Friday, December 5, 2008

It can always go lower

This might seem obvious, but it's a good thing to keep in mind, especially as a value investor. It can always get worse. Just look at the disastrous investments that "sophisticated" investors like Temasek and Cerberus made in companies last spring. Stocks can and do go to zero. You should at least learn that lesson from the current financial crisis.

So when you hear about the market possibly re-testing lows or capitulation, please ignore it. I'm not saying those people are stupid. They may in fact be 100% right, but their message is beside the point. As a value investor, you are trying to find a bargain, not the absolute best bargain or the bottom.

So what should you do when you buy a stock and it takes a hit. You should re-evaluate. Has anything material changed about the company or its prospects? Is the market just punishing stocks in general as it was in October? If it has, then please, by all means, sell and live to fight another day. If it hasn't, then maybe you want to buy more, maybe not. That depends upon your appetite for risk, available cash, etc.

You should also ask yourself, "how much am I willing to lose in the short-term?" I know that long-term investors are supposed to be immune to short-term developments, but we're not. We watch CNBC, read the financial press, and read message boards(much to my own dismay). We do not live on islands enjoying a monk-like existence allocating capital. Again, you know yourself better than I do. What kind of losses can you live with? Buffett thinks that anyone who can't take a 50% loss shouldn't be in the equity markets, but that's an unfair standard. Buffett after all is a billionaire buying for an insurance conglomerate. He can afford such a luxury. You, on the other hand, might need that money sometime within the next five years for retirement, paying for college, a down payment, etc.

So be honest with yourself. When it hits your pain threshold, sell. You can always re-establish the position. Don't try to be a hero and prove how smart and disciplined you are. It's good to acknowledge mistakes and learn from them.

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