I originally planned on writing about some of President Obama’s comments from his press conference this week. But based on comments I’ve heard in the media and from some acquaintances, there is something more urgent that needs to be addressed. Whatever economic stimulus package Congress approves, we might see some significant market volatility in response to those actions. But we won’t be able to assess the real impact of any plan for several months if not years.

I worry that many investors’ response to this economic crisis is likely to further damage their investment portfolios. Many people have a powerful emotional attachment to money. I used to organize seminars on options trading. In the first class session, the instructor would borrow a $100 bill from someone in the class. Then he would tear it into tiny pieces while everyone watched. Usually the person who provided the bill showed some discomfort. The most interesting part of the lesson was to watch the reactions of others in the class. There was almost always a loud gasp or two. Usually several class members showed signs of uneasiness, even though it was not their money that was destroyed.

The instructor then discussed the reactions with the class. He explained that losses were inherent in any options trading system and that those who felt their stomachs tighten when the $100 bill was destroyed might want to reconsider their desire to trade options.

Today many investors are feeling nervousness about their portfolios. For some who have experienced dramatic declines, that concern can verge on desperation. As a result, they might knowingly choose risky investments in an attempt to quickly make up for those losses. That is exactly the wrong approach to take.

The main objective of active risk management is to try to avoid investment losses that come from major bear markets like the world financial markets are currently experiencing. Many investors do not really understand the economics of losses and they incorrectly believe that when cycles turn up, losses can quickly be erased. Even after the significant losses incurred by major market indices over the past year, many investors we speak with are more concerned about missing potential gains than they are about avoiding additional losses.

To help explain how a major loss can impact a portfolio, let’s consider a specific example. From its peak in October 2007 until its low in December 2008, the Dow Jones Industrial Average lost about 46%. So an investor who started with $100 was left with $54.

This is where it gets interesting. If the Dow regains 46% in 2009, the investor will not be back to even in his account, because now we are talking about 46% of $54 instead of 46% of $100.

So after a 46% gain in 2009, that investor who started with $100 will have $78.84. To recoup his original 46% loss to make his $100 whole, the investor actually needs an 85% gain.

Here is another example to put these recent losses in perspective. Wednesday the Dow closed at 7,939. Ten years previously in February 1999 the Dow was at 9,298. In other words, the Dow today is 14% lower than 10 years ago. If that rate of return continues indefinitely, no one reading this will live long enough to regain the loss.

Be assured the markets are not likely to continue losing money indefinitely. There are going to be future opportunities to earn profits. But with the uncertainty that currently dominates the economic situation and with continuing market volatility, investor focus should remain on protecting existing capital and preventing additional losses.

As I write this Thursday morning, the Dow is off nearly 200 points. As you can see from the chart above, the current level is very near the lows established in November 2008. If the Dow breaks below this technical support area it could easily fall to 7,000 or even lower over the next few weeks. Other major indices are in similar circumstances.

Investors who are positioned in the safety of government insured money market funds should not be hurt by the continued deterioration of investment markets. Those who are still invested because they do not want to miss out on an eventual market upturn may well suffer continued losses that might take a lifetime to recoup.

Of course there is always a chance that today’s action could mark the bottom and the stock market could rebound strongly from this point. But that would be contrary to what our technical indicators are showing at this time. And betting against those indicators now does not seem worth the risk.
F.S.

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