FSO Editorials: Three Steps to Investment Success by Robert B. Gordon 01/05/2004

Three Steps to Investment Success
For Novice and Discouraged Investors
by Robert B. Gordon, Sc. D.
January 5, 2004

In this essay we will try to counter some of the prevailing "wisdom" that is preventing literally millions of investors from realizing their goals. It is extremely important for investors at all experience levels to unlearn almost everything being taught by Wall Street "experts" and nearly all mutual fund advertising.

Investors, young and old, are still being deluged with "buy and hold" propaganda irrespective of whether the market is bullish or bearish. Unless this critical information is available at the start, novice and experienced investors will end up in the wrong asset classes. With the current prospect of another huge leg down in this bear market, handing money to a fund or advisor that did well only in the bull market would be a tragic mistake.

Beware of the traditional recommendation to diversify, diversify. It may have worked for 20 years in the bull market. But, loading up on small caps, large caps, value and growth stocks caused huge losses in 2001 and 2002. If this bear market lasts for 20 years or more, as some experts predict, broad diversification will have disastrous results. Selection of those few special asset classes expected to rise is the only sure way to investment success.

How can an individual investor keep abreast of the huge bull and bear market swings? It will not come from watching CNBC or reading your daily newspaper. Serious investors who need to have their assets grow in all market environments can best follow the market pulse by following the advice of expert web pages such as www.financialsense.com.

Once an investor of any experience level understands the long term market climate, the job of selecting appropriate asset classes is of prime importance. We have devoted much effort over recent months to defining the very limited number of bear market asset classes available to investors. We have presented and discussed a number of portfolios, both small and large, to illustrate successful bear market investing. In the main part of this essay that follows we are going to stress the use of very simple portfolios to encourage their use in a planned program of education for all investors who are ready to learn.

We urge all investors who realize they need help, to erase from their minds all of the erroneous information they have acquired to date and replace it with lessons learned from someone who survived the last serious bear market in 1972-75 where some big name mutual funds lost 75% or more. And that event will rank eventually as a small bear cub alongside the huge grizzly that lies ahead.

John Riley of Cornerstone advisors has just released his December 30 comments. We reproduce below a part of his report to investors:

This past year was a gift for investors. But it will not last. As the realities of the economy and overvaluation of the market become known and factored into the markets, the bear market will likely resume. The next leg down could be worse than the previous declines. Why? It’s simple. Wall Street and their brokers are putting investors at more risk than ever before. Let me explain.

Market fundamentals (p/e, yield, price/book…) are not much better than they were in the first quarter of 2000, when the market saw extreme overvaluation numbers. Normally, markets bottom when these valuation numbers have declined by 75% or more. This hasn’t happened - yet. But with valuations so out of whack and a bear market fresh in their minds, you would think Wall Street would want to protect their clients and investors would be cautious about jumping back in. They are not. Bull/bear surveys show the highest ratios ever according to some studies, even higher than just before the crash in 1987. And bullish percent indices are at their peaks for every major average. Higher than the peak in January 2000. Investors are blindly buying this market with more enthusiasm than ever before, based on worse fundamentals than before. This doesn’t add up to a protracted bull market. It is a recipe for disaster.

Fool me once, Shame on you, Fool me twice… If I have heard it once, I’ve heard it a thousand times, investors saying that if only their broker had told them about the market risks back in 1999, they would have protected themselves. They would have sold their stocks and repositioned themselves to take advantage of the bear market. And then they usually follow it up with, "I won’t let that happen again." well here we are again, but this time, the bubbles are worse, the economy is in tougher shape, the risks are higher and what are most brokers saying? They are saying the same thing they said in 1999. They’re saying the same thing they said all the way down - "The market is going higher; don’t worry, it’ll come back; we’re in it for the long run…"

