Tips - Bear Proof Investing

Bear-Proof
Investing
Protecting Your Financial Future in
a Bear Market and Taking Advantage
of an Emerging Bull Market
Kenneth E. Little
A Pearson Education Company

Copyright © 2002 by Kenneth E. Little
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CONTENTS
Part 1: Bear Signs 1
Chapter 1: Bear Markets 3
Defining a Bear Market 3
Market Corrections 4
The Psychology of Bears 4
The Receding Bear 5
Bear History 6
A Bear Lesson 7
Slaying Bear Myths 8
Bear-Proofing Your Portfolio 10
Risk and Investing 10
Looking for Bear Signs 11
Avoiding Traps 11
Bear Your Assets 12
Bear Tracks 12
Bear Den 13
Bearskin Rug 13
Conclusion 13
Chapter 2: Investing as a Contact Sport 15
Risk and Reward 16
A Matter of Perception 16
Age and Risk 17
Types of Risk 17
Market Risk 18
Economic Risk 20
Inflation Risk 21
Where to Hide 22
Inflation’s Evil Twin 22
Conclusion 23
Chapter 3: Types of Bear Markets 25
Bear Market Types 25
Political/Financial-Instability Bear Markets 26
Market-Liquidity Bear Markets 28
Recession Bear Markets 28
Inflation/Interest-Rate Bear Markets 29
Looking Backward 30
What Does This Mean to You? 31
iv BEAR-PROOF INVESTING
The Deflation Bear Market 31

Information Bear Markets 32
The Technology of Investing 32
Conclusion 33
Chapter 4: Economic Indicators 35
Inflation Indicators 36
Employment Cost Index 37
Producer Price Index 38
Consumer Price Index 38
More Economic Indicators 39
Employment Report 39
Purchasing Managers’ Index 41
Durable Goods Orders 41
Industrial Production and Capacity Utilization 43
Retail Sales 43
Gross Domestic Product 44
Conclusion 45
Chapter 5: Market Indicators 47
Major Market Indexes 48
The Dow Jones Industrial Average 49
The New York Stock Exchange Composite Index 49
Standard & Poor’s 500 50
The Nasdaq Composite Index 50
What Do Market Indicators Tell Us About Bears? 51
Volume Signs 52
Advance-Decline Signs 52
Technical Analysis of the Markets 54
Earnings Forecasts 54
What Do Bond Investors Tell Us? 55
Conclusion 56
Part 2: Bear Traps 57

Chapter 6: Market Timing: The Two Most Dangerous
Words in Investing 59
Intentional Market Timing 60
Market Timers 60
The Unintentional Market Timer 61
The Truth About Market Timing 62
No One Knows the Market 63
Your Investments May Not Follow the Market 63
You’re Better Off Invested 64
CONTENTS v
Timing the Market Takes Time 65

You Have to Pay the Tax Man 66
Avoiding Snap Decisions 66
Value Timing in a Bear Market 67
Always Another Deal 68
Conclusion 68
Chapter 7: When It’s Time to Sell a Stock 69
Selling on Price 70
Not Selling on Price 71
Protecting Your Profits 71
It’s Getting Too Expensive 72
Rebalancing Your Portfolio 73
They Missed Their Earnings Estimates 74
They’re Restating Earnings 75
The Industry’s Changing 75
It No Longer Meets Your Needs 76
There Are Fundamental Changes 77
Management Is Incompetent or Corrupt 77
You Made a Mistake! 78
Technical Collapse 78
You Need the Money for a Better Deal 79
Poor Financials 80
Mergers and Acquisitions 81
Donate to Charity 81
For Some Fun 81
Conclusion 82
Chapter 8: When It’s Time to Sell a Mutual Fund 83
The Fund Loses Too Much 84
The Fund Gains Too Much 85
There Is a Strategy Change 86
Underperforming Funds 86
You Set New Goals 87
Rebalancing Your Portfolio 87
Avoiding Overlap 88
The Manager Leaves 89
The Fund Gets Too Big 90
Protecting Your Profits 90
Poor Management 91
Mistake at Purchase 91
You Need Money for a Better Deal 92
Fund Is Too Volatile 92
vi BEAR-PROOF INVESTING
Donate to Charity 93
For Some Fun 93
Conclusion 93
Part 3: Bear Assets 95

Chapter 9: Asset Allocation: The Two Most Important
Words in Investing 97
Asset Allocation in Context 98
More Than Diversification 98
Investing in History 99
Setting Realistic Goals 101
Variables of Asset Allocation 102
Risk Tolerance 103
Time Horizon 103
The Right Mix 104
The Balancing Act 105
Changing the Mix 106
Conclusion 107
Chapter 10: Asset Allocation in a Recession Bear Market 109
Recessions 109
What Happens When the Economy Goes South 110
Slowing Growth 111
Inflation Concerns 111
Rising Unemployment 111
Declining Consumer Spending 112
Other Recession Ramifications 113
Asset Allocation in a Recession Bear Market 113
Modified Market Timing 114
A Defensive Strategy 115
A Middle-Ground Approach 115
A Reasonable Approach 116
Conclusion 117
Chapter 11: Asset Allocation in Inflation and Deflation Bear Markets 119
Defining Inflation 120
Defining Deflation 121
Some Modern Examples 122
Recent Inflation 122
Recent Deflation 123
What You Can Do When Inflation Happens 124
What You Can Do About Deflation 126
Conclusion 128
CONTENTS vii
Chapter 12: Bear-Proof Assets 129

Stocks in a Bear Market 130
The Industry Sector Is Important, Too 131
Large Cap Stocks 131
Growth Stocks 132
Dividend-Paying Stocks 132
Value Stocks 133
Other Large Cap Stocks 133
Mid Cap Growth Stocks 134
Other Mid Cap Stocks 135
Small Cap Stocks 136
Foreign Stocks 136
Bonds 137
Mutual Funds 138
Bond Funds 139
Hybrid Funds 139
Bear Funds 140
Market Neutral Funds 140
Bear Ranking Funds 140
Sectors 141
Bear Attacks 143
Conclusion 143
Part 4: Bear Tracking 145

