Bear markets should be welcomed, not fearedArticle added by Christopher P. Hill on April 16, 2010
Christopher P. Hill, RFC

Christopher P. Hill

Vienna, VA

Joined: January 08, 2010

I firmly believe that one of the great myths in our industry is that our job is mainly to assist our clients in "growing their assets" or "outperforming the market". In fact, the majority of studies show that most investment professionals have consistently underperformed the market averages over time, with "over time" being defined as more than 10 years. So, if our clients truly believe that our job is to multiply their wealth, then why is it that many of us are not keeping up with their expectations?

My goal here is to provide some valuable concepts that will make us all better investors. Now, you might ask what qualifies me to give investment tips to such an esteemed group of financial professionals and registered financial consultants? Good question. What I can tell you is that in my personal journey in this wonderful career, I have been blessed. Not only has my father been a stock market professional for over 40 years, I have also had the great fortune of working for 12 years directly with one of the nation's leading money managers, who began his career in this business more than 42 years ago. One of his favorite sayings is "Experience is the name you give your mistakes... if you learn from them."

Well, for the past 20 years, I've had the gift of learning from both the good and bad experiences of these two seasoned professionals. I'd like to share with you what is, by far, the most valuable lesson that I have learned:

Try not to focus so much on growing your clients' assets, but rather on helping your clients avoid major stock market losses. In fact, I tell my clients on a regular basis that 90 percent of my job is to help them avoid large losses.

Now, that may sound a little strange or maybe even counterintuitive. So please allow me to help clarify this with an example that has helped me to better understand the real beauty -- and the fantastic opportunity -- that is afforded to all of us by investing in the stock market.

I'd like to call this example: The Bad, The Worst, The Good, and The Beautiful.

The Bad: Let's pretend you purchased a stock today at the price of $100. Let's also pretend that even though this stock is a seasoned blue-chip company, over the next 12 months the major stock market averages suffers a dramatic bear market. As a result of this major decline, let's assume the stock you purchased also collapses down 50 percent, reducing the price to $50. At this point, I think it's fair to say that most investors would be both pessimistic and fearful. In fact, studies prove that it is at times like this when most investors usually sell this stock, particularly if the news and media are extremely negative, as well. This is commonly referred to as "panic selling".

The Worst: So, why are most investors willing to sell a stock that is down 50 percent? In my opinion, there are several reasons. First, we can all attest to the fact that many of our decisions are not based on logic, but instead on the principles of fear or greed. Second, as we learn and grow older, we are largely taught to do three things, and usually in this order: read, respond, and react. And third, usually when an investor watches a stock plummet by 50 percent, they begin to think that the inherent risk is actually increasing, and their loss potential could be much more than the 50 percent loss they have experienced thus far. They begin thinking irrational thoughts such as "This stock could go out of business" or "The stock market might never stop going down". At this point, the real perceived risk is not the 50 percent loss, but rather losing more money, and possibly even 100 percent!

The Good: In our early years of schooling, we learned some valuable principles that would later, strangely enough, prove to be directly correlated to our investment success. For example, we learned basic things like "What goes up, must come down," and "Every action has an equal and opposite reaction," and finally, "For every uphill, there is a downhill." Although these principals seemed so inconsequential at the time, if we try to connect them to our investment example, I think we can come logically conclude that "Every bear market is followed by a bull market." I know this seems elementary and simple, but it becomes extremely difficult to apply these principles when we factor in losing money, the media, peer pressure, and our emotions.

The Beautiful: Now, let's assume history repeats itself yet again and a new and powerful bull market begins. As this bull market surges ahead for the next 12 months, our stock ascends from $50 back to our original purchase price of $100. If you do the math, as our $50 stock climbs back to $100, this is a gain of a whopping 100 percent! But here's the beautiful part: Although this stock has gained an amazing 100 percent, it doesn't have to stop there. Heck, this stock could continue to gain more and more -- maybe 200 percent, 500 percent, or 1,000 percent. If you don't think that is possible, take a look at Warren Buffet's stock (BRKA), which is priced today at around $119,300.

So, hopefully you can see there are two important morals to this story:
    1. Stock market investing contains tremendous mathematical advantages. In other words, on the downside, we have only arithmetic loss potential, meaning you can only lose a maximum of 100 percent. However, on the upside, there is geometric growth potential, meaning there is unlimited upside potential.

    2. The only way to be truly successful in the stock market over time is by focusing on avoiding large losses. Why? Well, if we use the example above, you will see that although this particular stock declined only 50 percent, it would have required a 100 percent return, not to actually make money, but simply to get back to even.
Most so-called "investment experts" and authors will tell you that by investing in the stock market, you should never expect to have both low-risk and high-potential working together, hand-in-hand, and for the most part, this is a true statement. However, there is actually one time when the stock market truly affords both a low-risk and high-potential environment, and that is at bear market bottoms. Although the perception at bear market bottoms is that the risk is extremely high and the potentials are very low, the reality is that these rare opportunities are where true fortunes can be made, if we learn from them.

Of course, I would be remiss if I didn't point out the fact that predicting the exact timing of stock market bottoms is 100 percent impossible. However, in my studies of the major market bottoms during the past 100 years, nearly all of these bottoms contained similar characteristics, such as: significant stock market declines (an average of roughly 30 percent), investor pessimism, extremely negative news, recession/depression, and/or a favorable Fed policy of lower interest rates. Does any of this sound familiar?

So in summary, bear markets should be welcomed and not feared, for they are the very reason we have the unique opportunity to double or triple our hard-earned money. Remember the golden rule, "buy low, sell high". However, as investment professionals, if we don't help our clients avoid the large losses that occur during bear markets, they can never expect to be truly rewarded from that exponential growth potential that the stock market offers to us.

The year 2008 proved to be yet another one of history's great bear markets. Prior to this bear market, we did not have a major decline for more than five years. So we should all be thankful for such a long-awaited gift!

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