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Expect, Don't Fear Corrections

 

 

Rule 14

You'd think that after the dozens of corrections we've had in the last 20 years, we would get used to the process. You would think that we would say, "Let's prepare for the correction because it has to be right around the corner." Yet most people I know act as if corrections are total shockers, the type of thing that never happens.

To me, they are like the rain. I expect it has to rain. I prepare for it. When it comes, I am ready. I have an umbrella and a coat or I stay indoors.

 

Expect corrections; don't be afraid of them.

 

Of course, corrections happen at allegedly unexpected times. The last few we had were preceded by terrific days during which we made lots of money and all systems seemed go.

That's when I worry most. I used to have a rule at my hedge fund: When I made 2% in a day on the upside, I knew I was too exposed, I knew I was too long. I knew that my portfolio would kill me if we caught a storm. So as the market lifted, or if my performance was swinging too much to the upside, I would pull back, sometimes furiously, into strength, so I would be ready for that big down day.

Sometimes it never occurred, and I had to swallow my pride days later and come back in. But when it did occur, I outperformed by so much that my partners thought I was a genius. Plus, I was ready to buy things with the cash I had taken off the table.

For example, let's take the oils and the oil drillers, companies like ChevronTexaco (CVX:NYSE - commentary), ExxonMobil (XOM:NYSE - commentary), Halliburton (HAL:NYSE - commentary) and Schlumberger (SLB:NYSE - commentary). I like to pick on them because they are classic rally/correction stocks. When these stocks were ramping every single day in early 2005, I knew we were setting ourselves up for a fall. So I did my best to scale out into strength.

I felt terribly naked when, for example, Kerr-McGee (KMG:NYSE - commentary) spiked to $81-plus and I had none left because I had been selling into strength. Sure enough, though, a week later, and it was already below where I had sold it. If I liked it so much, I could have bought it back.

You may not know when a storm might strike. But we do have barometric readings that help immensely. When the S&P's proprietary oscillator registers plus 5, that signals to me a level of overbought that I regard as dangerous and I pull back aggressively and wait for a correction. That might mean that if I owned a portfolio of Intel (INTC:Nasdaq - commentary), PNC Financial (PNC:NYSE - commentary), Electronic Arts (ERTS:Nasdaq - commentary) and Procter & Gamble (PG:NYSE - commentary), I might be selling up to half of those positions, no matter what, in order to be ready for the storm.

If the rough weather doesn't come, I underperform on the upside. But think of this: I compounded at 24% after all fees for my hedge fund career, about twice what the market did during a long stretch in which it was pretty darned good. The only empirical conclusion: My method of avoiding the big down days more than made up for having less exposure on the big ramps up.