10 Lessons Learned from Bear Stearns' Fall

Investors can use the fall of Bear Stearns (BSC) in a constructive manner by learning from the investment debacle.

1. Diversify

A strategy that I believe in, yet loathe at times. The key is to diversify just enough, but not too much that it takes your portfolio back to the mean. I am often asked if there are a specific number of stocks that should be owned in a portfolio. In general, I would say 14 to 20. That puts the average weighting of any one position from 5% to 7.5%. Imagine if you had Bear Stearns in your portfolio at a 5% weighting and held on until yesterday. For all intensive purposes, we will consider Bear worthless at this point. If you bought BSC at $170 last January and put 5% of your portfolio into the stock, the most you would have hurt your portfolio is 5%! So a $100,000 account in January 2007, with $5000 in BSC would be sitting at $95,000 if the rest of your portfolio was flat. Now that does not sound too bad. If you would have had a 50% stop-loss, it would only have an effect of 2.5% on your overall portfolio. I think you can see where I am going with this. It is important not to put all your eggs in one basket.

2. Stop-loss orders

A stop-loss order is a price (determined by you) that is considered the level in which BSC must be sold if it falls below your entry price. For example, if you bought BSC at $170 and your stop-loss was 20%, the stop-loss order would have been placed at $136. In hindsight you would have been a genius selling with a 20% loss in BSC. Going back to the example in number one, selling BSC with a 20% stop-loss would have only brought down your overall account by 1%! In the future, I suggest using a stop-loss to help protect your portfolio from another BSC situation. Remember, you will have to take losses in the stock market; as a matter of fact most investors lose on over half of their investments. By not letting your losers turn into an Enron or BSC is important to the overall performance of your account.

3. Asset Allocation

Here at Penn Financial Group [PFG] we implement a Top-Down strategy when choosing the stocks and ETFs for our clients. In general, this means we begin with the market and work down to sectors and finally to ETFs and specific stocks. We have been able to keep our clients exposure to the Financial sector below 1% during the credit crunch over the last year by this very strategy. It was clear the Financial sector did not offer an attractive reward-to-risk opportunity and therefore there was no reason to buy related stocks or ETFs. When we would build our asset allocations for clients we would earmark a small percentage of money for the Financial sector, however the opportunity to buy never arose and therefore we were able to avoid the direct hit of the credit crisis.

4. Do not catch a falling knife

Heading into yesterday, BSC was down 62% for the month and over 80% from the January 2007 high. What makes you believe you can now pick the bottom? Heck it looked like a bargain at $80 and $60 and $30. Yesterday on TV there was an “individual investor” that was complaining about losing money in BSC and that he was getting a bad deal along with all shareholders. Be that what it may, the point is that the investor bought BSC at $32 on Friday. So when he bought BSC at a new multi-year low on Friday, he was trying to make a “quick buck” and things were great. When the very risky trade went against him, it is now the fault of someone else. This does not surprise me because most investors I know would love a “quick buck” without taking the risk. If you were buying BSC on Friday and realized the potential upside and did not think about the downside - shame on you. With big reward often comes even bigger risk. My point is not to try and catch the falling knife that will slice your hand 99% of the time. This concept is very similar to not buying a stock hitting a new all-time high.

5. Rumor can become Truth

The rumors were flying last week that BSC could be heading for bankruptcy or a similar fate. I honestly let them fly in one ear and out the other because there are rumors of this magnitude on a daily basis coming across my desk. The fact I did not have exposure to BSC or any related companies it was not a major issue either way, but in hindsight it would have been prudent of me to delve into the rumors. That being said, if I had to research every stock or Fed rumor it would be and endless job and horrible use of my time. Keep in mind that 99% of the rumors I hear are just that - rumors. Just because the BSC turned out to be true, please DO NOT shift your investing strategy to playing the Rumor Mill.

6. History is on your side

Over the last century of the stock market there has not been an economic or stock related catastrophe in which the stock market did not rebound. The BSC debacle will not change that unscathed record. In the short-term there will be plenty of hurdles the market must get over as the bottoming process continues. The Crash of 1929, the Tech Bubble in 2000, and Black Monday in 1987 all looked like the end of the stock market and in each instance the market was higher a few years down the road. Do not give up on the stock market this time or you will regret it in a few years.

7. Alternative Sectors

It has been nearly impossible to make money in stocks in 2008. Heading into yesterday, the S&P 500 was down over 12% and the NASDAQ was down nearly 17%. Of the 239 sectors PFG tracks, less than 7% were up for the year. The one area that has been kind to investors has been the “Alternative Sectors”. The metals, energy, agriculture, and foreign currencies have all moved higher in 2008 and have been a great place for investors to put money during a falling US stock market. The commodities may be near a short-term top, but I believe the long-term outlook remains bullish and all investors must consider this area when building their asset allocation model.

8. Have a Plan

This may sound simple, yet many investors do not have a plan for their investments. Could you imagine building a deck on your house without a detailed plan of materials, cost, blueprints, and tools? Well I have built a deck and it would be impossible to build the best deck possible without the above-mentioned prerequisites. The same goes for investing; investors must have a solid, well thought out plan before putting any money into stocks or ETFs. Without a plan you may have been buying the financial stocks because historically they were “cheap”, when in reality they were undervalued for a reason.

9. ETFs

One easy way to help eliminate company-specific risk, such as BSC falling 90% in two days, is the use of exchange-traded funds (ETFs). Because they are composed of a basket of stocks, the collapse of one stock will not result in the magnitude of losses that a single stock can. The iShares US Broker/Dealer ETF (IAI) was down 8% yesterday, but that is much better than a 85% drop in BSC. If you feel you are not able to take the daily swings of an individual stock, please consider ETFs as an alternative.

10. $170 to $4

That is the fall BSC took from last January to today. If you held the stock the entire time, it is a painful situation and I do not want to harp on it for those poor investors. However, your $1 billion investment in 1/07 is now worth $24 million. The million in 1/07 is now sitting on a mere $24,000! Remember the stock market is not a game and as quickly as you make money, you can lose it. As they say in the movie “Wall Street”, “greed is good”. Sure it is a great line from a movie, but greed can also push back your retirement by 10 years. Just ask the poor guy/girl that had 100% of their 401K in BSC stock.

Disclosure: none