Chapter 13: Age-Appropriate Strategies 147
Dispelling Some Myths 148
We’re Never out of the Woods 148
Strategies Through the Ages 149
Ages Twenty to Thirty 150
Ages Thirty to Forty 152
Ages Forty to Fifty 154
Ages Fifty to Sixty 155
Ages Sixty to Seventy 156
Age Seventy-Plus 158
Conclusion 158
Chapter 14: Short-Term and Mid-Term Strategies 159
Short-Term Goals: Trouble Ahead 160
Mid-Term Goals: Now Comes the Hard Part 162
Solution A: Savings Plan 164
Solution B: Mutual Fund—Monthly Deposits 165
Solution C: Mutual Fund—Lump Sum 166
Conclusion 167
viii BEAR-PROOF INVESTING
Chapter 15: Fatten Up on Bear 169

Identifying Bargain Stocks 169
Look for Signs 170
Trouble by Association 171
Don’t Give Your Heart Away 171
Staying Power 171
Nothing Lasts Forever 172
A Rose by Any Other Name 172
What Do the Analysts Say? 172
Dead Cat Bounce 173
A Company Is Not Its Stock 174
Protecting Yourself 174
Short-Term Profits 175
Don’t Look for the Bottom 175
Identifying Bargain Mutual Funds 176
Where to Find Bargains 177
No Place Like Home 177
Value Funds 178
Sector Funds 178
The Best Defense Is a Good Offense 179
Conclusion 179
Part 5: Bear Den 181

Chapter 16: Pre-Retirement Strategies 183
Dangerous Times 183
Pre-Retirement Checklist 184
Investment and Retirement Portfolios 185
Understand Your Retirement Plan 185
Multiple Retirement Plans 186
Check with Social Security Administration 187
Hire a Professional to Help You Plan 187
Dangerous Timing 188
Lock In Returns 189
Bonds Come in Different Flavors 189
The Downside of Individual Bonds 190
Bond Mutual Funds 190
The Importance of Cash 191
Conclusion 191
Chapter 17: Retirement Protection 193
No Margin for Error 194
Two Opposite Problems 194
Too Conservative 195
CONTENTS ix
An Unlikely Friend 196

No Pain, No Gain 196
Too Aggressive 197
Start Paying Attention 197
The Market Timer 198
Bend in the Wind 199
Outlive the Bear 200
Conclusion 201
Chapter 18: Safe Havens 203
Bonds 204
U.S. Treasury Issues 204
U.S. Agency Bonds 205
Muni’s 206
Corporate Bonds 206
Bond Mutual Funds 207
Real Estate 208
REITs 208
Real Estate Mutual Funds 209
International Funds 210
Investing in Sectors 210
Finance 211
Utilities 211
Consumer Staples 211
Healthcare 212
Precious Metals 212
Bear Market Funds 212
Market Neutral Funds 213
Balanced Funds 213
Conclusion 213
Part 6: Bearskin Rug 215

Chapter 19: Your Best Bear Strategies 217
Buy-and-Hold 217
Buy-and-Hold: Pro 218
Long-Term View 218
Great Companies 219
Branding 220
Market Timing 220
Buy-and-Hold: Con 221
The “Great” Company Flaw 221
The “Great” Company Myth 222
The Long-Term Flaw 223
Courage to Hang On 223
The Buy-and-Hold Bottom Line 224
Price Followers 224
Price-Setting: Pros 225
Price-Setting: Cons 225
Dollar Cost Averaging 226
Time Strategy 226
Conclusion 227
Chapter 20: Diversify or Die 229
Puzzle Pieces: Stocks 230
Aggressive Growth Stocks 231
Growth Stocks 232
Hard Asset Stocks 233
Value Stocks 233
The Bottom Line on Stocks 234
Puzzle Pieces: Mutual Funds 234
Puzzle Pieces: Bonds 235
Stick with Your Plan 236
Why Slow and Steady Wins the Race 237
It Takes Courage to Stay Diversified 238
Conclusion 238
Chapter 21: Your Weapon of Choice 239
Monitoring Allocation 239
Hard Choices 241
Another Solution 244
What About Mutual Funds? 245
Rebalancing Schedule 246
Use of Cash 247
Irrational Expectations 247
Asset-Allocation Tools 248
Portfolio Allocator 249
The Goal Planner 249
Conclusion 250
Conclusion 251
Appendixes
A Glossary 253
B Resources 263
Index 269
INTRODUCTION
“What happened?!”
“For years, it was hard not to make money in the stock market—
all of a sudden, everything is dropping like a lead balloon. Now what do
I do?”
That’s the question every typical investor is asking after watching
dot.coms vaporize, IPOs become DOA, high-tech stocks fizzle, and util-
ities and blue-chip leaders fall to embarrassing lows.
Over half of all American households have some sort of stake in the
stock market, whether through an employer-sponsored retirement plan,
employee stock options, or cash in a mutual fund or stock portfolio.
Investing, even in boom times, is never as easy as it may have
seemed in the past few years. A bear market makes investment decisions
even more complicated. The slide in stock market values began in the sec-
ond quarter of 2000 and soon became an avalanche. Investors watched re-
tirement dreams change as accounts reversed double-digit growth rates.
Younger investors couldn’t believe stocks actually went down instead of
always up.
The choices facing investors aren’t so clear-cut anymore:
■ Convert everything to cash?
■ Mutual funds?
■ Value stocks?
■ Real estate?
■ Bonds?
Add the voices of the daily business news, which sound like the end of the
world is near (“live update at 10”), and it’s no wonder investors are con-
fused.
BEAR-PROOF INVESTING
What this book offers you is a set of strategies to make rational decisions
about investments in an unstable or down market. These are tried-and-
true methods of protecting your portfolio from the worst in falling mar-
ket conditions.
Your goal in a bear market is to hold your own and position your-
self to take advantage of an emerging bull market. In Bear-Proof Investing,
you will learn …
■ The two most important words in investing.
■ The two most dangerous words in investing.
■ Economic and market indicators you should watch.
■ How to handle short-term financial goals.
■ Age-appropriate strategies for retirement planning.
■ Safe vehicles for short-term cash reserves.
■ How to decide what to hold and what to fold.
■ How to fatten your portfolio in a bear market.
Bear-Proof Investing is your edge in an unstable market. It gives you the

