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Issue XV

April 1998

Sharp Investing

Lifeboat Drills: How will you handle the coming bear market?

Investors who have grown used to the unusually high returns of the market over the last three years may wish to work through a return to reality process known as lifeboat drills. People that have been in the stock market for only a couple of years have experienced markets that only go up, and at twice the pace of long-term historical returns. Historically, when markets have had a wild party bull market for several years running, they typically get a fairly decent-sized hangover in the form of a bear market that follows. An average sized bear market (35% decline over 12 months) would bring three years of 20% returns down to long-term averages of 10% by the end of the fourth year.

I'm not saying that this has to happen, just that in the past when each bull market has ended, on average the following bear has taken away 35% of the newly acquired wealth over a period of about a year. Combine that with the fact that the market has now strung together the best run this century, and you can see why I cringe every time I sit across from someone who looks me right in the eye and says "The Market always goes up, right?". The first step to the lifeboat drill is examining current investor thinking.

A study done just prior to the market crash in October gave valuable insight in just how quickly investors can pick up unrealistic expectations. This study found that 75% of all investors questioned believed that there would not be a correction of more than 10% for the next 20 years. The fact is that this type of correction happens on average once per year and happened less than a month after this study was done. The other finding was that the majority of investors believed they would exceed 20% returns per year for the next 20 years by simply buying the stock market, which is twice the normal average growth. This has never, ever happened before in 400 years of human financial markets. What do you think, expectations a bit unrealistic?

The next step to the lifeboat drill is to examine the rational behind the idea that markets will always go up. Over 400 years of financial markets, the same exact

reasoning comes up again and again; things are different this time!

Things are different this time because of the economy. The economy has been a powerhouse through most of the '90s, no dispute there. High growth with low inflation and 8 years without a recession - an economic miracle! Substitute '80s for '90s and the exact same thing was being said about Japan, which is currently mired in a multi-year recession and multi-year bear market. Big party, big hangover.

The bottom line is that much of our good fortune of high growth with no inflation comes at the expense of Japan and other faltering economies. These economies have been keeping our inflation under control without Greenspan having to do it by tightening credit. We'll give U.S. companies credit for superior earnings and high growth over the last few years, but the inflation fighting has been done for us by the rest of the world and Greenspan's hands-off policies.

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The business cycle has been repealed and recession and inflation are things of the past. I think that there has definitely been an improvement in the way the macro-economic environment is fine- tuned by the Federal Reserve and other policy makers, mainly due to the widespread availability of instantaneous information. This does not eliminate economic cycles, but smoothes them out and minimizes really violent swings in economic conditions. It also does not eliminate exogenous shocks, such as Asia. So, some of our economic fortune is luck, and some is skill, but conditions will continue to fluctuate. Relying on a perfect economy to drive the stock market at double its normal rate of return forever is not a wise decision.
Things are different this time because of the baby boomers. One can't argue that there is a population bulge moving into their peak earning and savings years, and putting money into stocks and mutual funds at record levels. This has obviously inflated the demand for the hot investments of the day. But is that enough to keep the stock market on 20% returns virtually forever, or at least until the boomers retire? Not a chance.

Twenty-five years ago we had the exact same environment, a population bulge moving through peak earnings and savings years. Current wisdom of the day put money into gold, bonds, anything but stocks. The money had to go somewhere, but not necessarily into stocks. There have been lots of population bulges in countries all over the world for many many years, and the extra demand going into a hot investment simply translated to an extra big stampede out when the investment cooled off, whatever it was.

It is well known that inflows into mutual funds decrease after months where the market has done poorly and increase after months where the market has done well.

Imbalances in supply and demand cause greater short-term volatility, but this can move a market down as well as up. The truth of the matter is that there has been more excess demand in the last couple of years from foreign investors than baby boomers, and that will dry up once our economy cools and foreign economies stabilize. Once again, the world's misfortune has been our good fortune.

Things are different this time because today's sophisticated investor is in it for the long-term and knows to "buy on the dips". This one is really a hoot! The only thing that is 100% completely predictable in financial markets is the consistency of human nature. It does not change. There is a whole field of study called "behavioral finance" with hundreds of studies documenting the consistency of human nature with regard to investing.

