What follows applies to personal investing, but much of it also applies to professional responsibilities as a portfolio manager. At the tender age of 23, I was a retail stockbroker at Paine Webber. From 1961 through 1966, I dealt with individual investors, traders, and a few high-roller speculators. This time span included two bear markets (1962 and 1966). In retrospect, this experience was invaluable as an education in human nature and investor psychology.
Greed and fear are critical stock market elements and also the twin barriers on the road to long-term investment success. In truth, I probably learned more about investor psychology in those years as a retail broker, than in the following 45 years being a relatively detached analyst, portfolio manager, and investment strategist. For a real understanding of investor psychology, I think it is necessary to deal direct rather than from the relatively remote positions of analyst, portfolio manager and investment strategist.
Anyway, after five decades at various positions in the investment business, here is my version of the Ten Commandments — the ten lessons I think are most important to keep in mind when managing your serious money…your mother lode. I learned most of these lessons only after first violating many of these “ten commandments.”
I. Know Thyself
Everyone has their own investment strengths and weaknesses. It is particularly important to know your weaknesses so that you can defense against them and compensate for them. Here are some examples:
- You hate to admit you’re wrong, so you have difficulty taking a loss
- You’re a sucker for tech stocks
- You’re inherently pessimistic or optimistic
II. Discipline Is Essential
Establish your own personal set of investment disciplines, carefully considering and counteracting your own investment weaknesses. Write them down and keep them under your desk blotter and in your billfold or purse. Check them out each time you are planning to buy or sell. Revise the disciplines from time to time, but no more than once a year, and never when emotions are high.
III. Always Consider Risk As Well As Return
Before making an investment, make an estimate as to how much you might lose if it does not work out. Focus on the downside as well as the upside, the potential risk as well as the potential reward. Does it make sense if the potential gain is 25% over the next year, but if things go wrong, the risk is 50%? While admittedly an inexact exercise, you can apply this mental discipline to an entire market (bonds, stocks, real estate), as well as individual stocks.
IV. Cash Is Not Trash
Cash reserves reduce overall portfolio risk in declining markets. But, more importantly, cash reserves provide the investor with the ammunition to take advantage of the unexpected opportunities that can develop. Cash reserves can be a great offensive weapon…See “Commandment V”…
V. Always Consider A Market Crisis As A Potential Market Opportunity
Your emotions say sell, sell, sell! But, those personal disciplines you previously established say BUY! However, if you have no cash reserves, a great opportunity can be lost. Crisis opportunities seem to develop once or twice a year. There are times when even typically conservative investors might consider using some margin buying power. However, buying on margin should be reserved for special opportunities.
Leverage should never be standard operating procedure when managing your “mother lode.” Maximum leverage (maximum margin) supports your mother lode portfolio “as a rope supports a hanged man.”
VI. Bonds Can Be Best
If yield falls from 4% to 3% over a year’s time, a 20-year bond will produce a total return of about 15%. This is 1.5 times the historical annual return achieved by the stock market. What of the risk? If yields rise to 6% rather than falling to 3%, the total return loss from the bond is 23%, thus an unattractive risk/reward ratio (see “Commandment III).
VII. Stock Market New Valuation Eras Have Always Been Temporary
When stocks have run up big, like in 1998-2000, and Wall Street uses the term “new era,” saying, “It’s really different this time,”…well, that’s the signal to consider asset class alternatives like cash and bonds. While stock market bubbles can inflate beyond most expectations, they always ultimately burst.
On the flip side, late in a big bear market and even in 2009, many on Wall Street will again conclude it is a “new era,” with a depressed economy, depressed earnings, and depressed equity valuations for as far as the eye can see. Again, the refrain is “It’s really different this time.” These bearish “new eras” have (so far) always proved to be temporary…These bearish “new eras” are typically the prime time to build equity holdings.
Case in Point: Back in late-2002, while we were hearing more and more from the “new era” bears, our own indicators turned positive towards stocks, and we proceeded to increase equity exposure in our Leuthold Core Investment Fund to its maximum guideline level. In retrospect, it was the perfect time to buy. And, many others were running for the exits! (Although we don’t anticipate our timing to normally be quite so perfect.)