tools and strategies you need to protect your investments and position
yourself to take full advantage of an emerging bull market.
ACKNOWLEDGEMENTS
I would like to thank to Renee Wilmeth, Phil Kitchel, Christy Wagner,
and all the other folks at Alpha Books for their hard work in making this
book possible. In addition, thanks to my family for letting me shut the
door to my office for weeks on end so I could finish this book.
PA R T 1
BEAR SIGNS
It’s easy to spot a bear market, and any other market phenomena,
in the rearview mirror. In retrospect, it’s easy to see all the warning
signs and wonder why it wasn’t obvious at the time. Stock market
participants are great at pondering the “what if ” questions:
■ What if I had bought XYZ at $25 instead of $45?
■ What if I had sold XYZ at $50 instead of $5?
■ What if the CEO of XYZ weren’t in prison now?
The dreaded Y2K disaster failed to materialize at midnight on Jan-

uary 1, 2000. Instead, it popped up in the spring when the Inter-
net stock bubble began its protracted burst. By the time the new
millennium truly began in 2001, the stock market was in the grips
of a large bear. Many younger investors were shocked to learn you
could actually lose money in the stock market.
In Part 1, we’ll focus on the history of bear markets and de-
fine the different varieties (species) of bear markets. We’ll discuss
the risks associated with investing, and examine economic and mar-
ket indicators that foretell a bear market.
CHAPTER 1
BEAR MARKETS
A declining stock market may strike younger investors as something

of an oxymoron, like jumbo shrimp or military intelligence. How-
ever, it is a fact of life, as any investor who’s been in the market for
more than 10 years knows.
In this chapter, we will look at …
■ The common definitions of bear markets.
■ The history of past bear markets.
■ The consequences of bear markets.
At the most basic level, stock prices rise when there are more buy-
ers than sellers and fall when there are more sellers than buyers. So
what changes buyers to sellers? How can the history of bear markets
help us today and warn of future downturns?
DEFINING A BEAR MARKET

The general, but not universal, consensus is that a bear market oc-
curs when the broad market is down by 20 percent or more from
the previous month for a “sustained period of time”—usually two
or more consecutive months. Some folks place the decline at 15 per-
cent or more; however, the 20 percent number is more common.
That’s the technical definition. What matters to you is that
the broad markets, and most likely your portfolio, are dropping like
rocks and “investor confidence” is right behind them.
4 BEAR-PROOF INVESTING
Tip
There are always pundits, usually with a service to sell, who warn of dire
circumstances ahead. When the respected media, like The Wall Street
Journal and Morningstar.com, start sounding warnings, that’s when you
should listen.
MARKET CORRECTIONS
You have to understand the definition of a bear market in order to un-
derstand the underlying causes. Bear markets and “market corrections”
are not the same. Market corrections are declines of short duration, al-
though they can be severe.
The Standard & Poor’s 500 Index (S&P 500) lost some 10 percent
of its value in just a few days in October 1997. Investors in that month
had to decide if this was a market correction or the beginning of a bear
market. Investors who panicked and dumped stocks for “safer” havens
like bonds and cash instruments watched the market roar back, which put
them in the unenviable position of selling low, then buying high to get
back in the market. Investors who rode it out saw continued increases
until things began to unravel in the spring of 2000. Of course, they then
faced the same question again. This time it was a bear market.
THE PSYCHOLOGY OF BEARS

Bear markets are not just movements of stock prices in a downward di-
rection. They also represent a state of mind in the investing community.
During the roaring bull market of the 1990s, the general mood of
investors was that stock prices were going to continue to rise. Your entry
point didn’t really matter because prices were going up. No rational in-
vestor will admit to this mindset, but investor confidence was very strong.
No one wanted to be sitting on the sidelines while the markets, particu-
larly the Internet/tech stocks, were flying high.
In a bear market, the reverse is true. Investors expect prices will keep
falling and take measures to protect their portfolios. Part of this protec-
tion usually means dumping higher risk investments for more stable ones.
This pressure to sell only adds to the momentum of a declining market.
BEAR MARKETS 5
It usually takes time and sustained good news for a bear market to reverse
itself. As we said, this is one difference between a bear market and a mar-
ket correction.
THE RECEDING BEAR

A bear market and an economic recession are not the same things. Al-
though many of the same factors cause both, the stock markets do not al-
ways move with the economy, nor does the economy always move with
the markets.
For example, analysts usually consider low unemployment good for
the economy because more people are working and they are buying more
goods and services. However, the stock market may view low unemploy-
ment quite differently. Low unemployment means employers must com-
pete for workers, causing wages to rise. Rising wage rates may drive down
profits.
Investors purchase a stock based on the expectation of future prof-
its. If those future profits are threatened, the stock’s price may drop as
buyers look elsewhere for growth. Of course, it’s not quite that simple.
Rising wages can bring on inflation, which is one of the major causes of
bear markets.
Plain English
A recession is a decline in the gross national product for two consecu-
tive quarters. The gross national product is the sum of all goods and
services produced in the United States during a single year and is ex-
pressed in dollars.
This is not to suggest there is no connection between recessions and bear

markets. Sometimes a bear market will lead the economy into a recession
(after all, investors are betting on the future). Other times a bull market
can appear to lead the economy out of a recession: The 1990s bull mar-
ket began in the middle of a recession.
The point is that investors should look closely at the factors push-
ing the markets toward a bear state of mind. We will look at these in more
detail in Chapter 3, “Types of Bear Markets.”
BEAR HISTORY
Bear markets are part of the history of the stock market. They occur often
enough for many observers to include them in an ongoing cycle of boom
and bust.
The biggest bear market occurred in the 1929 to 1931 market crash,
when the market lost almost 90 percent of its value. This devastating loss
of wealth and the accompanying depression shaped our history for
decades. It took the deficit spending of World War II to get the market
back on a sustained track. However, even that didn’t last long. The mid-
1950s saw the first modern bear market, the first of nine, not counting
the one that began in 2000.
Tip
Deficit spending spurred the economy by making the U.S. government
an active buyer of goods and services to support the war effort. Deficit
spending, however, can have the opposite effect when taxes are raised to
pay the increasing debt.
The sustained bull market of the 1990s convinced many of the 50 mil-
lion Americans who own stock that they were on a one-way ride to a com-
fortable retirement. The 10-year run also convinced many people who
had never invested in the stock market before to give it a try. Many were
totally unprepared for what happened.
The stock market, led by Internet and technology stocks, was highly
overpriced. When investors failed to see the profits they expected from
these rising stars, they panicked and began a sell-off that drove prices down
dramatically. Uncertainty spread to other parts of the market, and the bear
was loose.
Unfortunately, history has a way of repeating itself at the most awk-
ward times. If they had looked at the following chart of bear markets since
the 1950s, they might have been better prepared for what was coming.
This chart shows the nine bear markets leading up to the bull market of
the 1990s. Many investors might remember the beginnings of a devastat-
ing bear market of 1987 and Black Monday, when the market plunged
hundreds of points, as the worst in modern history. The chart clearly
shows, however, that it was only the third worst, and its recovery was
much quicker than previous bears.
BEAR MARKETS 7
Percent Length Recovery