A timely study done again right before the October crash of 1997 asked investors what they would do in the event of a 23% decline, ala 1987. Two thirds said they would do nothing, they were in it for the long-term. Then after the October crash when the market bounced back quickly within just several weeks it was trumpeted that the small investor had saved the day by keeping a cool head and buying on the dip! So far so good, right? After all, buying on the dip has tremendously rewarded investors over the last few years as the small corrections that we have had have snapped back extremely quickly, most within a matter of a few weeks or months.

So why did these same investors who bought on the dip domestically yank $2.5 billion dollars out of foreign mutual funds after the October crash, at the bottom of
the panic? I'll tell you why, because the damage wasn't a little quick set-back of 10% or so, in most cases it was well in excess of the 23% cited in the study, and in many cases, more like 30-50%. So what do you think will happen the first time we get a 10% correction, investors buy in, and then we get a further 10% decline? I'll tell you what will happen, human nature. Most investors in today's market have not experienced anything like this, and once the "buy on the first dip" strategy doesn't give immediate results, human nature will take over.

It happens everyday on a less dramatic level. A recent Morningstar study looked at the top performing mutual funds over the last three years. These funds averaged 31% return during this time. However, the average dollar invested in these funds only made a 13% return for the same three-year period. Why? Human nature. A fund would have a big year, outperforming most of its peers just for that year. Then the money would pour into the fund the next year, and the fund, on average, would then have a below average year, so most of the money in the fund didn't do well even though the two year track record still looked great. So for the third year, out the money would go chasing the next hot fund, and meanwhile the fund would have another good year, but with less money. So the bulk of the money in the fund during that three-year period of great performance did not
benefit from the high returns. It didn't matter whether the fund was institutional (professionals) or retail (individual investors). How smart or sophisticated
the investor were, seemed to have absolutely no bearing on their ability to control human nature.

The vast majority of investors will give in
to their human nature and react to markets
in predictable ways. This is just about the only absolute in financial markets. Hanging your hat on the idea that markets will go up forever because investors say they can control their human nature is a more dangerous assumption than just about anything else because the evidence is so overwhelmingly to the contrary.

So, whether or not I have convinced you that markets can go down as well as up and that markets will eventually revert to normal growth rates, you do need to examine how you would handle the next coming bear market. I don't know when, I don't know how bad, but I do know that eventually you will be faced with the possibility of watching your portfolio decline by as much as 1/3 at some point in the next few years. The big question for you is how you will actually handle it as opposed to how you currently think you would handle it. Going against human nature feels so wrong, and is a difficult thing for most people to do. Human nature is a feeling, not a step of logic, which is why investing smarts are not enough to deal with difficult situations.

Just as it is completely unrealistic to assume that this can't happen to you, it is also unrealistic to assume that investing in strategies that have a long-term historical rate of return of 10% will glean you a 20% rate of return for the next 20 years. There is no such thing as a free lunch.

There are investing strategies that have a 50-year history of 20% returns, or roughly double what the market has provided over that time. But these strategies are

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uncomfortable and have nothing to do with buying the hot stock of the day, following popular thinking and trends of the day, or getting instant gratification in terms of quick profits. In other words, to successfully participate in these above average, market-beating strategies, human nature must be suppressed. Of course, I am speaking of value investing strategies that are used by Sharp Investments.

If your goal is 20% returns, is it more realistic to think you will obtain those returns long-term from a market that has provided 10% returns since WWII, or from a strategy (value investing) that has provided those 20% returns on average since WWII?

Don't let the above-average returns of the market the past few years lull you into the unrealistic expectations that it can continue at this pace forever. In five years I might be telling you not to let the below-average returns of the past few years scare you into thinking it will be that way forever.

I can almost guarantee you will obtain 10% long-term market returns from a normal market investing strategy, just as I can also predict 20% long-term returns from a market-beating value investing strategy. That's realistic, and based on hundreds of years of investing and hundreds of different financial markets all over the world, rather than three years experience in a single marketplace. Things are definitely not different this time.
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