Disciplinary Action

There's a lot of talk in the popular press these days about an "imminent" US recession and the tired old legs of this bull market. You've probably heard these stories many, many times before. A "collapsing" US dollar, real estate "bubble," inverted yield curve, over-indebted consumer, and a million other things are going to take the economy down and the stock market with it. If you're a regular reader to these pages, you're aware most of these risks are either misconstrued or already priced into stocks. If you're not so lucky, you may believe the time has come to get defensive. But this is a time when a strong investing discipline can pay dividends.

Markets do one of only four things in a given year:

1. The market can be up-a-lot
2. The market can be up-a-little
3. The market can be down-a-little
4. The market can be down-a-lot

These are the "four market conditions," and they should play a fundamental role in your investing discipline. Consider them a framework for guiding your behavior and keeping you from being led astray. The four market conditions tell you the most important thing about your forecast is the direction of the market, not the magnitude. They'll help you stay on the right side of the market.

You're probably not too concerned with the first two scenarios—they'll still give you positive returns. It's those last two that probably scare you. But the only time to get out of equities is in the fourth scenario, down-a-lot. You may think the third scenario, down-a-little, warrants running for cover. Unless you're really confident you know something others don't, though, you're too likely wrong for what is only a little benefit. The fourth scenario is rare and the only time to take on massive benchmark risk by going to cash or another defensive posture. It can only be prompted by something you know that most others don't.

You may say to yourself, "I'm risk averse and just don't want to take the chance of losing money this year." The table below should make you realize just how much you can lose by trying to side-step every minor market decline. Note that even if you miss only 10 of the best trading days, your annual return drops over 2.5%! (See table below.)

Smart investing is about having a discipline and sticking to it. It can be difficult to ignore the incessant chatter in the media, but doing so will serve you better in the long-run.