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Preserving Capital a Priority in This Risky Market
By Stephen T. McClellan
Author of Full of Bull (Updated Edition): Unscramble Wall Street Doubletalk to Protect and Build Your Portfolio

This is a tricky, confusing, and difficult to predict stock market. The debate rages between bulls and bears, the S&P 500 some 36% below the high of October 2007 but 47% above the trough last March. Wall Street is no help. It is a giant marketing machine and always plays the role of cheerleader. Given its congenitally favorable bias it is accentuating the recent rally. It pays no attention to risk or preservation of capital. The Street never tells you that it requires at least double the percentage gain to offset a given loss. At this point, it will necessitate a 131% upside move for the S&P 500 to get back to even following the 57% drop through early March, a long way to go even after the 47% surge since March.

In my book, Full of Bull, I emphasize it is never too late to focus on protection of capital. But don't turn to Wall Street for assistance. Consider its sorry record during 2007-2008 and its own holdings of toxic assets such as subprime loans and collateralized debt obligations. Inattention to risk led to the capitulation of Lehman Brothers, Bear Stearns, Merrill Lynch, AIG, Fannie May, and Citibank. If the Street is not protecting its own capital, do you think it is paying heed to yours?

Protection of capital is a paramount investment objective far ahead of gains and returns. There are no excessive returns without commensurate risk. Think of Long Term Capital Management, the Internet bubble, the toxic asset financial debacle, the housing bubble, etc. Brokerage firms and research analysts rarely indicate the worst-case downside risk in a stock, only the upside price objective. Amid a bear market in the first half of 2008, during the crisis of confidence when the financial sector was being decimated, a major Street firm advised investors to purchase growth stocks, emerging market stocks, and international stocks. There was little reference to cash or how to avoid losing money in its outlook report. Investors are already taking enough risk by owning common stocks. A conservative approach is warranted.

California's largest pension fund, Calpers, incurred an almost $60 billion loss in its investment portfolio amidst the state's current financial crisis, similar to many college endowment funds, investing billions in high-risk private equity, hedge funds, emerging markets, real estate, and toxic assets. But in Calpers case, it seems to have learned nothing about risk from that debacle. In appointing a new head of investments, its strategy now is to pursue further high-risk investments, such as junk bonds and California real estate, to seek higher returns in order to make up the loss. Calpers is not humbled or taking a more cautious approach as the strategy should have been all along. It is still not focused on protection of capital.

The goal here is don't lose, the secret of superior investing. Charles D. Ellis makes the point in a Financial Analysts Journal article that "large losses are forever -- in investing, teenage driving, and fidelity . . . and are almost always caused by trying to get too much by taking too much risk." He discusses the excitement of "the big score," which causes the investor to put too much emphasis on offense, with little regard to defense.

So forget the 57% bear market dive through early last March, and the subsequent 47% upsurge. That's history. Take the attitude that it does not matter what your stock or investment has done up until now -- whether it is ahead from where you purchased it or underwater. When I recommend selling a stock that has plummeted far below the purchase price, people often retort: "I can't do that; I'll lose too much money." They think the loss is not real until they sell, that it exists only on paper, and are frozen to a past decision. Consider what is in store for the stock going forward. The only aspect you can control is today's investment decision. You cannot alter previous mistakes, especially by being stubborn and refusing to reassess the prospects.

A low risk portfolio contains a material amount of cash equivalents. There should be good balance between stocks and more secure investments like bonds. Stocks should be value-oriented carrying modest PE ratios and strong balance sheet financials. Dividends are key and almost always go together with value stocks. Dividends usually connote reasonable profits, cash flow, financial strength, and balanced, appropriate management principles.

Currently, the stock market outlook seems fraught with risk. Is this a bear market rally, are stocks overvalued, will deficits, deflation, unemployment, consumer devastation, falling housing prices, and a weak dollar cause yet another market dive? Or is the wall of worry a tonic, the negatives already discounted, federal monetary policy providing huge liquidity, and the trillions of dollars on the sidelines an underpinning to funds inflow to the market? It's always about risk. This element should be the core of any investment strategy or, like Calpers, you've learned nothing from the bear market.

©2009 Stephen T. McClellan, author of Full of Bull (Updated Edition): Unscramble Wall Street Doubletalk to Protect and Build Your Portfolio

Author Bio

Stephen T. McClellan, author of Full of Bull (Updated Edition): Unscramble Wall Street Doubletalk to Protect and Build Your Portfolio, was a Wall Street investment analyst for 32 years, covering high-tech stocks as a supervisory analyst. He was a First Vice President at Merrill Lynch for 18 years until 2003, and ranked on the annual Institutional Investor All-America Research Team 19 consecutive times, The Wall Street Journal poll for 7 years, and has a place in the Journal's Hall of Fame. From 1977 to 1985, he was a Vice President at Salomon Brothers and before that held a similar position at Spencer Trask for 6 years. Before commencing his Wall Street career, he was an industry analyst with the U.S. Department of Commerce. From 1964 to 1967, the author served as an operations officer aboard the USS Suffolk County (LST-1173) in the U.S. Navy.

Mr. McClellan has a Chartered Financial Analyst (CFA) designation, is a member of the New York CFA Society and the CFA Institute, was President of the New York Computer Industry Analyst Group, and was President and Founder of the Software/Services Analyst Group. He has made television appearances on Bloomberg TV, FoxBusiness News, CBS, CNN MoneyLine, CNBC, and Wall Street Week. He has conducted several radio interviews on such programs as Bob Brinker's Moneytalk and given presentations to numerous organizations, at conferences, and to companies. Mr. McClellan has published articles in the Financial Times, The New York Times, Forbes, and other publications. His MBA in Finance is from George Washington University and his BA is from Syracuse University.

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