Great Investment Mistakes: The Bear Trap

Free Verse It's poetry day! In response to my request for investment confessions, Mr. S. sent the following -

My mistake: sold all stock 2005 after reading Mr Volckers April Op-Ed in WaPo felt stupid till 2008 but ultimately vindicated bought 2008-9 bottom 20% Waited for even more blood on street as expected by the perpetual doomsayers

Sold all and decided to give money to "one who knows” One who knows is the eminent and very decent John Hussman seemed so aware, correct in his Rx with beautiful HSGFX performance till that point

Luckily only bought HSGFX with 20% (came so close to 100%!!) remaining port cash

Like opium his elegant and confident weekly columns soothed the unease to leave $s there

The line that got me and kept me was the confident “superior over the full market cycle”

Come to Jesus moment: 6 mo ago decided to think this through: Fund has lost 50% already - how would he make up the 100% to break even over the full cycle??

Never fell for the charlatan and doomster arguments but sucker for a well argued and elegant argument specially if they have amazing graphs!! (I am an academic so may be susceptible)

Am sure he will be right eventually - and may be I am the capitulating seller! Am a boring 60/40 and loving getting on with my life

Lesson: no points for elegance (think Peter Bernstein said)

In Other Words Translating to prose –

1) Mr. S. sold his stock holdings in April 2005, after reading a gloomy Washington Post editorial from former Federal Reserve chairman Paul Volcker. Although Volcker made no stock market predictions, the article claimed that the economy was "skating on increasingly thin ice."

(Volcker Fact: While running the Federal Reserve, the 6’ 7” Volcker would intimidate his visitors by standing near them, so that they were forced to tilt their heads to look up. Then, to complete the conquest, he would light a cigar. Different times.)

2) Mr. S’ action quickly led to regret, as the U.S. stock market rose by 40% over the next 2.5 years (oops!). Then came the unmistakable thrill of schadenfreude as the market reversed course. Stocks eventually landed 35% below their April 2005 levels, making Mr. S. feel vindicated indeed. He put 20% of his cash to work at the market’s bottom.

(Volcker Fact 2: His editorial was half-right. He correctly foresaw that a financial crisis would set off the next recession, and he was appropriately concerned about rising debt levels. However, he thought that foreign capital would trigger the problem, not domestic defaults from housing.

3) Mr. S. sold that position and once again had everything in cash. He almost put everything into

4) Quite spectacularly, Mr. S.’ new purchase managed to lose half its value--an extraordinary achievement during a stock bull market for a fund that, per its prospectus, invests “primarily in common stocks.” The fund lost 13% in 2012, 7% the next year, then 8%, and again 8%, then 11%, and is down just over 4% so far this year. At least Mr. S. resisted the temptation to go all-in.

5) Six months ago, Mr. S. sold his Hussman position, and he is now invested in the conventional balanced asset allocation of 60% stocks, 40% bonds. (Presumably, he is doing so through diversified, low-cost mutual funds.) That portfolio has been appreciating nicely, and our subject is sleeping better. He closes with what, per a failed Google search, may be an apocryphal quote from the late investment-writer Peter Bernstein.

One-Way Trip It's easy enough to find investment mistakes. One would be making an all-or-nothing decision, based largely on a single source. Another is purchasing an investment that would finish 21,138th out of 21,347 mutual funds over the trailing five years. (Yes, there were 209 worse funds during that time, but almost all were highly specialized.)

For me, though, Mr. S.’ biggest error occurred with his first three words: “sold all stock.” In theory, I am not adamantly opposed to market-timing. Assuming that the sale doesn’t lead to a tax bill, there’s nothing terribly damaging about being on the sidelines for a short while. Yes, there is the possibility that stocks will rise sharply during that period, but the odds are low. The investor is no likelier to be a perfectly bad timer than he is to be a perfectly good timer.

So, a dab of market-timing is acceptable. The problem lies with the return. Consider Mr. S.' case. Once he sold equities in spring 2005, he was loath to return until he could land those stocks for less. To buy them at a higher price would be to admit defeat. Historically, investors have struggled to make such trades because of loss aversion. They tend to hold, and hold, and hold.

(As Mr. S. notes, loss aversion also affected how he viewed his Hussman position, as he feared that he was “the capitulating seller!”)

Mr. S. got bailed out, as it were, by the 2008 crash, which gave him the opportunity to re-enter the stock market. He took only partial advantage of the occasion, because while that market’s trough may now easily be identified, it was deucedly difficult to recognize at the time. Many pundits predicted “more blood on the street.” Mr. S. kept awaiting that blood, but it did not come.

Such is the bear trap. It is among the most dangerous of investment mistakes. It takes extraordinary self-discipline to admit having made a market-timing error and to get back into equities before too much damage has occurred. Historically, few have managed that feat. Fortunately for Mr. S., he is among the exceptions. His escape was not quick, to be sure, and he will suffer regret if stocks decline anytime soon. But his breakout is nonetheless to be celebrated.

The Case for Cramer (Sort Of) Friday's column was unkind to Jim Cramer, if for no other reason than Mr. Cramer is so kind to himself that other views are required for balance. One item that might have been unduly harsh, however, was the column's implication that the U.S. stock market was near its very bottom when Cramer (in)famously advised on Oct. 6, 2008, that "whatever money you may need for the next five years, please take it out of the stock market right now." Not so. Stocks had fallen precipitously already, but they had another 30% to go. Thus, Cramer's counsel was in a sense correct--but not necessarily helpful. After all, Cramer gave a five-year horizon when giving his advice. By October 2013, stocks were 60% above their October 2008 levels. Those who had followed Cramer's words would have done well for the very short term--but when would they have eluded the bear trap and returned to stocks?

The question is rhetorical; we cannot know that answer. But I am not optimistic. Friday’s subject, Marty Bannon, never got back into stocks. In that, he surely is not alone.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.