Lessons From Investing's Lost Decade

Aug. 2, 2012— -- The 2000s, when the stock market punished many investors with an up-and-down ride that delivered no overall gains, are widely referred to as the lost decade.

The disappointment hasn't ended. "The lost decade is now in its thirteenth year," says Martin J. Pring, co-author of Investing in the Second Lost Decade.

Since 2000, the S&P 500 has registered two plunges of more than 50 percent and several of more than 10 percent, leaving this index slightly lower today than it was 12 years ago. With portfolios (including those held in 401(k) plans) now under fire from the most volatile stock market ever, the current decade holds little promise for improvement over the last.

This isn't your father's market. Gone are the days when using a buy-and-hold strategy – purchasing a variety of stocks and sitting on them long-term – makes sense.

"Buy-and-hold investors have little to show for the roller-coaster ups and downs, aside from a nauseous gut," says Pring, chairman of Pring Turner Capital Group.

That's because a buy-and-hold strategy can easily leave you open to big hits. It's critical to protect your portfolio from such hits because it could well be impossible to recover, especially if you're approaching retirement.

Today's unforgiving market makes it more important than ever to fortify your portfolio against risk. Here are some defensive moves to consider:

Take refuge in cash. By "cash," I don't mean dead presidents but investments that are highly flexible because they can be quickly liquidated without penalties. These include money market funds and extremely short-term Treasury bond funds.

Go light on growth stocks. When the market plunges, stocks of rapidly growing companies often go down disproportionately. Market drops of 10 to 20 percent can drag these growth stocks down 25 to 60 percent. In bear markets, it's not uncommon for them to drop 70 to 80 percent from their highs. When this happens, your portfolio ship's propellers turn into anchors. The moral is that you don't want to be too heavily invested in growth stocks in a severe correction or bear market.

For value investors, begin focusing on quality. Value investing is the practice of buying stocks you believe are undervalued but will eventually rise. In the current market, even the best of these value horses are likely to falter. Instead, look for companies that the market sees as being high quality now.

Quality companies have good balance sheets year after year, and they have lower volatility. Thus, they have good returns for the risk taken. They may not rise meteorically during good markets, but they can serve as safe havens from market storms.

Identify defensive market sectors. Some sectors or industries are inherently defensive. Among these are mature companies including utilities, which aren't race horses in brisk markets but protect capital during tough times because they tend to have stable revenues and predictable costs.

Established pharmaceutical companies with household-name drugs can be protective. So can a category of companies known as consumer staples –for example, Coca-Cola and Johnson & Johnson.

Options. These are contracts that give investors the option, but not the obligation, to buy or sell a security at a set price within a given time period.

A widespread misconception about options is that they are strictly a speculation tool. Yet they are also used to protect against losses.

Let's say you own shares in Apple. You believe the company may be vulnerable, but you're not sure you want to sell the shares. So you buy a "put" option on your Apple shares, allowing you to sell them at a set price within a set time period.

If, when the option is about to expire, you want to keep the shares, you do nothing. But if the shares have declined substantially and you don't think they're going to come back, you might be able to sell them at a price far higher than the current market value.

By buying the options, you've insured your Apple shares against risk -- a use of options that many investors aren't aware of. "When I ask investors if they have life insurance, auto insurance, homeowner's insurance, health insurance, disability insurance, I get a lot of 'yeses,' '' says Stan Freifeld of McMillan Analysis Corp., an investment advisory firm that specializes in options.

"When I ask the same investors if they have any portfolio insurance, they look at me as if I had three eyes! Why would someone who apparently believes in the insurance concept not have any insurance on what is probably their first or second largest asset -- their investment portfolio?

The answer is they probably don't know it's available," says Freifeld, whose colleague, Lawrence G. McMillan, explores uses of options in Options as a Strategic Investment.

You can insure your entire portfolio by buying put options on indexes (such as the S&P 500) or by buying "call" options -- giving you the right to buy an underlying security at a set price during a set period – on the VIX, or market volatility index. This way, you can manage risks posed by the current rollercoaster market.

Tactical asset allocation. This is changing your portfolio's percentage of one type of investment versus another based on where the economy is headed. Pring has developed a model for this called Dow Jones Pring U.S. Business Cycle Index.

Pring Turner Capital Group has successfully used this strategy for clients over the years, outpacing the S&P 500 since 2000. The strategy involves buying or selling different types of securities at different points in the economic cycle. For example, the model calls for buying stocks near the trough of a recession and selling them just after the peak of economic expansion. And it calls for buying commodities after the economy begins to grow out of recession and holding them until after growth has peaked and the economy has turned downward again.

Though this tool may be a bit complex for some individual investors to use unassisted by an advisor, it nonetheless shows the kind of proactive approach that the current market requires.

Buying and selling too much can be costly, but in today's market it's often the lesser of two evils. The greater of the two is to believe that you can just buy, hold and sit back without playing defense. When you do this, chances are the market will eat you alive.

Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.