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August 02, 2009

A Time-Tested Investment Approach
by Tom Madell

Finding meaningful success from investing in stock mutual funds these days seems a little like recent reminiscing about astronauts landing on the moon: it's something that hasn't happened for a long time.

Back in 1999, I began publishing a not-for-profit, free newsletter and have continued ever since. Rather than merely expressing my investment opinions, I attempt to use research, most of it my own, to ferret out what actually works in investing with a significant probability of success vs. what doesn't work.

The aim of my newsletters has always been to help investors achieve good relative returns without taking on excessive risk. Coming out ahead as compared to most investors and even market indices by, for the most part, starting with and tracking a relatively constant set of fund recommendations over at least several years is our modus operandi. In trying to help investors achieve such good relative returns, we cannot expect to always achieve positive returns over the shorter run. And as an outgrowth of our approach, only when things change significantly and reliably enough to likely affect one's returns over the next several subsequent years, do we suggest a major change of strategy.

Of course, some people would rather attempt to select good investments just one time, and hardly ever make any adjustments. We agree that this can be a particularly good strategy for stock fund investing, assuming sound investments can be held through thick and thin with a long-term holding period of a minimum of 10 years, or better still, 15. For such buy-and-hold investors, use of an investment newsletter, or an investment advisor, seems likely to be restricted mainly to starting up an appropriate portfolio rather than making changes along the way.

On the flip side of the coin, some people choose to dart quickly in and out of their investments. While in some cases, you might think of these people as traders, this group also includes those who, once in an investment, want reassurance fairly quickly that it is doing well, or at least, that it is not losing ground. For these investors, holding an investment over at least a several year period that inevitably will include both ups and downs tends to be extremely difficult.

As I have emphasized many times, while I wish I might be able to be more helpful to those inclining toward more rapid changes, especially in the event of losses, I have found little evidence that this is usually an effective strategy for fund investors. While some investors are able to minimize losses using such a strategy, minimizing losses in itself is probably less than half the battle. Unless one's overall strategy can also achieve sufficient gains, "less losses" are still losses.

If neither buy-and-hold, nor recommending frequent, substantial changes fits, how then would you describe my Newsletter's approach? Although I may have not written much about this before, I have continually tried to emphasize the importance of patience. I believe that patience is perhaps the most important quality to have in order to be a successful investor. (Incidentally, can you think of any area of extended endeavor where patience is NOT important? I can't.) But patience in investing, I believe, does not simply translate to mere waiting. Yes, patience implies waiting. But while you are waiting, you should also be watching.

Perhaps hardest of all is the patience and conviction required while waiting for a would-be bloomer of an investment to grow productively. But a second type patience may also be called for: waiting for possible new, and particularly significant, buying opportunities to arise. Such will tend to occur, in our view, not every week or even every several months, but more likely, only about once every several years. Thus, there is much to be said for the strategy of "keeping your powder dry." This entails patiently waiting for a meaningful "shift in the winds" in an asset category (usually, a particularly big downdraft followed by a significant period of stabilization) as a new found opportunity to buy. We think we may be close to quite a few such opportunities in the months ahead, IF stock prices which plunged head-over-heels roughly between Oct. '07 and Oct. '08, achieve a new level of stabilization which brings them back to at least where they were a year earlier.

And there is yet a third type of patience. Investors should also be waiting for those occasions during which investments might need to be trimmed down; once winnings are achieved, you should be willing to take at least some off the table. Our approach suggests that you sell on performance strength, not on weakness. Selling on strength preserves gains; selling on weakness actualizes losses.

Unfortunately, failure to act to preserve gains when winnings are strong (such as during ongoing bull markets, which realistically can't, and won't, go on indefinitely) seems to be almost hard-wired into the human psyche. This truth was reported recently on CBS's Sixty Minutes: Very few people who are ahead at the Las Vegas casinos ever simply pocket their profits. Most continue betting until their winnings are completely gone. Unlike gambling winnings which may seem to be "playing with the house's money," if your goal is indeed to come out ahead, it is imperative for investors not to be lulled into a state of inattentive complacency, or even a degree of overconfidence, both brought on by prolonged positive market action.

Learning when to slowly withdraw from the action, "settle" for reasonable winnings, and not be willing to shoot for even higher but increasingly less likely gains, is where many of us stumble. (Reminder: Whether you accept the situation now as a bona-fide bull market which is likely to go on for many years, or just a sharp, but real, rally within an ongoing bear market, we are again currently seeing bull market returns. This is once again a time to re-evaluate what action, if any, you should take.)

Of course, it should go without saying that our goal of trying to help you outperform a target over several years time, such as the S&P 500 Index and a similar index on the bond market side, is extremely difficult to achieve. What specifically then are our overall guideposts, which have so far at least, very consistently succeeded?

First, rather than looking at the performance of the stock and bond markets each as single entities, we look for pockets of opportunity within each market, including trouble on the horizon, as well as signs of unsustainable performance.
Second, we follow economic data releases to get a sense of where the best opportunities might lie, whether in stocks or bonds, or sometimes, even cash.
Third, we continually monitor what some of the country's most savvy financial experts are saying about what are the strengths and weaknesses in investments overall, and in certain kinds of investments.
Fourth, we rely heavily on "reverse psychology" this means that we tend to have an above average degree of skepticism in what the consensus opinion might be. We agree with investing guru Warren Buffett that, in sensing what to do next, a high level of fear may actually foretell some of the best investing opportunities. Conversely, a high level of felt confidence in an investment, or the stock market as a whole, is often one of the poorer times to invest.

While no single one of these guideposts is unique to our investment approach, the combination of all of them together, coupled with an overwhelming focus on empirical results as opposed to mainly trying to apply a rational, intellectual analysis to where the markets are headed, we believe, will give you a significant advantage.

Tom Madell, Ph.D.
Publisher
Mutual Fund Research Newsletter

Mutual Fund Research Newsletter is a free newsletter which began publication in 1999. It has become one of the most popular mutual fund newsletters on the Internet, ranking number 7 on the Google Directory page for Mutual Funds News and Media Newsletter websites. Since we began publishing our quarterly Model Portfolios, 29 out of the 36 Stock Portfolios have outperformed the S&P 500 Index over the following year (data as of Sept., 2009). Since 2000, 28 of our Model Stock Portfolios have had the opportunity for at least 3 years to pass since we first published it. 25 out of 28 of these Model Stock Portfolios have outperformed the S&P 500 Index over the following 3 years, and ALL Stock Portfolios (20 out of 20) have outperformed over 5 years as well. Mean level of outperformance has ranged from about 3% over 1 year to over 4% PER YEAR over 5 years.