Dates Loss (Months) (Months)
Aug. 1956 to Oct. 1957 21.6% 14.7 11.1
Dec. 1961 to June 1962 28% 6.4 14.3
Feb. 1966 to Oct. 1966 22.2% 7.9 6.9
Nov. 1968 to May 1970 36.1% 17.9 21.3
Jan. 1973 to Oct. 1974 48.2% 20.7 69.4
Sept. 1976 to Mar. 1978 19.4% 17.5 17.3
Jan. 1981 to Aug. 1982 25.8% 19.2 2.3
Aug. 1987 to Dec. 1987 33.5% 3.3 19.7
Jul. 1990 to Oct. 1990 19.9% 2.9 4.3
Source: Standard & Poor’s Corp.
Many observers called the bear market that began in 1973 a “super” bear,
in part because it occurred during a period of high inflation and because
of the lengthy recovery. Pity the poor soul who had planned to retire dur-
ing this period. After investing for many years, a long, painful bear mar-
ket takes almost one half of her portfolio’s value, and inflation takes a big
bite out of the remainder.
Losing one half of your retirement nest egg would be devastating.
Could it happen again? It most certainly could.
Caution
Don’t believe the popular notion that “things are different” now and
bear markets will not be long-lived or too severe. No one knows that for
sure.
A BEAR LESSON
The previous chart makes it all too clear that investing involves risk.
(We’ll look at this in more detail in Chapter 2, “Investing as a Contact
Sport.”) If you look at those nine modern bear markets beginning in 1956
and ending in 1990, you will notice that during this 34-year period, in-
vestors have struggled with bear markets about 25 percent of the time.
Contrast that with the 10-year uninterrupted run of the last bull market,
and it’s easy to see how investors became overconfident.
This overconfidence, combined with little experience with bear

markets, left many investors wondering what hit them. The classic mis-
take for inexperienced (and even experienced) investors is to watch prices
rise in a bull market and buy near the top. Then when the market heads
south, they follow the stock down and sell near the low. A “buy high and
sell low” strategy is no strategy at all.
Many folks writing about bear markets encourage investors to sit
tight and ride out the storm. This may make sense if the investor is 30
years from retiring, but the poor soul we mentioned earlier doesn’t have
the luxury of riding out a bear market—she can’t wait five years to re-
cover her loss. The only way she can meet her immediate needs is to cut
her losses as quickly as possible and retreat to safer investments, such as
cash and bonds.
The lesson of the modern bear markets is that what goes up can and
almost certainly will come down. Investors need to be prepared.
SLAYING BEAR MYTHS

Not all bear markets are the same. In Chapter 3, we’ll go over the primary
causes of bear markets in detail. However, it is important to slay some
basic bear myths before we go any further.
■ Everyone loses in a bear market. We’ve defined a bear market as
including most of the market leaders, such as the bellwether S&P

500. Not every stock or even every stock sector loses money dur-
ing a bear market, and there are always stocks that do poorly dur-
ing bull markets. The cliché that a “rising tide lifts all boats” is not
true in the stock market.
Plain English
The S&P 500 Index represents 500 of the largest companies in Amer-
ica. It is the most widely used proxy for the whole stock market and is
the most widely used index in measuring performance of investments.
■ You can see it coming. You can’t. Bear markets are notorious for
disguising themselves. Market corrections, which we discussed ear-
lier, are great decoys for bear markets: You never know when a mar-
ket correction is going to escalate into a full bear market. In our
BEAR MARKETS 9
earlier example of 1987, investors faced a sharp market decline.

Was it a market correction that would rebound shortly, or the be-
ginning of a continual decline into a bear market?
In Chapters 4, “Economic Indicators,” and 5, “Market Indi-
cators,” we will look at some of the indicators investors should
watch for bear signs.
■ Bear traps are false signals sent by the market that suggest it is
about to reverse course and head up. A bear trap occurs when a
stock drops sharply and panicked investors sell near the bottom,
only to watch the stock rebound. The broad market can execute
bear traps also. A straight-line drop in prices seldom marks a bear
market. Most often, prices will fall, then rebound to a level near
the original point, and repeat the pattern over and over. However,
the long-term trend is that the rebound never quite regains all the
lost ground.
Casinos use a version of the bear trap on their slot machines.
You put in three coins and pull the lever. A ringing sound means
you won. However, when you look in the tray, the machine has
only returned two coins. This incremental loss doesn’t seem as bad
as not getting anything back, so you’re encouraged to try again. In
the stock market, this type of incremental decline is a perfect dis-
guise for a bear market.
■ Bear markets can be averted. It’s preposterous to think we can
control the stock market. If we could control the stock market,

there would never be any bear markets. Actions can encourage or
discourage bear markets (such as interest rates and taxes), but there
are no controls. In Chapter 3, we’ll discuss the causes of bear mar-
kets in more detail. We may even need bear markets to bring down
stock valuations to more reasonable levels, thus setting up future
bull markets.
The Persian Gulf War caused the bear market that began in
1990. Oil prices escalated along with interest rates. Rising energy
prices often lead to inflation. All these factors negatively affect the
stock market. Toward the end of the 1990s bull market, the Fed-
eral Reserve Board (the Fed) raised interest rates six times and oil
prices escalated. Many feel the Fed went overboard in its attempt
to cool the economy and precipitated the bear market.
Caution
The U.S. markets can be affected by more events abroad than just po-
litical and military unrest. As globalization continues, we will be more
vulnerable to problems in foreign markets.
■ The Fed is responsible for the stock market. The Fed is not re-
sponsible for the stock market, although it watches the market
closely. Fed pronouncements about the economy and interest rates
are widely followed by investors. The Fed views its primary re-
sponsibility as controlling inflation. As we will learn in Chapter 3,
inflation is a primary cause of bear markets, but the Fed is more
concerned with the whole economy. Inflation is deadly to any
economy and benefits virtually no sector. The Fed of course knows
that raising interest rates could eventually hurt the stock market,
but inflation hurts everyone.
BEAR-PROOFING YOUR PORTFOLIO

