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Investment Risk-> (Part 2) Are You Prepared for a Correction?

Posted by Larry Jones on Sep 23, 2021 9:30:00 AM
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Market Moods and Why They Swing

In the last post I discussed the fact that the stock market is a paranoid schizophrenic! Most of the time changes in the market have absolutely nothing to do with the underlying value of the firm represented by that stock. Just because the value of Microsoft is $100 a share on Monday and $80 a week later does not necessarily mean that the product that Microsoft puts out has just become junk. No, more likely it's because investor sentiment has changed due to some report, causing the stock price to fall. (Caveat: sometimes prices DO fall because the company is struggling...the saavy investor needs to do his research). The true value of Microsoft is probably about what it was a week ago.

There is however, a school of thought, known by the way as Modern Portfolio theory, that states that the listed price of a stock on any given day accurately reflects a true valuation of that firm. The reason for this is that, due to technology and full disclosure rules, there is nothing that is unknown to the investor, if he does his research. Therefore, Mr. Market has correctly evaluated the price of the stock for you. In other words, there's no use in trying to beat the market because you cannot do it. And in fact, the vast majority of professional money managers do not beat the market! Think about it....you are quite likely paying your stockbroker 1-1.5% in fees to do something you could do yourself for next to nothing!


Investment Risk and True Value

Benjamin Graham was a finance and economics professor at Columbia University in the early part of last century. One of his most famous students is a fellow by the name of Warren Buffett. Graham was a proponent of "value" investing. He taught that the investor should try to accurately determine the value of a company and then, once the price of shares in that firm fell below that value, the investor should buy. The idea was that, no matter what kind of mood Mr. Market happened to be in at the time, the shares would eventually reflect their true value. Mr. Buffett shared this philosophy (along with Peter Lynch, Charlie Munger, and many others) to spectacular results.

What does any of this have to do with investment risk? Modern Portfolio theory would say that you cannot eliminate risk in your portfolio, so why try? The value investor, such as Buffett, would say that you cannot eliminate risk, but you can lower it substantially by putting a proper value on your investment before you buy. Who's right? I believe that both sides have valid points. But the common denominator for both classes is dealing with risk.

Now, I'm sure at this point, that you're asking the question: what does this have to do with me and my portfolio?

If you are a sold-out proponent of the Modern Portfolio theory, then your attitude towards risk is likely quite tolerant. After all, even the 40-55% losses of 2008 have come back, right? Well, yes but it took about six years to do it.

If you are a value investor you may actually look for downturns as an opportunity to acquire an undervalued company. But you could be wrong in your assessment of that company, and suffer greatly because of it. Keep in mind that folks like Buffett and Lynch have spent their entire lives learning the tricks of value investing. Are your appraisal skills as good?

So what about you and your portfolio? Is a market correction approaching?

  • The Market is Trading at 25-30 times earnings

If I offered you $25 for a dollar bill because I believed that eventually that dollar would be worth $25 would you think me rational? The market today is trading at a P/E ratio above 25. This could signal that Mr. Market has been overvalued in the court of public sentiment. In other words, it's not worth as much as we think it is.

  • Many of the Market Signals Mirror 2008

In 2008 the price of oil began to slide. The strength of the U.S. dollar was high. This is the case again today. In addition, IPO's are running at an extremely low level, which normally signifies a sluggish economy. Add to that global instability and the Fed raising interest rates, and we may very well see a market pullback.

  • Injections of Government Money Have Been Exhorbitant

Trillions of dollars have been injected into the American financial system since 2009. Is that a sign of a healthy economy? Many economists believe that we are in a bubble. What do bubbles do? They pop.

  • Global Investments are Down

Even though the American stock market is doing pretty well, that's not the case worldwide. In fact, I believe one of the reasons our market IS doing so well is because it's one of the last places worldwide to get growth. Foreign investors are helping our market. 

  • The Gravy Train is Running at Full Steam

One of the maxims that Warren Buffett lives by is this: "when everyone else is jubilant, be afraid. When everyone else is afraid, be jubilant." This advice has served him well for over fifty years. Today, jubilance abounds.


How Are You Preparing?

 

People ask me all of the time, "what should I be doing right now with my investments?" as if I know what the future holds. I don't. But I do know that the market goes up, and it goes down. It's up right now. Will it go to the moon? I doubt it. At some point rational valuation will step in and the market will find something close to it's true value. 

Perhaps you don't have the skill of Warren Buffett, yet are uncomfortable with a significant loss every few years that Modern Portfolio theory says that you must accept. I say that if you are above 50 then a 50% loss is unacceptable! That's why I work with Horter Investment Management. Our tactical fund managers are able to be defensive in downturns, and can take advantage of a bull market, as well. It's a matter of risk. How much do you want to take with your portfolio? My answer: as little as necessary to achieve your desired results. (See: Peace of Mind Investing)

Curious?

Give me a shout and let's take a look at where you are now, and where you'd like to be in the future. I think you'll be pleased that you made the call.

Until next time,

Larry

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