When was the last time they anticipated a decline? Wall Street strategists are collectively re-assuring investors that they don’t anticipate a return of the bear market or even a moderate market decline. When was the last time they did expect the market to decline and told anybody? They sure missed the 1999 – 2000 top. Remember, most brokers didn’t anticipate the bear the last time. They didn’t recognize it when it arrived. They didn’t know what to do when it took hold of the markets. What is different this time? Have brokers all-of-a-sudden learned how to recognize the signs of a bear market? What have brokers learned over the past few years? Wall Street hasn’t prepared brokers for an over-valued market. They still discourage alternative investments. They still tout over-valued stocks as "good buys." You can’t say you weren’t warned this time. It just wasn’t by Wall Street or CNBC. They still believe the company line and are pushing a "new bull market". To keep from getting caught in the bear’s grasp again, investors first need to eliminate any emotion in their thinking

I have no personal grudge against commission or fee-based brokers and certified financial advisors but, based on the information I receive from reader e-mails, it appears that no more than 1 in 100 are qualified to give sound bear market advice to helpless investors. I receive e-mails from a small handful of bearish advisors spread across our country from California to Connecticut who tell me they are the only "bear" in their office and are isolated from the others who think they are crazy.

Due to their very small number, the chance for one of our readers of finding a qualified advisor who can do well in a bear market is very small and hardly worth the much greater risk of taking advice from one of the 99% bulls.

The problem exists since nearly all such professionals received their training and experience during the years of the long bull market and have not changed their minds and actions to meet the new challenges of a severe bear market. Using any advisor who is so badly informed could lead to heavy losses in the future. But, literally millions of investors have never made any investment decision on their own and are terrified at the very thought of doing it. I am writing this essay especially to reach such individuals and help them make a first small step on their own.

I have received e-mails from hundreds of readers requesting the names of bearish fee-based advisors. My answers are completely impartial and in most cases are without any knowledge of the amount of money involved. Typically, the investor disclaims any ability to manage their own money. This is a very regrettable situation since the investor will never have a basis for grading the performance of the advisor. Hence, when I am told that the assets run into sizable six figures, I usually suggest the assets be split between two advisors so there can be a comparison of results. In several cases, I have had younger people request help in managing estates that run well into seven figures- an extremely challenging responsibility. These experiences have led me to make a new recommendation to all readers, regardless of their current wealth.

You surely didn’t learn to invest in high school or college. You probably were not taught by your father or an uncle or a friend of the family. No doubt you have been told for years by brokers and mutual fund spokesman to leave the details to them, just send your money. But would you believe that most of these "experts" have probably not learned the very important first lesson of investing - when to buy and when to sell or when the major market cycles are favorable or unfavorable. Right now, 99% of investors and analysts are bullish at a time when a severe bear market is about to resume. It is essential for my readers to know that the majority is always wrong at major turning points. Never forget that fact!

Regardless of your age, education level or prior experience, every adult reader of my essays should have at least a tiny part of their assets in a simple, easy to manage mutual fund portfolio like the examples given later. There are so many obvious reasons for doing this. In my mind, it is much more important than being computer literate although that ability will surely help a do-it-yourself investor.

1. Bonds are in a bull market when interest rates are declining.
2. Bonds are in a bear market when interest rates are rising.
3. Stocks rise in a favorable bull market climate.
4. Stocks fall in an unfavorable bear market climate.
5. In the last century there were 3 stock bull markets of about 17 years,
6. In the last century there were 3 stock bear markets of about 17 years
7. Most stocks rise in a bull market and fall in a bear market.
8. Only a few special asset classes rise in a major bear market.
9. Knowing when the stock and bond cycles change is very important.
10. Cycle changes can be forecast in advance by the Elliott Wave Principle whose 70 year history is known by only a tiny percent of investors.

We are going to present three teaching portfolios aimed at building confidence and a feeling of success in any investor who is now frustrated or discouraged. They can be built and managed in sequence over a period of years or two or three portfolios can be run in parallel to gain experience much faster. Really serious investors can learn at a surprising rate by simply watching the weekly and monthly price changes of the different asset classes. Watching the market action of four asset classes will teach much more than watching only two.

First, we will list the principle asset classes we favor for use in a long and severe bear market. Those listed under the Stable Assets category are believed to be most likely to provide a positive gain while those listed under Volatile Assets are believed to have a long term positive trend plus shorter term swings over and below the trend line.

