Why You Should Be Terrified

Why You Should Be Terrified

By Richard Gibbons

 

There are so many reasons to be terrified of the market right now.

 

The Fed has been raising interest rates, which can be a precursor to a bear market. At the same time, the yield curve just inverted, which often foreshadows a recession or even depression.

 

Housing may be in a bubble, and rising interest rates are finally starting to hit that market. Consumer spending has been driven by people cashing in on the cheap equity in their homes. Who knows what will happen if housing prices fall -- reducing homeowners' equity and their ability to use that equity to buy new gadgets from China? Non-mortgage debt is unlikely to pick up the slack -- consumer debt ratios are already at all-time highs.

 

And then there's the dollar. We're running record budget deficits and record trade deficits -- meaning that countries are lending us money to sustain our lifestyle. If the world becomes reluctant to do so, we could face a plummeting dollar -- which would likely result in inflation, falling stock markets, and a real decline in both wealth and income. And I haven't even mentioned war, terrorism, oil, derivatives, secular bear markets, hurricanes, or Sith Lords.

 

The truth

But the truth is, when it comes to investing, this is all so much bovine fertilizer. The media loves to focus 90% of its attention on those issues because they're exciting. But when it comes to investing, they're less than 10% of the story. America is arguably the most resilient country on the planet. Last century, we faced two World Wars, the Cold War, communism, a depression, the failure of numerous banks, the impeachment of a president, an oil shock, interest rates rising from 2% to 15%, several stock market crashes, and disco. We didn't just survive; we overcame these challenges and prospered.

 

It's a mistake to bet against America, even in the face of these scary macroeconomic issues. So, instead of being overwhelmed by the impossibly complex big picture, narrow your focus to individual companies. The market does not dictate your portfolio's performance; it's dictated by the performance of the stocks you own. Even in a bear market, some stocks outperform. Your job -- and ours -- is to find those stocks.

 

That's not to say that you shouldn't be aware of risks, but rather that you should focus your analysis on understanding how such factors can affect the businesses in your portfolio. If you own JPMorgan Chase (NYSE: JPM) or Bank of America (NYSE: BAC), war and hurricanes are likely to be less important to you than a potential derivative meltdown. These two companies are among the biggest players in the derivatives markets, so you should focus your efforts on understanding that risk.

 

But beyond these macroeconomic factors, there are two potential mistakes that may not seem as worrisome as the world running out of oil, but are actually so terrifying that they should keep you awake at night, whimpering quietly under your covers. The bad news is that they can destroy your returns. The good news is that they're completely under your control.

 

1. Not knowing what you own

The biggest mistake you can make in the stock market is not understanding what you're buying. The stock market has some similarities to a casino -- it's possible to make or lose money in complete ignorance. But the market doesn't have to be that way. The market may seem irrational, but over the long term, it's supremely logical. Strong companies prosper, weaker companies die or are devoured by competitors.

 

So, before you invest, make sure you have rational reasons for investing. Don't invest based on tips or stories, only invest in businesses. Make sure you understand both how the business makes money and why it will continue to do so in the future. If you don't understand what float is or a combined ratio is, don't invest in AIG (NYSE: AIG), even if you're heard that it's a top insurer. If you don't know what VOIP stands for, then you probably shouldn't invest in either AT&T (NYSE: T) or Cisco (Nasdaq: CSCO) -- two companies that will be significantly affected by voice over Internet protocol (VOIP) in very different ways.

 

At Motley Fool Inside Value, to get up to speed on a company, we begin by picking through a company's SEC filings, such as its 10-K. These documents provide an overview both of what the company does and potential risks. Then we sift through articles, conference calls, websites, press releases, and even discussion boards to gain a greater understanding. Finally, we distill that knowledge into an overview that subscribers can read to understand a company's business, competitive position, and risks.

 

2. Buying above fair value

A second mistake that should frighten your boots off is the possibility of buying stocks above their fair value. Look at the long-term charts for Amazon.com (Nasdaq: AMZN) and Yahoo! (Nasdaq: YHOO). These companies are among the strongest, most successful Internet companies. Six years ago, investors recognized correctly that these businesses would be two of the most dominant tech companies over the next decade. Yet investors who bought then lost roughly 90% of their investment in a few years.

 

The problem? They bought these stocks at prices way above their fair value. Regardless of how successful you are at picking "the next big thing," if you consistently buy businesses well above their fair value, you will underperform. It's simple mathematics -- if you pay $1 to for something worth $0.50, you're almost certain to lose money, unless you can find a bigger idiot willing to pay even more than you.

 

This dynamic is reversed when you buy below fair value. If you pay $0.50 for something worth $1, you have a decent chance of later being able to sell at a profit, and less chance of losing money. That's what value investing is all about.

 

If you don't know how to value a stock, we can help with that. One of our Inside Value discussion boards is focused on that topic, and a member of the team has created an online course to teach people how to value a stock. Plus, we have a discounted cash flow calculator that can be used to work out the fair value of any stock. Of course, our stock picks only include stocks that are trading below their fair value, and every recommendation includes an estimate of what that company is worth.

 

Knowledge is power

So, the way to deal with these terrifying issues is knowledge -- knowledge of the business in which you're investing and the fair value of that business. Such knowledge not only reduces macroeconomic nightmares to manageable risks, but also puts you in a position to actually profit when fears of such risks are overblown.