This One Is For My Father

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Includes: QQQ, SPY
by: Aristofanis Papadatos

Summary

I am about to lose my father in a few days.

While he was averse to the stock market, investors can learn some precious lessons from his attitude towards it.

Those who ignore these points are likely to incur devastating losses at some point in their investing career.

Unfortunately, I am about to lose my father in a few days. Everyone can understand the magnitude of this loss, while it is also extremely painful to watch his condition deteriorate day by day. While he has helped me in several aspects of my life, in this article I will analyze only the essential points that are related to the investing process. I believe that investors can greatly benefit from these points.

First of all, he was an extremely hard-working person. He had his own enterprise and devoted his whole life to it. He worked almost every waking hour; he did not exclude the weekends and hardly ever offered a vacation of more than a week per year to himself. Notably, he was very averse to the stock market.

During the impressive bubble of the US stock market in 1999, the Greek stock market experienced an even greater bubble, one of unprecedented magnitude. Valuations skyrocketed to inconceivable levels. During that period, the my father's sister teased him that her daily profits from her stocks exceeded what my father earned in months through his hard work. She also claimed that she did not have to make any effort whereas he was working all day long. While that situation lasted longer than one could reasonably expect, my father was not enticed. He just warned her that her profits would probably evaporate faster than they accumulated. Indeed, this is what happened, not only in the Greek stock market but also in Nasdaq (QQQ), which peaked in 2000. There are certainly some precious lessons investors should keep from this case.

1. Very hard work is required in the stock market.

My aunt thought that she would continue to see her profits accumulate forever without any effort from her side. Unfortunately, there is no such thing as a free meal in the market. Competition has heated more than ever in most sectors and hence investors should continuously monitor the growth prospects and the valuation of their stocks. Otherwise, they are condemned to experience a hard landing to reality at some point.

To be sure, even the best-of-breed stalwarts, which have consistently grown for decades, have stopped growing in recent years due to increasing challenges. For instance, Coca-Cola (KO), Wal-Mart (WMT), Procter & Gamble (PG) and General Mills (GIS) have failed to grow their earnings during the last four years. Even AutoZone (AZO) and O’Reilly Automotive (ORLY), which had grown their earnings per share at double-digit rates for almost 40 consecutive quarters (!), have faced strong challenges lately and their stocks have plunged by about 35% since December.

Investors should take note of this fact and realize that they should work very hard to manage their portfolio if they want to achieve their long-term investing goals. If they think that they will see their portfolios grow year after year with minimal effort, they will inevitably learn their lesson the hard way at some point.

2. When the market offers you exceptional profits within a short period, you should protect them.

S&P (NYSEARCA:SPY) has historically returned 8.6% per year on average. Of course the index has not offered this return in a straight line. Instead it has experienced pronounced fluctuations in its performance. Therefore, when the market offers exceptional profits within a short period, investors should carefully check whether their stocks have become clearly overvalued. If this is the case, they should thank the market and sell their stocks.

Some investors hesitate to sell their stocks because they find it hard to pinpoint promising alternatives, particularly when most stocks are overvalued. In that case, they should target slightly lower returns, with securities that are much less risky than stocks. For instance, as most stocks are fully valued or overvalued at the moment, I can certainly accept the approximate 6.0% annual yield to maturity of the 20-year bonds of Yum! Brands (YUM). While the market has historically returned 8.6% per year, it is likely to offer much lower returns going forward from its current valuation. Therefore, I certainly prefer the above corporate bonds, which are also much safer than stocks.

Investors can also reduce their delta by switching from stocks to short positions in put options of their stocks. In this way, they change their risk/reward profile of the stocks they own. As long as a stock does not rally strongly, the at-the-money and slightly out-of-the-money put options of the stock have a more favorable profile.

3. Never become arrogant about the stock market.

During bubbles, most investors become complacent and think that the party will go on forever. Even worse, some investors become arrogant and boast of their extraordinary daily profits. Unfortunately, these investors are the least likely ones to take notice when the bull market ends. As the stock market starts to plunge off its peak, the arrogant investors remain stubborn and wait for a recovery without performing their due diligence. This is certainly a recipe for disaster.

Investors who want to succeed in the long term should always try to eliminate the effect of their emotions on their investing decisions. And while many investors are aware of this, it is much easier said than done. For instance, it is impossible to leave emotions out of the picture when one is highly leveraged or one has picked weak stocks, which will collapse upon the first downturn. Therefore, investors should carefully select the least risky securities that are likely to offer them their target return. Only in this way will they be able to leave their emotions out of their investing process.

The bottom line

Although my father is averse to the stock market, investors can greatly benefit from the above lessons drawn from his stance towards it. Those who ignore the above points run the risk of facing devastating losses at some point in their investing career. A strong headwind in the stock market can easily destroy investing efforts of many years or even decades. As far as my father is concerned, I will always be grateful to him for everything he has done and taught me. I will always remember him.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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