a large percentage of a fixed dollar MM fund for a first time investor. The short funds will produce gains for the duration of the bear market period that will be transferred periodically to the MM fund during each rebalancing. Thus, the portfolio assets will be better able to weather periodic bear market rallies.

The greatest value to new investors will come from building and managing a number of small portfolios, each containing only two major asset classes. After several years of periodic rebalancing as described above, the bear market performance of each major asset category will have become quite apparent. All that is required is to keep simple records of the total value of each portfolio several times a year. Once the investor has the real performance data, it is a simple matter to determine which portfolios to keep and which to modify or discontinue.

I recommend that investors, new and old, start the practice of creating automated computer portfolios as available on AOL, MSN and other web programs. Once set up in a process taking only a few minutes, these portfolios are automatically updated with each day’s prices.

Simple portfolios such as suggested above form an important part of a serious learning process so that new investors will get a good understanding of the price volatility and relative market performance of each major and minor asset class. Once these lessons are learned, there is no special value in keeping them separated. Experienced investors can start with a single portfolio incorporating as many of the recommended asset classes as desired.

Any investors who have survived the first 3 years of this bear market, know that there is no such thing as a guaranteed "no loser". However based on their past and expected future bear performance, we can specify composition ranges for a large diversified portfolio with three very desirable characteristics:

1. A positive probability of growth continuing as it has in the bear market to date.
2. The definite prospect of more stable growth from use of periodic rebalancing.
3. The potential to meet unanticipated events through portfolio modifications.

Here is a portfolio structure that could accommodate moderate to sizable assets:

A Stable Diversified Portfolio
     20% U.S. Treasury MM fund
     20% U.S. Treasury short/medium bond fund
     20% Foreign Government
       5% Gold and Silver coins or bullion
       5% Gold and Silver mining stocks
       5% Precious Metals mutual fund
       5% Fully managed short mutual fund
       5% Reverse S&P index fund
       5% Reverse Nasdaq index fund
       5% High Yield Oil/Gas resource stock
       5% High Yield Timberland REIT stock

A portfolio along the above lines could be started with moderate dollars and increased as the investor gains experience and confidence. Five of the eleven asset classes will provide dividend income while the others will provide gains from precious metals and short positions. We consider the 60% in bonds and MM to be a "middle of the road" position to be altered as each investor considers his or her individual risk tolerance.

Using representative stocks and mutual funds, we determined the performance of this portfolio from 3/20/00 to 12/20/02 as tabulated below:

Asset Class	Total Return (%)	Weighted Return (%)
U.S. Treasury MM Fund	4.0	0.80
U.S. Treasury Bond Fund	11.9	2.38
Foreign Govt. Bond Fund	6.6	1.32
Gold & Silver Bullion Fund	11.2	0.56
Closed End Gold Stock Fund	139.2	6.96
Open End Precious Metals Funds	117.9	5.89
Fully Managed Short Fund	122.1	6.10
Reverse S & P 500 Short Fund	62.1	3.10
Reverse Nasdaq Short Fund	123.8	6.19
Oil & Gas Natural Resource Stock	18.6	0.93
Timberland REIT Stock	6.7	0.33
Total Portfolio		34.56%

Note: The above data is from our FastTrack database (go to www.fasttrack.net for info.)

Although, the future is unknown, this carefully balanced asset mix should continue to do well and probably much better than any hit or miss approach. It holds representative members of every asset class believed to have merit for the duration of this bear market. As in the earlier examples, this portfolio should have its assets rebalanced periodically to prevent the large gainers from assuming a disproportionate role. This process is the key to protecting the portfolio from larger losses when the more volatile elements are losing price, not gaining.

In previous essays, we have provided further information on gold, short funds, foreign government bond funds and REITs. From our archive, select essays with titles describing these asset classes. On the web, bearmarketcentral.com provides a daily price listing of short mutual funds. Yahoo, Morningstar and Quicken provide price charts and fundamental data on both stocks and funds. Sometimes, typing the full fund or stock name or asset class in the google.com search engine brings some surprisingly good information sources.

We appreciate your e-mails and will try our best to answer general questions. We are not licensed to give investment advice and cannot respond to specific questions about stocks or funds. Our goal in all of our essays is to help you to become a proficient and happy investor. We wish all a Happy Holiday Season and a bright and successful New Year.