Why acting bearish is a dumb move

Everyone 'knows' the market can only get worse from here. That can lead to some truly stupid investment behavior.

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By Jason Zweig, Money Magazine senior writer/columnist

The risk of call options
When you sell a call option on stock you own, you collect a premium that can offset losses. But if the stock rises above its strike price, the option buyer takes your shares.
Strategy 1:
Buy stock for $100 a share.
Strategy 2:
Buy stock for $100 a share. Then, in return for a premium of $10 a share, sell a call option with a strike price of $110.
  • If the stock falls to $90...
Strategy 1:
You lose $10.
Strategy 2:
You lose nothing (thanks to the $10 premium).
  • But if the stock climbs to $150...
Strategy 1:
You gain $50.
Strategy 2:
You gain only $20 (and the stock is taken from you).

(Money Magazine) -- If the thought of opening up your mutual statement makes you squeamish or if you avert your eyes whenever CNBC comes on at the gym, it's understandable. This has been one ferocious stock market. Not only has Wall Street been flirting with a bear market - conventionally defined as a 20% decline in the major indexes - but we're now in "the second-worst eight-year period for stocks since the 1930s," says money manager Martha Ortiz of Aronson Johnson & Ortiz in Philadelphia.

Yet there is still a bull market raging in one commodity on Wall Street: utter nonsense. Frightful times in the stock market almost always bring out rash, stupid and dangerous ideas about how to invest money. And this downturn is no exception.

For instance, a growing chorus of bears thinks that the worst is yet to come and that investors should get out of the market. After all, everyone knows stocks will keep sagging since it's obvious the economy is sinking into recession, right?

What this advice fails to mention is that you'll incur brokerage commissions and capital-gains taxes if you sell outside a 401(k) or an IRA. And once you're out of the market, you'll have to decide when to get back in - and Wall Street isn't going to send you a singing telegram announcing the time is right.

Even if the economy is headed for real trouble, don't assume that your portfolio is too. Larry Swedroe, director of research at Buckingham Asset Management, notes that the U.S. economy has experienced 11 recessions since World War II. From the first day of those economic contractions to the last, stocks still managed to deliver average gains of 7.1% vs. 5.1% for cash.

"Even if you could have predicted every recession with perfect foresight, you would have underperformed the market by moving your money into cash," he says.

While your success as an investor always hinges on your knowing what to do and when, it also depends - maybe even to a greater degree - on your knowing what not to do and what not to believe in times like these. And the fact is, there's a lot of unwise "wisdom" floating around:

"It's a stock picker's market." Instead of owning all the stocks in a broad market through an index fund, this argument goes, the way to get ahead in tough times is to invest with a really smart fund manager who will buy only those few shares that are going to rise.

Here's a question for those who espouse this strategy: How come folks who couldn't beat the market when stocks were doing well are suddenly smart enough to outperform now?

To be sure, some managers may be truly skilled at picking stocks (including Robert Rodriguez, Money's pick for "The best fund manager of our time" on. But their jobs have not gotten easier just because the market has gone down. If that were the case, mutual funds led by active managers would significantly outperform in bear markets.

But between March 24, 2000 and Oct. 9, 2002, the average actively managed U.S. stock fund lost an annualized 18.8% (only slightly better than the 20.6% annualized decline for index funds). And so-called focused funds, whose stock pickers concentrate on only their "best ideas," did even worse. The average actively managed fund with fewer than 100 holdings fell 19.6% a year.

"Invest in bear market funds." These portfolios short the market, a classic strategy of selling borrowed shares in hopes of paying back the original owner with stock that has fallen in price. Thus, when shares go down, these funds go up. In January and February, as investors yanked more than $20 billion out of conventional stock ETFs, they poured more than $4 billion into the "short" and "ultrashort" ETFs offered by ProShares.

An ultrashort fund earns twice the daily inverse of the market's return. So every 1% daily market drop means your fund is supposed to gain 2%. But you also lose 2% on a day when stocks go up 1%, since the doubling effect in these funds magnifies the swings of the market in both directions.

While these funds' daily returns are very predictable, their long-term returns are utterly uncertain, warns Matthew Hougan, editor of IndexUniverse.com. Why? Even in the worst bear market, stocks don't go down every single day. And each day that equities happen to rise, an ultrashort fund will go down - in a loss twice as big as the market's gain.

If a down market is punctuated by enough up days, an ultrashort fund can easily lose value under the very conditions under which you would expect it to mint money (see the graphic above). "The differences can quickly become enormous," says Hougan.

"Write covered calls." Also known as a buy/write strategy, this approach has you buying stocks (or an index of stocks) while simultaneously selling, or "writing," call options on them. Whoever purchases the option has the right to buy the stock from you at a predetermined higher price - the strike price. The idea is, you collect a premium for writing the option, putting cash in your pocket and helping offset any losses you might suffer on the stock.

There's a catch, however. You get to keep the shares only if they stay below the strike price; otherwise, the option holder "calls" the stock away from you. You've covered your downside, but you've given away almost your entire upside.

"Invest in alternative assets." Recently, U.S. and foreign stocks have gone down together like twin scuba divers in cement overshoes. As a result, many pundits say you need new tools to diversify, such as gold, oil, fine art, coal, corn, timber, private equity or Chinese real estate.

True, many of these alternative assets have soared lately, but the hype drowns out some hard facts. Most alternatives don't produce income or dividends, and some - like fine art - are expensive to store and insure. Most have a lousy (or no) long-term track record, and many can be quite volatile.

Okay, we've just reviewed a lot of advice you shouldn't take. What, then, should you do? Ignore what's hot and focus on what's cold. Resist complexity and embrace simplicity. That means shunning overly complicated strategies like writing covered calls and goofy assets such as coal or corn.

Instead, favor tried-and-true investments that have taken a hit lately - for instance, municipal bonds (see "Munis: The new power portfolio"), real estate investment trusts and even the broad stock market. The S&P 500, now yielding 2.3%, offers nearly as much income as - and probably no less safety than - a five-year Treasury note.

And remember that this isn't a stock picker's market; it's a stockholder's market. That means that index funds, which buy and hold the whole market rather than frequently trade selected stocks, are just as good a bet as ever.  To top of page

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