Stock Investing Tips

A bear market is when the stock market is down 20% from its highs. Not only has 2008 been a bear market, the last two months have in of themselves been a bear market.

The economic slowdown caused by the housing collapse and credit crisis has spready worldwide. At first, 2008 looked to be a commodities bull market. Oil went over $140 a gallon and commodity stocks like Freeport-McMoRan Copper & Gold (FCX) and Potash (POT) recorded huge gains.

Then, the full effects of the economic slowdown on global demand for commodities kicked in and commodites plunged. Freeport McMoran is down almost 70% over the last 3 months, and the price of oil has been slashed by over 50%.

The election brought a severe drop in stocks as well. Most believed that the market fully anticipated an Obama victory, but stocks still plunged 10% in the two days after his election. The day after, this past Friday, stocks managed to regain some of those losses with about a 3% rally.

Bear markets is what separates the men from the boys. Many investors have been killed by margin calls and speculations that went south. The CEO and founder of Chesapeke Energy Corporation (CHK) was forced to sell a significant amount of his holding in the company due to a margin call. While it is in a way reassuring that the CEO believed so much in his company that he bought stock on margin, it greatly hurt him and investors in the company when he was forced to sell a large chunk of his holdings to meet a margin call.

As bad as 2008 has been with the S&P 500 down about 37%, the year still isn’t over. If the year ended today, it would be the worse year since the Great Depression. The only two worse years were 1931, when the market lost 52.7% and 1907, when it dropped 37.7%. For us to get back to only the second worse year since the Great Depression, we’d have to beat 1974’s brutal returns of -29.7%. Hey, if we managed that, we’d have a nice little year-end rally from here on out!

For those of us on this side of Wall Street, investing can be quite the challenge. Many amateur investors compound this issue by speculating in companies that are a part of a sector they know nothing about. To get an edge on the market, it is imperative to invest in what you know. 

To truly break the market, one must know what others to not know. Buying companies that you know little about it not too unlike throwing darts at a board. Such a strategy isn’t necessarily bad if the market is primed to make a run. But on that token, why not just buy an ETF (like SPY) to ride the upswing so and avoid exposing yourself to companies you know little about?  

The market is pretty efficient at taking into account earnings reports and analyst expectations. These numbers are available to anyone, anywhere. There is no money to be made in knowing something that everyone else knows. It’s like coming up with an idea for a device that turns on the lights when you clap. Sure, it’s a good idea, but someone already thought of it before, so you’re not going to make any money off of it. Stocks work in precisely this same fashion. 

When you’re ready to stop throwing darts at a board and truly start investing, play to your strengths. What do you know that others might not? Is there a restaurant chain in your area that Wall Street might lack awareness of their upside? Is there a company within the industry you work for that is slowly gaining a competitive edge while not seeing an improvement in their stock price? Look around you. You don’t have to be a seasoned investing professional to find a gem of a stock pick.  

Remember, when you invest in what everyone else wants to invest in, you’re not on the cutting edge, you’re merely part of the herd. This has been a conundrum that Jim Cramer has had to face with the increasing popularity of his show, Mad Money. There is an inverse correlation between the value of his stock tips and the number of viewers of his show who buy the stocks he recommends.  

Sure, you might squeeze out a buck or two by investing with the herd. But like I said earlier, if you’re going to invest with the herd, why pretend to be doing otherwise? Just buy an ETF and spend your time elsewhere. There’s absolutely nothing wrong with that. But if you’re ready to break the market with your portfolio, you have to get out on the cutting edge by investing in what you know [and that others don’t know].

To beat the market, you need to do something better than other investors. Sure, you can just get lucky sometimes. Luck can ever propel some people to better-than-market returns for several years. But to beat the market in the long-run, your investing approach must be superior than the average investor.

There are many ways to go about this. The most basic way is pick stocks that outperform on average. You can use fundamental analysis or technical analysis to do this. With fundamental analysis, you believe the market is undervaluing an aspect of the company. In essence, you feel that you understand the company a little better than the market, and that the market is currently undervaluing its potential.

With technical analysis, you hope to beat the market by trading on trends. You analyze the psychology of the market and hope to beat the market by predicting what other investors will do. You look at the chart of the stock and predict its future course of action. In a sense, you are betting that your ability to predict the future of the stock’s movement is better than the average investor’s.

There are other ways to get an edge on the market as well. In fact, you don’t even need to be the one that picks and chooses the stocks. If you believe you have a keen ability to evaluate mutual funds and know which one’s will outperform the market over time, then picking mutual funds might be for you. While many funds are duds, some are super stars. If you are able to choose the ones that outperform the market, you will beat the market that way.

Another way is if you feel you can choose sectors that will perform well. You might believe you don’t know which stocks will do well, but you feel that you know which sectors will outperform. This is pretty tough since it involves a lot of macro-economic understanding that most people don’t have. But nevertheless, some people can beat the market this way. Investing in sector ETFs is an efficient way for these types of investors to beat the market.

If I’m going to have a blog about “breaking the market,” I think it’s only prudent to define the term to begin with :). Some people hope to get 50-100% returns in a year. They see an informercial on TV about people turning a couple thousand into millions and think they could be them.

Quite frankly, these people are delusional and only end up getting defrauded or losing their entire investment. To me, breaking the market just means beating the market consistently over time. So, if the S&P 500 returns about 10% on average over 5 years, breaking the market would imply 13% returns or better. If the S&P was up only 4% over 5 years, gaining 8% is definitely amazing.

Beating the stock market isn’t easy, but it can happen. With the right amount of discipline, smarts, and sometimes just plain luck, it’s entirely possible to beat the market.