Learning from the Market Meltdown

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Sep. 17th 2008 in 8 Stock Portfolio

“Marge, my friend, I haven’t learned a thing.”

-Homer Simpson

I don’t think I have to rehash the events of the past few days. I’ve put together a quick list of possible lessons or takeaways. If you’ve lost money, at least learn from it.

You don’t have to be in on every trade or every situation. When FNM and FRE were teetering on the brink, they experienced periods of sharp gains amidst the sharp declines. Even during the week before the government stepped in, both stocks posted in excess of 100% gains from intraday low to intraday high. Most people were predicting a stock price of zero, but some still felt compelled to make the trade, to “buy a lottery ticket.” That is not how investing works. If you find yourself thinking along these lines, turn off your computer and go out for a sandwich. That sandwich will probably turn out to be a wise investment.

Sometimes you can beat the market by staying in cash. Money managers are lauded for their ability to “beat the market.” This year the indexes are down in excess of 25%. This means that you could have beat the market by more than 25% simply by staying in cash.

Lower prices don’t make stocks bargains. This runs somewhat counter the purpose of the 8 Stock Portfolio, but it’s true. Ask anyone who thought Lehman was a bargain at $4. If you are dabbling in beaten down stocks, at least stay away from the epicenter of the problem. When I selected the 8 stocks for this portfolio, I intentionally avoided all financial stocks.

You should understand how companies that you own make money. Did the average shareholder of FNM, FRE, LEH, or AIG really understand how the companies made their money? And more importantly, did they understand the corresponding risks associated with those methods? Of course not. It’s becoming apparent that even management did not have a grasp of this.

Nothing is sacred. The largest insurance company in America and a component of the Dow Jones Industrial Average was brought to the brink of insolvency. The stock price declined from over $70 to $2 per share. The fourth largest investment bank in the US with a history stretching back to 1850 has just declared bankruptcy. Blue chip stocks and financial icons can meltdown, too. Even if a company is “too big to fail” common shareholders can still be left with little or nothing.

You should know exactly what you will do in the event of a market meltdown. What did you do this week? Did you dump shares of your favorite stocks? Did you join the mad rush to buy GLD? Or did you use this as an opportunity to buy shares in companies that you carefully selected months before?

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