You can run, but you can’t hide from a bear market. The ugly truth in-
vestors discovered after the recent bull market ended is that you can and
will lose money at some point if you stay invested for any length of time.
That’s the bad news. The good news is that you can protect your portfo-
lio from the worst effects of most bear markets. The trick is knowing a
bear market from a market correction.
RISK AND INVESTING

Despite all the talk about a “new economy,” there are fundamental truths
about investing that haven’t changed. The first is that investing involves
risk: There is a chance you will lose money. The more you stand to gain,
the higher the risk.
It’s ironic that an investing community that watches and benefits
from markets climbing to dramatic heights is shocked when they collapse.
The Nasdaq Composite Index went from over 5,000 to 2,600 is less than
a year. People were shocked and angry. Those same people didn’t mind
when the index was up 80 percent the year before!
BEAR MARKETS 11
In Chapter 2, we’ll look at the risks associated with investing and

how you can protect yourself. Your tolerance for risk should be one of the
primary considerations of your investment plan.
LOOKING FOR BEAR SIGNS

Investors should watch a number of market and economic indicators for
signs of a bear. Unfortunately, it is not always easy to identify bear mar-
kets, because not all bear markets are equal. Interest rates cause some; oth-
ers find a home during a recession; some are triggered by political unrest
or a war that no one saw coming—the invasion of Kuwait (as well as other
factors) triggered the bear market of 1990.
Tip
When you read about the overpriced “market,” understand that it
doesn’t apply to every stock. Even during the super-heated markets of
the late 1990s, there were stocks trading at very low valuations. Some
were sound companies that simply didn’t excite the investing commu-
nity like the dot.com wonders of the day.
When markets become overpriced, watch out. At least, that’s the conven-
tional wisdom. Market observers repeatedly sounded the warning during
the 1990s bull market, but if you had heeded the early warnings and re-
treated to safer investments, you would have missed most of the strongest
bull market in history. When the bubble finally burst, pundits were shak-
ing their heads with an “I told you so” attitude. Like the boy who cried
wolf too often in the fairy tale, eventually they were bound to be right.
In Chapters 3 through 5, we will look at different types of bear mar-
kets and some of the economic and market indicators that may help you
spot them coming.
AVOIDING TRAPS
Part 2, “Bear Traps,” deals with three difficult issues for investors:
■ Market timing, or trying to buy at the absolute low and sell at the
absolute peak
■ When to sell a stock

■ When to sell a mutual fund
Market timing is a disaster waiting to happen for investors who think they
are smarter than the market. No one, no matter what they say in their ad-
vertising, can consistently call the market correctly, and neither can you.
You don’t know where the top is and you don’t know where the bottom
is. (I don’t either.) However, there are solid ways to make investment de-
cisions that take the guessing out of the process. Bear markets, as noted
earlier, often disguise themselves as corrections or something else.
There are two sides to every investment decision: when to buy and
when to sell (although the buy decision seems to capture more attention
than the sell decision). Protecting your portfolio may mean moving out
of one class of investment and into another. Do you have an exit plan? We
will look at the process of selling stocks and mutual funds in detail.
Plain English
Your portfolio is simply your basket of investments. It can include
stocks, mutual funds, bonds, and cash instruments.
BEAR YOUR ASSETS

You know that diversification is a powerful safeguard against an unstable
market. Asset allocation is how you go about that diversification. Many
investment professionals maintain that how you allocate your assets is
more important than picking the individual assets. As a rule, you want as-
sets split among stocks, bonds, and cash. A number of factors determine
how much you should allocate to each.
In Part 3, we will discuss the process of asset allocation and how fac-
tors such as the type of bear market and your age change the contents of
your portfolio.
BEAR TRACKS
Part 4, “Bear Tracking,” takes a look at some strategies from two perspec-
tives: age and time horizon. Our poor soul at the beginning of this chap-
ter who lost one half of her retirement portfolio the year she planned to
BEAR MARKETS 13
retire would have benefited from reading these chapters. We will look at
short-term strategies in particular, since almost everyone has financial
goals that are less than 20 years down the road.
Are bear markets a time to pick up some bargains on decimated
stocks? This strategy walks very close to market timing; however, with the
proper research, you may find some roses among the thorns.
BEAR DEN
Investors nearing retirement are the most vulnerable to bear markets be-
cause they have less time to ride out the storm. What strategies should
you use and when? Part 5 discusses the concerns of pre-retirees and fol-
lows them through retirement. You worked hard and invested wisely so
you could enjoy a comfortable retirement. Don’t let a bear market rob you
of that goal.
Are there “safe havens” in a bear market? Although there are no
completely safe places to hide, you can protect yourself from the worst the
bear has to offer.
BEARSKIN RUG
Part 6, “Bearskin Rug,” discusses the three major considerations in sur-
viving a bear market and gives some examples of why they are so impor-
tant. These tools and techniques will help you avoid the worst the bear
has to offer. However, there are no “silver bullets” that are guaranteed to
kill the bear.
Investing is about risk, and nothing will change that. You can arm
yourself with information and education so you can make investment de-
cisions with a reasonable knowledge of their outcome.
CONCLUSION
Bear markets are as much a part of investing as bull markets. Indeed, we
may not be able to have bull markets without bear markets. Unless you
like ugly surprises, you should be able to identify bear markets and know
what they can do to your portfolio. Forewarned is forearmed.
CHAPTER 2
INVESTING AS A
C O N TA C T S P O R T
Investors are, by definition, optimists. After all, you’re betting the

future will be brighter than the present—at least for your invest-
ments. When investors talk about risk, they’re asking if the risk of
the investment is reasonable compared to the potential gain. You
cannot separate risk from investing: No investment is absolutely
safe.
The safest investment you can make is in U.S. Treasury bonds
because they carry the full faith and credit of the U.S. government.
If you had bought a 10-year U.S. Treasury Bond in 1990 and held
it to maturity, you would have received your money back plus a
guaranteed interest payment in the single digits. However, if you
had bought a mutual fund that tracked the S&P 500 in 1990 and
held it 10 years, you would have received an average 17-plus percent
annual return. Your money would have been “safe” in bonds, but
you would have missed out on the greatest bull market in history.
Caution
Structuring your portfolio for maximum safety makes sense late
in life when you can’t afford losses. However, while you are still
accumulating wealth, a very conservative portfolio may be very
expensive in lost opportunities.
RISK AND REWARD