Stable Assets	Volatile Assets
US Treasury MM Funds	Precious Metals Stocks/Funds
US Treasury Bond Funds	Selected Energy Stocks/Funds
Foreign Government Bond Funds	Selected REIT Stocks/Funds
Foreign Government Bond Fund + Gold PSAFX	Fully Managed, Short fund + Gold BEARX
Hedged Income Fund HSTRX	Short Stock S&P Indext Fund
Fully Hedged Stock Fund HSGFX	Short Stock NASDAQ Fund
	Short 30-Year Bond Fund RYJUX

Five of the 13 classes, named above, are believed to be unique (only one fund in it’s class) but it is important for each investor to select the others from the large amount of information available on internet web pages like Bloomberg, Quicken, Morningstar, Yahoo and Zack.

There are quite a few sub asset classes within the categories listed above. For example in large portfolios, we expand precious metals to include gold and silver bullion, gold and silver stocks and small and large mutual funds. Among bond funds we can choose different maturities. Because the unique funds given above are so useful, especially to new or nervous investors, we will use just four of them in our three ultra-safe teaching portfolio examples.

Confidence comes to investors who choose asset classes for their ability to provide gains over time in the anticipated market climate. This confidence then builds over time as the portfolio’s actual action in the market fulfills the expectations. We have now run many paper trials of various portfolios which have performed exactly as expected over the past 3 bear market years.

We know very well from our e-mails that many investors are discouraged by losses in the past and are very nervous and reluctant to risk any of their assets. Or, they write about their parents or their children or their relatives, who are afraid to take even one ultra conservative step into a volatile market. We also know there are many potential investors on the sidelines who need a little help in getting started. To help them gain confidence we recommend they start with a two fund Portfolio #1 described below, both funds being managed by a brilliant manager and designed to use hedging to prevent any losses in down markets. I own both of these funds and have recommended them highly as soon as I discovered them six months ago.

The most unusual thing about these two mutual funds is that they were designed over three years ago to be "the only two funds you will every need", the exact words printed in their prospectus. They were developed and are managed by a very bright Ph.D., John Hussman, who placed his name on both new funds. The Hussman Strategic Total Return fund HSTRX can hold various kinds of bonds and dividend paying stocks plus Foreign bonds and gold. It has the ability to hedge its portfolio by 30% against losses if ever needed. It has had a very steady gain of about 9% per year in its16 month life. The Hussman Strategic Growth fund holds a diversified list of stocks that can be hedged by 100% against losses if ever needed. It has gained about 19% per year over the past three plus bear market years and has earned a 5 star Morningstar rating for its outstanding performance.

Despite their safe design and brilliant bear market records, we plan to use them with periodic portfolio rebalancing which will, over time, improve both their safety and performance. I fully realize this sounds too good to be true, but please read on for the details. It would also be helpful for you to read a number of my recent essays covering the subject of portfolio rebalancing - an almost magic way to increase the return over time from one of our stable/volatile portfolios.

In order to win the confidence of as many readers as possible, I am suggesting the creation of 3 very simple portfolios expected to be both safe and profitable in a bear market environment. The first portfolio uses just two Husssman funds that can be purchased with a total cost of just $2,000 in a taxable account or $1,000 in a tax-free account. They can be purchased from the fund company (800-487-7626) with no commission or fees. If you buy in an ordinary or tax free account, please specify that you want dividends reinvested in fund shares as these dividends will add to growth over the long term.

These two funds provide a broad mix of stocks and bonds with an option to diversify into foreign bonds and gold and use hedges to protect against market losses. Return from this portfolio during the past year would have been 15.6%.

40% More Stable Component HSTRX
30% Less Stable Component HSGFX
30% Less Stable Component PSAFX
100% Total

This portfolio adds Prudent Global Income, PSAFX, one of two Prudent Bear funds we have great confidence in. It adds 25.2% of short term foreign government bonds and a modest 4.8% of precious metals. The weighted average growth for portfolio #2 and its four asset classes was 15.2% during the past year.

