Lessons Learned the Hard Way

02/12/2009 3:33 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

After participating in MSN Money’s Strategy Lab the last few months, I now know how the gladiators must have felt in the Colosseum back in Ancient Rome.

Everywhere they turned, it was thumbs down.

During maybe the worst six-month period in stock market history, none of the usual strategies worked. To navigate these treacherous markets, investors had to be nimble and undogmatic and think outside the box.

That’s why Andrew Horowitz, this round’s winner, racked up very impressive gains while the Dow Jones Industrial Average fell nearly 30% and the Standard & Poor’s 500 index was off almost 35%.

Isn’t that the kind of absolute return hedge fund chieftains are supposed to deliver? Or mutual fund managers? Or even some big-name investment advisers?

For the most part, though, the professionals seriously lagged their benchmarks.

So, many of us who finished in the red in Strategy Lab (I was down about 15%) still did better than people who are paid big bucks to beat the market.

But my own experience in this round has led me to some conclusions about how to invest now.

The bottom line: I did a lot of things right, and they saved my portfolio, but I could have done even better had I been more consistent.

In a contest with a six-month deadline, I invested very differently than I do in my 401(k) plan or even in the 20% of my portfolio I use for active investing. I traded more and held less, and followed news events a lot closer than I do in my own account.

(You can read my Strategy Lab strategy here and a summary of my first picks here.)

Having said that, here are three lessons I’ve learned.

1. Cut your losses quickly. That was one of the key precepts I laid out here late last year. If you’re an active investor in a market like this, you need to set firm stop losses or stick to specific targets, no matter what.

I set mine at 10%, so I would automatically sell a stock or ETF when it lost that much—no questions asked. When I stuck to it, it worked fine. When I didn’t, I got in trouble.

I bought four stocks at different times—IBM, Johnson & Johnson, Qualcomm, and Perrigo—and I sold them all within weeks, when they dropped more than 10% below what I paid for them. I dumped the US Oil ETF a week after I bought it, when it fell below that threshold. (I bought back Qualcomm much later and much cheaper.)

Had I continued to hold them all until the end of the round, I estimate I would have lost another $8,000, putting me about 23% in the red instead of 15%. Big difference.

But I didn’t follow my own advice when it came to three other positions I held: iShares S&P MidCap 400 Growth Index, SPDR S&P Biotech, and Dolby Laboratories. There, for some reason I can’t explain, I let these losers run. True, both Dolby and the biotech ETF beat the market by about 15 percentage points, while trailing my overall average by about five points.

(You can see my Strategy Lab portfolio and transactions here.)

But by sticking to my rules and selling them at the 10% threshold, I could have prevented about $7,000 in losses, which would have put me solidly in second place.

In retrospect, I also took much too big positions in the biotech and midcap ETFs at the outset. Coulda, shoulda, woulda.

2. Don’t fall in love with a stock. Peter Lynch famously advised people to invest in what they know, but unfortunately familiarity can breed contempt in the stock market.

Here I must make a confession: I am a big audio/video fan—not the kind of fanatic who stays locked up in a basement busting the family budget in a quixotic quest for the “perfect” sound, but a fan nonetheless. I have owned several home stereo systems and a few years ago graduated to home theater. (Hint: Don’t pump your subwoofer to the max when you’re watching The Dark Knight in a Manhattan apartment.)

So, to me, Dolby Labs was a great way to play that passion, which is apparently shared by millions. It’s also a great company which repeatedly beat its earnings estimates, was a clear market leader and had several different revenue streams. The stock had had a good run but was selling at reasonable prices when I bought it in Strategy Lab.

But, ahem, in this kind of economy, you get by with your old 36” plasma and sign up for Netflix (a stock I should have bought). Even all the licenses Dolby had for PCs, which I thought were its ace in the hole, aren’t worth as much when people and companies stop buying computers, too.

This is a mistake many investors make, even the best—even Warren Buffett. I like wine, too, but that doesn’t mean I have to buy Constellation Brands. Lesson learned.

3. Buying individual stocks is mostly a bad idea. I follow a lot of advisers at MoneyShow.com, and the ones who did the best last year avoided individual stocks like the plague. Like them, my best picks were ETFs: ProShares Ultrashort FTSE/Xinhua 25 Index, PowerShares US Dollar Bullish, CurrencyShares Japanese Yen Trust. Two of the three, you might notice, were currency plays not tied to any stock market.

There’s lots of research that shows individual investors don’t do a good job picking stocks, principally because the risk of an individual stock is much greater than, say, buying a sector ETF.

From having spoken to thousands of investors over the years at Money Shows and other events, I’ve come to the sad conclusion that not too many do the basic research—reading financial statements, etc.—but instead buy an individual stock to cash in on a trend, such as solar energy. ETFs are far better suited to that, in my opinion.

And too many people, I suspect, are trying to make up for their losses by chasing the latest hot stocks. If you listen to only one thing I say, please, please, please don’t do that!

If this market has taught us all one thing, it’s that risk must be respected. For most people (and there are some exceptions), focusing on individual stocks adds too much risk to their portfolios.

After a tough, tough year like this one, we don’t need to learn any more lessons the hard way.

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own.

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