You may have a good understanding of risk, but I encourage you to read
this chapter as a review and in light of protecting yourself in a bear market.
One positive consequence of the 1990s bull market was that a large
number of people got involved in investing who never had before. Internet
and high-tech stocks in particular seemed like they could go nowhere but
up. Unfortunately, many new investors lacked the tools to fully understand
the risks involved. The hysteria associated with initial public offerings
(IPOs) led new investors down a path that would ultimately see a number
of these companies go out of business or lose 80 or 90 percent of their value.
Plain English
An initial public offering (IPO) is the first issue of stock sold to the
public by a company. The company retains the proceeds to finance
growth. Once the company sells its stock to the public, subsequent sales
are between investors, and the company doesn’t receive any of the
money.
At the height of the Internet stock “bubble,” I was producing a Web site
for beginning investors. The questions I received by e-mail showed a dan-
gerous lack of understanding on the part of novice investors: “I’ve been
reading about how much money you can make with IPOs, so I thought
I’d get in on the action. How much does 10 shares of IPO cost?”
Money poured into the market in unprecedented amounts, and the
bubble got larger and larger. Individual investors were encouraged to
dump their low-performing investments and hop on the express train to
wealth. Those investors who did well were smart enough to get in at a rea-
sonable price and take a profit in the short run (but this is more like spec-
ulation than long-term investing). Ironically, the investors who lost the
most got into the market, often near the top, thinking they could ride out
falling prices by holding on or even buying more as the stock dropped.
A MATTER OF PERCEPTION
Only you can decide what level of risk you can handle without losing
sleep. What may seem risky for one investor may not appear that way at
all to another investor. Some investors find individual stocks too risky and
I N V E S T I N G A S A C O N TA C T S P O R T 17
are more comfortable in mutual funds where there is professional man-

agement and diversification. On the average, individual stocks offer a
higher potential return than mutual funds. The major risk factors listed
later in this chapter have a greater affect on individual stocks. Individual
stocks have no protection by diversification unless you buy a number of
different issues in different industries. Diversification is your primary de-
fense against risk.
Nevertheless, you know your stomach’s tolerance for stress. Pay at-
tention to your consumption of Rolaids. I’ve heard too many stories of
people who talked themselves into risky situations because their neigh-
bor’s dentist’s brother-in-law had a sure thing.
Tip
Hot tips are for suckers. The Internet is a breeding ground for “pump
and dump” scams where a person will disclose the name of the next Mi-
crosoft with the intention of driving up the price so they can sell at a big
profit. Many times the company mentioned has no knowledge of the
swindle.
AGE AND RISK

Regardless of your personal tolerance for risk, there are times in your life
when it is appropriate to take risks and times when it is not. Simply stated,
the closer you are to a financial goal, the less risk you should take. As you
approach your goal, the window of time needed to recover from a bear
market or even a market correction decreases.
Later in the book, we’ll spend more time talking about strategies to
address the issues of risk, time, and age in structuring your portfolio.
TYPES OF RISK
There are three basic types of investment risk, and any one or a combi-
nation can cause a bear market. However, your investments are subject to
these risks even if they don’t precipitate a bear market. The types of in-
vestment risk are the following:
■ Economic risk
■ Market risk
■ Inflation risk
These aren’t mutually exclusive—it is possible to experience all three at

once. It is important to note that virtually every stock, mutual fund, or
bond is subject to one or all of these risks regardless of whether there is a
bear market or not.
Tip
When you see a market going crazy over a particular sector (such
as technology stocks), a red flag should warn you that eventually this
frenzy will end and the sector will collapse.
MARKET RISK
Internet and technology stocks fueled the 1990s bull market, especially
toward the end. The market was definitely behind companies that rushed
to the Internet and new technology. It was fairly simple to follow the
money and see what was hot. Billions of dollars poured into the high-
tech/Internet companies. If you had a two-page business plan and a com-
pany name that ended in “.com,” no matter how outrageous the plan or
inexperienced the managers, there seemed to be no end to the line of peo-
ple wanting to give you money.
However, many of these “new economy” wonders were really only
good at doing one thing: eating money. Toward the end, phrases like
“burn rate,” which refers to how fast a company is going through its cash,
began to be part of the dialogue.
The amount of cash the companies consumed was alarming. Even
more alarming was the fact that many of the companies would never make
a profit. Investors, particularly big institutions and mutual funds, began to
see things more clearly. When the market turned on the Internet and tech-
nology stocks, it did so with a vengeance. Stock prices plunged and com-
panies ran for cover by looking for a merger with a strong company. You
could say that investors woke up toward the end, rubbed their eyes, and
said to themselves, “I’ll never drink that hype again.”
Meanwhile, many companies such as Bank of America and Gen-

eral Motors were languishing. Their stock prices were near record lows
and nobody wanted them. There was nothing fundamentally wrong with
these companies; they just couldn’t compete with the sexier, high-flying
dot.coms. Where did the money go that fled the failing dot.coms? Sur-
prisingly, some market analysts were recommending value stocks like
Bank of America and General Motors.
Caution
When the Nasdaq passed 5,000, some people were saying the 10,000
mark would soon fall. Even after the index plunged 50 percent, some
people were predicting it would hit 5,000 again and soon. All these pre-
dictions are idle speculation. No one knows where the index will be in
six months.
The Nasdaq Composite Index dropped by 50 percent in one year as even

the more established technology companies began reporting slowing
growth and lower earnings. The market remains so fragile that a handful
of technology companies can lead the Nasdaq up or drag it down. If Mi-
crosoft, one of the largest companies in the world, sneezes, the rest of the
market gets pneumonia.
The market is notoriously fickle, and today’s front-runner is tomor-
row’s also-ran. One way to reduce market risk is to avoid the current hot
sector in favor of solid companies with long-term prospects. In retrospect,
it’s easy to see that many of the Internet wonders had no real chance for
success in the long term. When the market becomes overheated for a par-
ticular sector, as it did for the Internet/technology stocks, you move out
of the realm of investing and into a legalized form of gambling.
Tip
Speculating and investing are two different things. If you want to spec-
ulate in short-term trading, do so with the understanding that in the
end you will lose more often than you will win.
A theory called the “Bigger Fool Theory” describes how a market reacts
when it’s overheated. In the past, it described oil and gas booms and
real-estate runs. The Bigger Fool Theory states that it doesn’t matter
what you pay for the item because a bigger fool will come along and pay
you more for it.
If you want to speculate in an overheated market, do it with
money you can afford to lose. You should have a plan for entry and exit
and stick with it. Be satisfied with merely obscene profits. Remember
the golden rule of Wall Street: Bulls profit and bears profit, but pigs get
slaughtered.
ECONOMIC RISK
Economic risk is when the economy turns against an investment. Perhaps
interest rates go up or consumer demand goes down—either way your in-
vestment could be at risk.
For example, energy prices affect a wide range of industries; how-
ever, transportation companies and certain manufacturing concerns are
particularly vulnerable. Automobile manufacturers and homebuilders suf-
fer when interest rates rise sharply. A drop in consumer spending hurts
discount stores and clothing manufacturers.
■ Recession. Many of the preceding factors contribute to or mani-
fest themselves during a recession, which usually leads to a bear

