The Error-Proof Portfolio: Speculating in a Turbulent Market? How to Not Get Burned

The combination of the unfolding tragedy in Japan and unrest in the Middle East has equaled a whole lot of market turmoil. The broad U.S. stock market is down about 5% during the past month, whereas the MSCI EAFE Index, a widely cited benchmark for foreign market performance, has shed about 7% of its value during that same stretch.

Such gyrations tend to prompt a variety of investor responses. At one end of the spectrum are investors who run for the hills amid times of trouble, selling stocks and embracing cash and Treasuries with the expectation that the market could drop even further before it's all over. Given the extent to which stocks have been dropping while Treasury bond prices have been spiking, this is a large contingent of folks right now.

At the opposite end are the risk-takers. Far from fearful, they're looking hard at what others are selling in the belief that market panics can create opportunities for steely nerved investors. In recent days, for example, I've heard fellow investors buzzing about everything from Japanese small caps to newly downtrodden technology stocks.

It's true that that kind of contrarianism can be profitable, and it's certainly better than chasing securities that have recently gone up with the expectation that they'll continue to do so--the classic mistake of novice investors.

But the risks of delving into a troubled market sector can also be substantial, particularly if a tumultuous situation is still unfolding as you're buying. In such situations, you can be buffeted around by your emotions just as much as those investors who sell during market panics.

If you're inclined to make a play on a market sector in turmoil, here are some considerations to bear in mind.

Be Honest About Your Track Record
A key first step before undertaking a speculative bet--even a contrarian one--is to take stock of how you've done with such forays in the past. As investors, we naturally tend to remember our successes more than maneuvers we've gotten wrong, but overconfidence is the bane of successful investing, as Financial Analysts Journal editor Rodney Sullivan argues in this interview. 

Before you stake money in a troubled market sector, examine your past track record with such maneuvers. Did you buy too early, or get nervous and pull the plug before your position could bear fruit? Or do you have a history of investing in troubled markets or companies that never quite rebound? An honest assessment of your past track record can help you determine how much to invest--or whether to invest at all.

Explore Conflicting Opinions
In any decision--including contrarian-minded ones--it's common to seek out opinions that corroborate your own while ignoring conflicting ones. Yet before taking a long position in a market sector or stock that's dropping, pay as much attention to the downside potential. Is it possible the naysayers know something you don't? The best bargain-hunters are pessimists, thoroughly exploring the bear case and building themselves a big margin of safety in case things don't work out as they had hoped. If you don't have the time or wherewithal to do that kind of investigative work, recognize your purchase for what it is: a speculative bet.

Set Your Parameters
Part and parcel of examining the bear case is putting specific limits around your investments: how much you'll invest, how big of a loss you're willing to endure, and how you'll react if your position doesn't work out as you thought it would. Will you add more to your holdings or beat a hasty retreat? Creating a mini investment policy statement for your position--a simple written declaration of why you're buying a security and what your sell triggers will be--can serve as an additional safeguard to keep your worst behavioral instincts from taking over if things don't play out as you envisioned. 

Check on Whether You're Doubling Down on a Bet
Before you bet on an unloved part of the market, take a moment to gauge your exposure to that sector. Morningstar's Instant X-Ray tool can be a great way to keep tabs on your current exposures: asset class, investment style, and geographic and sector positioning. After reviewing your portfolio's X-Ray, you may find that your existing exposure is plenty--you don't need to add any more.

Also consider the possibility that even if you don't have much exposure to a pocket of the market right now, you may have more of it in the future if your fund manager is adding to it. Rather than adding to an unloved pocket of the market directly, you may instead opt to send more money to your favorite bargain-hunting fund. Your manager is no doubt assessing opportunities just as you are, but he may have more resources available to help him analyze the problem.

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