30% More Stable Component HSTRX
30% Less Stable Component HSGFX
30% Less Stable Component PSAFX
10% Managed Short Fund BEARX
100% Total

This portfolio adds a small percentage of a fully managed short fund Prudent Bear Fund, BEARX, that raised the total gold content to 6.8%. BEARX, despite its 20% gold content, lost 10.7% last year in the bear market rally. The overall weighted average growth of portfolio #3 with five asset classes was 14.76% during the past year. The two Prudent funds have a minimum purchase of $2,000 in a taxable portfolio and $1,000 in a tax free portfolio. Their phone number is 800-711-1848.

Although, these 3 portfolios become slightly less conservative as you move from #1 to #3, please remember they had good gains last year in a huge bear market rally even though they are selected to gain in a long bear market in which #3 is expected to be the overall winner due to its modest short fund percentage.

Over time, it is expected that all three of these portfolio will make additional gains for their owners through the true miracle of portfolio rebalancing. How can this happen? I have explained how it works in recent essays but will do it again. We will use portfolio #3 as the example because the effects will be smaller in the other two less volatile portfolios.

The expected volatility of the funds in portfolio #3 would place BEARX as most volatile and HSTRX as least volatile and the other two as intermediate. Looking at a chart of their prices over several years, we would see HSTRX as the smoothest curve and BEARX with numerous price peaks and valleys. Now, in the case of the highly touted "Buy and Hold" style of investing, there is no provision for taking profits from temporary high price points and redistributing them to other temporary price low points in other securities. As we have shown in recent essays, in a period of say 6 years, redistributing these temporary profits from volatile securities to less volatile stable securities can make a noticeable increase in the overall gains. The gains come automatically in a diversified portfolio and, if not redistributed to stable securities, they simply disappear and are lost.

In the case of portfolio #1, year by year, the growth fund will grow faster than the income fund. My suggestion would be that at least once every two years, the excess growth in HSGFX be transferred to HSTRX, provided you wish to retain the original 50-50 ratio. Profits will be greater by rebalancing and should certainly be done when large amounts of money are involved.

Portfolio #2 will have a larger volatility than #1 but quite a bit less than #3. See the examples of the added gains from rebalancing given in recent essays. If questions remain, please request help.

PLEASE READ THIS. In our previous essays, we stated the need to have at least 50% of stable assets for a good bear market portfolio. Here is the percentage of stable assets in the suggested three portfolios.

                                         Portfolio 1 - 100 %
                                         Portfolio 2 - 95.2%
                                         Portfolio 3 - 85.2%

In other words, these portfolios are very safe and conservative and will not cause any loss of sleep. But the small differences between them are large enough to teach basic principles of investing to novice investors IF they do the necessary home studies of the differences in each fund’s price behavior. If this is not done, building the learning portfolio will be a waste of time. Please note this very will.

Having owned and studied many hundreds of mutual funds of all descriptions over the past 50 years or more, I have developed a facility for evaluating new funds that has been greatly helped by my FastTrack database and graphing capability. A reader inquired how I could recommend the two Hussman funds with their limited life to date. It was easy for me after reading the huge amount of material offered in the fund literature and viewing their price charts on my computer screen. I have only acted this quickly several previous times, but when I see something of extraordinary quality, I am quick to accept it.

Now, it is quite unnecessary for any reader to spend 50 years studying mutual funds. With the technology now available, everything I have done could surely be compressed into five years or less. And with a FastTrack mutual fund data base costing about $30 per month, the progress would be even faster.

Assuming a reader decides to build one, two or three of the suggested portfolios, what is the best way to proceed. With apologies to veteran readers, I am going to address and help a reader who I assume has never purchased a mutual fund directly, without fees or commissions, from a no-load fund company.

I resolve during the coming year to discontinue any new relations with investment advisors who lack meaningful bear market training and experience. I further resolve to make a sincere effort to eliminate my fear of starting and managing a mutual fund portfolio, completely without outside help.