Test for investors in bear market

SERIOUS MONEY:Warren Buffett notes that the first rule of investing is never to lose money and that the second rule is to never forget the former, writes Charlie Fell

IT HAS BEEN a challenging 12 months for bull market cheerleaders as one glowing forecast after another has proved embarrassingly wide of the mark.

The investment community at large remained optimistic throughout the past year despite mounting evidence that challenged their inertia. The eruption of the subprime crisis was dismissed as innocuous last summer but, once this proved incorrect, continued optimism was justified on the premise that aggressive action by the Bernanke Fed would alleviate the malaise and restore normality.

However, the crisis gathered momentum and what the bulls had previously described as containable verged on a full-blown systemic crisis by the spring as Bear Stearns teetered on the brink.

The hurried rescue of the veteran Wall Street firm saw the bulls emerge unfazed from their trenches to declare that the markets had reached bottom. They were proved wrong once again as stock prices have since registered new lows and are now firmly in bear market territory.

It is said that even a fool can make money in a bull market. The acid test of an investor's competency and skill comes only when conditions become more hazardous. Warren Buffett, the world's most successful investor, notes that the first rule of investing is never to lose money and that the second rule is to never forget the former.

In this respect, the vast majority of active investors have proved wanting in the current environment and negative compounding has decimated long-term returns such that almost a decade of effort has not even compensated for inflation.

Active investment is a losing proposition in aggregate and, without a clear understanding of the rules of the game and a well-developed process thereof, it is almost certain to be a fruitless pursuit. Investors need to be aware that they operate in a probabilistic field just like professional gamblers and, in order to be successful, must always seek to turn the odds in their favour.

Buffet notes that he and partner Charlie Munger "detest taking even small risks unless we feel we are being adequately compensated for doing so.

"About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton."

Unfortunately, most investors fail to assess the risk/reward pay-offs appropriately in stock selection and asset allocation. The first foible is the emphasis placed on fundamentals without regard to expectations reflected in market prices.

The focus on information-gathering is undoubtedly important but the forecasts derived thereof can provide a false sense of security and unwarranted confidence in subsequent decisions. More data does not mean better data and forecasts derived thereof typically represent a linear extrapolation of the recent past.

Academic research confirms that it does not lead to better decision-making, corroborating the idea that it is how an investor uses the information that matters and in this regard expectations matter.

Michael Steinhardt, who generated compound average annual returns of 28 per cent from 1967 to 1995, notes that his recipe for long-term success was "holding a well- founded view that was meaningfully different from market consensus".

The naïve use of information without regard to market expectations may prove successful in the short-term due to nothing more than the laws of chance, but luck usually runs out over longer periods.

The comparison of a well-founded opinion with market expectations is a necessary ingredient of a well-designed investment process but alone it is not sufficient. The world's most successful investors typically base their decisions on probability-weighted outcomes or expected values.

Buffett notes that he and Charlie Munger "take the probability of loss times the amount of loss from the probability of gain, times the amount of the possible gain" and only invest in positive expected-value outcomes. Most investors however, bet on the most probable rather than probability-weighted outcomes because the desire to be right outweighs expected-value considerations.

This means that investors typically build portfolios that contain a high percentage of winners. Unfortunately, the small profits generated by the winners are often overwhelmed by the large losses attributable to losing stocks leading to subpar performance.

The failure to apply a well-calibrated probabilistic analysis of potential outcomes is all too apparent midst the current market turmoil. Credit market indicators warned of an impending recession early last year and by the summer, the probability reached 30 to 35 per cent. Bear markets or stock market declines of more than 20 per cent always accompany economic downturns so the chance of loss in the period ahead times its magnitude gave minus 6 to 7 per cent.

It would have required a 10 per cent gain with 67.5 per cent probability to produce an expected return of zero and a gain of almost 20 per cent to justify an overweight position in stocks. The required return input grew ever larger and increasingly improbable as recession probabilities climbed through the remainder of 2007 and with it the possibility of a major market setback.

The failure to adjust investment portfolios appropriately is now plain to see. Pension managed funds have lost more than one-fifth of their value over the past year and the substantial drawdown sees all but one investment manager fail to beat inflation over the past decade.

The words of Warren Buffett spring to mind.

"It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently."

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