Best to take a defensive position

Jul 28, 2014

Paris, France

Dear diary,

Stocks fell 123 points on the Dow on Friday. And on Saturday, our youngest son, Edward, returned from Africa. He had escaped capture by a rebel army in the Democratic Republic of the Congo...walked 50 miles through the jungle...and eventually made his way to the American embassy in Kinshasa, where he was given a new passport.

As to the Congo, Edward reported to his grandmother: "Rich country (in natural resources), hard place to do business. The local people are nice. Until they decide to kill you."

Grandmother: "Why would you want to do business there?"

Edward: "Because it's there. It's a challenge. It's an adventure."

Grandmother: "You don't get extra points in life by doing things that are not worth doing."

That wise counsel in mind, we return to the stock market. As we explained last week, we can only know what is false, and not what is true. Even as to what is false, we are sometimes surprised.

But since our ground is firmer on the 'what we don't know' side of the hill, investing is best approached from a defensive position. That is, don't worry about finding the best stocks or the best investments; just be sure you don't have the worst ones. And don't worry about missing the market's best days...just watch out for the worst ones.

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This view was recently confirmed for us by a study (thanks to Richard Russell's DowTheoryLetters for bringing this to our attention). If you missed the 10 best days of market action during the last 25 years, and your rate of return would have been cut in half. Instead of getting over 6% per years, your return would have been only 3.67%.

On the other hand, if you missed the 10 worst days over the last 25 years, your rate of return would have risen to nearly 11%.

The lesson from this is familiar: if you can avoid the market's worst days, you're way ahead of the game. Of course, this is probably true of a lot of things. Think how much happier your marriage would be if you could blot out the 10 worst days of it. Or what a nice life General Custer might have had if he just not spent that awful day at the Little Big Horn!

But when do the market's worst days arrive? We haven't studied the matter, but they almost certainly follow a big run-up in prices. 1929. 1987. 2000. 2008. Typically, you get big drops after a long period of gains.

Or in grandmother's terms: trying to capture the last gains of a bull market is probably not worth doing. Even if one of those gains turns out to be one of the market's 10 best days (which is unlikely) it is still not worth the risk that you will stumble into one of its 10 worst days.

We bring this up today because we don't want you say we didn't warn you. One day, perhaps soon...perhaps not, the stock market will have one of its worst days. It will fall, maybe 1,000 points...maybe 3,000. And unlike previous recent episodes, this time stock prices may stay down for 10 or 20 years.

Bear markets - and market crashes - are not hypothetical. They are real. They are part of the market cycle. They are a part of life.

But wait. What's that you say? Janet Yellen and intelligent financial management techniques have banished bear markets? Knowing that the Fed will always come to their aid with more cash and credit, investors will never again sell stocks in panic; those days are over?

Is that true? Never was before. But who knows? Time will tell.

"There aren't enough Indians in the world" to defeat my army, George Armstrong Custer is thought to have said, before having one of his worst days ever.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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