Friday 29 May 2009

Stay Disciplined Over the Long Haul

Stay Disciplined Over the Long Haul

1. It is essential to stick to your strategy for the long term. Even the best strategies have down periods, and it can sometimes take over a year to reap the benefits of a good method. If you try to time your use of a strategy, you'll likely miss out on some big gains.

2. Expectations shape reactions; be prepared for short-term 10 to 20 % downturns that are inevitable in the stock market - and the less frequent but also inevitable 35 to 50% downturns you'll occasionally experience. You can't predict when they'll happen, so you just have to roll with them if you want to reap the market's long-term benefits.

3. Give the Internet a rest. Checking your portfolio every day, let alone every 10 minutes, can make you want to jump in and out of the market, which hurts your long-term performance.

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You should have the right mindset going into your market endeavors.

As you're building your portfolio, at some point, you're bound to experience a short-term 10 to 20 % drop, and that you'll also endure less frequent larger drops.

About 6 years after his retirement, Peter Lynch addressed this idea in an interview. Lynch said that 10% declines in the market had occurred in more than half the years in the twentieth century; 25% declines - a bear market - had occurred on average, every 6 years.

"They're gonna happen," Lynch said, "If you're in the market, you have to know there's going to be declines. And they're going to cap and every couple of years you're going to get a 10% correction. That's a euphemism for losing a lot of money rapidly.... And a bear market is a 20-25-30% decline. They're gonna happen. When they're gonna start, no one knows. If you're not ready for that, you shouldn't be in the stock market. I mean stomach is the key organ here. It's not the brain. Do you have the stomach for these kind of declines?"

Lynch was speaking about the broader market, but the same applies to your own portfolio. Joel Greenblatt stresses again and again that his strategy won't beat the market every year. In fact, his testing found that the formula underperformed the market one out of every four years from 1988 through 2004. But if you had used the formula for any two-year period during that time, your chances of underperforming fell to one in six. And, over three-year periods, the formula beat the market 95% of the time - and it never lost money in any of the three-year periods over that 17-year span. (Greenblatt says that even in its worst three-year period during that 17-year span, the formula actually gained 11 percent).

It's a similar story for just about any strategy you can imagine. All of the greats - Lynch, Buffett, Dreman, Graham - have had years when they failed to beat the market. But they stuck with their strategies, and that's what enabled them to post such great long-term returns.

If you acknowledge at the outset that all strategies - even great ones - go through down periods, you won't be surprised when your portfolio does take a short-term hit. As with many things in life, it's the surprise that often leads to anxiety and fear. If you're ready for those down times, you'll be amazed at how much more calm you'll remain when your portfolio takes some short-term lumps.

Unfortunately, most investors don't do that. (In fact, Lynch has supposedly said that while he was at Magellan's helm, more of the fund's investor LOST money than gained money because they would jump out of the fund when things got rought - selling low - and then jump back in when the fund was doing well - buying high.) Not being prepared for those downturns makes it all the more easy to be bowled over by emotions when times get tough. And if you give in to your emotions, you'll probably end up selling after big losses, and buying only after the market has made some big gains.

Hulbert said the newsletter (The Prudent Speculator) that his group rated as the best performer since mid-1980, has demonstrated great faith in the market's upward trend and been rewarded for it. The newsletter "has been the most buffeted by short-term market gyrations" of any he has monitored, he said. "And yet, none surpasses it in its willingness to either ignore or tolerate those gyrations." Hulbert said a testament to the newsletter's faith in the market's long-term benefits came after its model porfolio lost 57% in the crash of 1987. While others panicked, The Prudent Speculator kept its fully invested approach, and ended up winning big over the long haul. "Long-term investors need not lose sleep over the markets' short-term gyrations because the markets' long-term patterns will eventually assert themselves," Hulbert wrote.

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