market. The bear market of 1981–1983 was the result of then Fed
Chairman Paul Volker raising interest rates to staggering heights.
In Chapter 3, “Types of Bear Markets,” we will look at inflation
bear markets.
When the Fed saw the economy contracting at a rate that in-
dicated a recession was looming, it lowered interest rates in early
2001 in an attempt to head off the recession or at least soften the
blow. Lowering interest rates is one way bear markets get back on
their feet, although this alone isn’t guaranteed to do the trick.
Plain English
Money supply is the cash circulating in the economy. The Fed controls
the amount of cash and uses that control in its fight against inflation.
■ Fads and gimmicks. Beware of companies built around fads and

gimmicks. That may seem like overstating the obvious, but it’s
worth repeating. Someone will come out with a new doo-dad and,
the next thing you know, it’s all over the media. Companies that
try to capitalize on these fads usually end up stuck with ware-
houses of product that no one wants.
■ Foreign threats. Globalization is an economic reality, and al-
though this process has many benefits, there are also some dangers.
As economies become interdependent, the chances of a foreign cri-
sis affecting U.S. markets increases. Political and economic unrest
with key trading partners like Japan and Europe can affect U.S.
markets.
■ Falling profits. Another economic risk is falling profits from key
industry leaders. There are usually a handful of leaders in every in-

dustry group. When these companies report stagnant or lower
profits, the rest of the industry group also falter. If you don’t own
the leaders in a particular industry group, be aware your invest-
ments may suffer if the leaders don’t meet earnings expectations.
Tip
The investing community watches earnings (profits) reports with great
anticipation. When companies fail to make their earnings projections,
the market batters the company’s stock.
INFLATION RISK
One of the greatest economic risks to every sector of the economy is in-
flation. Inflation is when prices rise rapidly and the currency loses value.
Simply stated, inflation is when too much money is chasing too few
goods and services.
Inflation is the most feared of all economic maladies because it
bleeds the value from investments and from workers’ payroll checks. The
Fed’s primary job is to keep inflation under control. It uses interest rates
and money supply to do this. If the Fed sees economic indicators point-
ing toward rising inflation, it will increase interest rates to cool off the
economy. It did this six times during the last bull market.
Unfortunately, rising interest rates can have a chilling effect on the

market and can ultimately lead to the bears taking over. Out-of-control
inflation in the 1970s and 1980s contributed to numerous bear markets
in this era. (See the table in Chapter 1, “Bear Markets.”) It’s a vicious
cycle: The threat of returning inflation sets off interest-rate increases,
which lead to a bear market and ultimately a recession. Lowering interest
rates can break the bear market; however, this increases the threat of in-
flation.
Caution
Many economists consider inflation the most dangerous of economic
problems. The Fed is willing to take extraordinary steps to keep it in
check. Some of these steps, like rising interest rates, can hurt the stock
market.
There is a delicate balance between stopping inflation and undoing a re-

cession and bear market. Finding that balance is as much art as science.
WHERE TO HIDE
Investors traditionally look to hard assets like gold and real estate to pro-
tect themselves from the ravages of inflation. So-called hard assets have an
intrinsic value that historically has done well in times of inflation—that
is, until the 1980s, when gold, especially, took a beating.
Real-estate funds and inflation-indexed bonds are the most popular
defenses against inflation today. I hope that the Fed will keep inflation
under control. Those of us who lived through the hyperinflation of the
1970s and 1980s remember the pain and frustration of inflation.
INFLATION’S EVIL TWIN

Deflation is inflation’s evil twin and is very rare. Deflation occurs when
there are more goods and services than money. As with the stock market,
when there are more sellers than buyers, the price drops. Deflation hurts
companies by forcing them to reduce prices to stay competitive. This
pressure can come from cheap foreign imports that flood the market.
Deflation hasn’t happened on an economy-wide basis since the

Great Depression. However, certain industries have suffered the effects of
deflation in their particular market sectors. When inexpensive Japanese
cars began pouring into the American economy, U.S. automakers reduced
prices and introduced cheaper models to remain competitive.
U.S. industry has responded to the threat of cheap foreign compe-
tition by taking an “if you can’t beat them, join them” strategy. Many
manufacturers have moved all or parts of their operations overseas to take
advantage of cheaper foreign labor. The threat of deflation is probably less
because American-owned plants overseas make most of the cheap goods
pouring into the U.S. market.
CONCLUSION
Investing is a contact sport. You can, and probably will, get hurt at some
point. Whether it is a full bear market or a severe market correction, you
need to be aware of the factors that lead to falling prices.
Information and education will help you structure your portfolio
for the amount of protection you need at a particular point in your life.
Market risk, economic risk, and inflation risk are with you con-
stantly, even if there is not a bear market in progress. In a bear market,
these risks can become amplified and even more dangerous. You can’t
hope to achieve even modest returns without some risk. The trick is to
keep the risk at a level you can tolerate and to be aware of the risk you
have no control over.
CHAPTER 3
TYPES OF BEAR
MARKETS
Knowing your enemy is half the battle. In a television commercial,

basketball legend Bill Russell does a monologue about how he was
so successful as a rebounder. He says that he knew every player’s
strengths and weaknesses; what they do in certain situations; what
they are thinking before they shoot the ball. Russell concludes by
saying he got most of his rebounds before the opponent even shot
the ball.
Knowing your enemy is no less important in investing. Bear
markets and market corrections can play havoc with your portfolio.
Armed with information about how bear markets come about, you
will be better prepared to deal with the consequences.
This chapter examines the different varieties of bear markets
and how they affect your investments. In Part 3, “Bear Assets,” we
will look at these strategies in detail.
BEAR MARKET TYPES