VIII. Short Term Trading Is A Loser’s Game
It took me about 20 years to learn this lesson. It’s true there are a few full-time professional short-term traders who have been consistent winners, but even they ultimately burn out or go down in flames with one or two huge losing trades. With non-professional short-term traders, about 95% will end up losers if they stay in the game.
Even those with “winning” trades two-thirds of the time can end up losers, since losses on bad trades are typically at least twice as large as the average gains realized on the good trades. Even if successful, the ultimate price can be high, since those few who do win often end up as life’s losers, married to their trading machines and losing their families.
IX. History is Experience…Learn From It
Financial history is not a Xerox machine, and does not repeat itself exactly. But, simply put, history is mankind’s past experience. And, it is said, experience is the best teacher. It is much less painful to learn the hard lessons from the experience of others. This is why financial history is a vast early warning system, and this is why I hope you will learn from and pay attention to these ten investment lessons derived from my experience.
Why does old financial history provide so many guideposts and lessons even in today’s world of advanced technology? Well, regardless of technology, human nature has not changed. Investor psychology in the horse and buggy days was no different than today. Society may have changed, but fear and greed continue to be the ultimate dominant market forces now, just as they were in 1905 and 1805.
X. Don’t Assume The Great Companies of Today Will Be The Great Companies Of Tomorrow
Back in 1970, the popularity of the “Nifty Fifty” buy and hold approach (advocated by McGeorge Bundy and the Ford Foundation) was all the rage with pension funds and bank trust departments. It was simple. Just buy and hold the biggest and best companies in America and focus your attention on golf and tennis. Long-term investment success was thought to be that simple for both individual and institutional investors. At least that is what many of the biggest professional managers had concluded, more than willing to follow the lead of Bundy and the Ford Foundation.
But a century of stock market history tells us shifts in the relative fortunes of America’s leading corporations have taken place in a far more dramatic manner than most of us might perceive. In the last few decades, this reversal of corporate fortunes has shifted into high gear, driven by creative destruction and intensified competition. Here are some examples:
- 1970 Top Tier “Nifty Fifty” Stocks included: GM (#3), Eastman Kodak (#5), Xerox (#9), Avon (#15)….Farther down the list: Polaroid (#33), Kresge (#44), and Burroughs (#45)
- Of the 50 largest market cap stocks January 1, 300, 48% had fallen off the list by 2014, either by merger or declining price
- Only about 8% of the companies included in the S&P 500 in 1957 remain in that index today. McKinsey & Company estimated a few years ago that S&P 500 component companies will now remain in the index as average of ten years or less
“NO GROWTH IS PERMANENT”
Back in my early years in this business, I read a treatise by Mansfield Mills concerning the rise and fall of corporate fortunes. Mills postulated that U.S. companies typically evolved from being growth leaders, to mature growth. The next stage became earnings cyclically and finally earnings decline. This typical life cycle of companies is often ignored by investors, but market history confirms its existence.
Back in 1979, I knew of a longer term IBM holder who gave his heirs strict instructions to never, under any circumstances, sell IBM. An 80 year old gentleman I personally knew told his grandchildren they must hold the Warner Lambert stock he was leaving them for as long as they lived. In the early 1960s, there was a classic case where trustees attempted to challenge the original trust donor’s binding instructions that his beloved Penn Central (then heading for Chapter 11) could never be sold.
In recent years, “creative destruction” was coined, a term describing the dramatic rapid changes in the technology world that create new superstar companies and at the same time destroy the old leaders. Wireless and the internet have destroyed the profitability and business models of what were once blue-chip telephone companies. Polaroid was put out of business by dramatic changes in photography and now Kodak is on the ropes. Burroughs and Sperry Rand were once big names in the computer industry, but no more. Long before the term “creative destruction” was coined, there were evolutionary destructive events in U.S. economic history as airlines replaced passenger trains, discount stores closed many retailers, and decentralized meat processors replaced Armour, Swift, and Wilson.
And, so it goes…even Apple may not be forever!