In previous chapters, we looked at some of the causes of bear mar-
kets and some of the risks associated with investing in general. It is
important to remember that often (maybe always) more than one
factor causes bear markets. Sometimes a primary cause and con-
tributing factors make the bear market particularly bad.
One chilling prospect is that we may be on the verge of seeing an

entirely different type of bear market, one driven by large numbers of in-
dividual investors moving in concert thanks to the Internet.
In this chapter, we will look at the following types of bear markets,
which I created for the purpose of explanation. These distinctions are ar-
bitrary and there is not universal agreement about the causes of bear mar-
kets. It doesn’t matter what you call them; the important thing is to see
them coming.
■ Political/financial-instability bear markets
■ Market-liquidity bear markets

■ Recession bear markets
■ Inflation/interest-rate bear markets
■ Deflation bear markets
■ Information bear markets
Remember my caution from earlier: The closer you are to your financial
goal (retirement, in particular), the more concerned you should be about
bear markets and the more carefully you should watch the markets and
the economy. A good financial advisor will help you watch for warning
signs.
POLITICAL/FINANCIAL-INSTABILITY
BEAR MARKETS
As economies of the world become more intertwined and dependent on
each other, the potential for foreign instability to disrupt the stock mar-
ket increases. The invasion of Kuwait in 1990 precipitated the bear mar-
ket that set the stage for the 10-year bull market that ended with the 2000
disaster for Internet and tech stocks.
Wars and political instability are part of modern life. At any given
time, there may be 30 to 40 wars in progress around the world. All wars
are terrible, but the stock market is more concerned with some wars than
others. The Gulf War that made Gen. Norman Schwarzkopf a hero was
significant because instability in that part of the world threatened Mid-
dle Eastern oil supplies, which the United States depends heavily on to
fuel our economy. Instability always leads to higher prices, and higher
TYPES OF BEAR MARKETS 27
energy costs have a devastating effect on our economy; we could not

allow those oil reserves to fall into unfriendly hands. The stock market is
always looking forward: As the action in the Persian Gulf escalated, the
stock market worried about the outcome and what it might mean for our
economy. Would this be another Vietnam that would drag on for years
and cost billions of dollars?
Caution
Energy prices are critical to our economy. Rising energy costs always
have a negative affect on the economy and stock market.
Although we won the war, the stock market and economy suffered exten-
sive damage. A bear market and a recession may have led to the defeat of
President George Bush in the 1992 presidential election. The stock mar-
ket’s real concern with the Gulf War was the disruption of oil supplies
from the region.
In Chapter 4, “Economic Indicators,” we will look at some of the
economic indicators that signal changes in the economy. When energy
prices increase, you can be sure things are going to get worse, not better.
As this is being written, California is experiencing rolling blackouts be-
cause of mismanagement by the state’s utilities; crude oil is over $30 a bar-
rel; and my natural gas bill is double what it was last year.
Plain English
A soft landing is economist-speak for a recession that doesn’t quite ma-
ture, but still has a negative affect on the economy.
The current debate is whether the economy will sink into a recession or
have a “soft landing” with only short-term consequences. Even the experts
don’t know what will happen in the short run, but an unstable energy
price scenario does not sound encouraging. Foreign oil problems are not
the only threat to our financial well-being. A protracted recession in Japan
and credit problems in Southeast Asia are sticky concerns for many U.S.
companies looking to these areas for new markets. A severe recession with
other major trading partners could have negative effects on our economy
and the stock market.
MARKET-LIQUIDITY BEAR MARKETS

Market liquidity simply means there are plenty of buyers and sellers.
When no one wants to buy a particular stock, you can bet the price will
drop dramatically. Every market transaction requires two parties: the
buyer and the seller. If one is absent or in short supply, the price will move
in the opposite direction.
For example, John wants to sell his XYZ stock and hopes to get $50
per share. No one wants to buy XYZ. His options are to sit tight and hope
buyers show up at $50 per share someday or to lower his price for the
stock. However, even if he lowers his price, there is no guarantee he will
find any buyers for his stock. On the other hand, if John wants to sell his
stock for $50 per share, he might find several buyers for XYZ, and they
bid the price up to $65 per share.
Tip
The most recent dramatic example of market liquidity occurred on
Black Monday in October 1987, when the Dow Jones Industrial Aver-
age dropped over 500 points in one day. Sellers flooded the market; how-
ever, there were few buyers. The result was a huge drop in the market.
In the first scenario, there was no liquidity because John could not find
any buyers for his shares. We assume that we can sell our stocks at any
time. When there is a serious bear market, buyers will be hard to find.
Stocks are not like bonds or certificates of deposit that have a fixed, and
in the case of most CDs guaranteed, principle. Stocks are only worth what
someone is willing to pay for them.
RECESSION BEAR MARKETS

Although it is sometimes difficult to separate the two, recessions and bear
markets are not the same. It is possible (and it has happened) for there to
be a bear market during good economic times and a bear market during
a recession. It may be helpful to remember that the economy and the
stock market are two faces of the same phenomenon. The difference is
that the economy is looking backward to see how it did and the stock
market is looking forward to see how it will do. These different perspec-
tives account for why the economy may view one statistic as positive while
the stock market may view the same statistic as negative.
I have used the example of unemployment figures before, but it’s
worth repeating. The economy views low unemployment figures as good
because more people are working and contributing to the economy. For
some companies, this may be a double-edged sword. It’s good that con-
sumers have more money to spend, but low unemployment means
stronger competition for labor, which means high salaries and ultimately
lower profits if the extra costs can’t be passed on to customers. The com-
pany may lower future earnings estimates, which is sure to disappoint the
market.
The intertwining of the economy and the stock market make them
siblings, even though they may look in different directions. If the econo-
my goes south, it can’t be good for the market. A bear market spreads
gloom and distrust, which erodes consumer confidence.
INFLATION/INTEREST-RATE
BEAR MARKETS
The inflation/interest-rate bear market can be the most damaging to in-
vestors and the economy in general. The 1973–1974 bear market was
especially devastating. (See the table in Chapter 1, “Bear Markets.”)
Economists believe that inflation is the most dangerous threat to our
economy. The Fed’s Chairman Alan Greenspan agrees. His best tool to
fight inflation is interest rate adjustments. During the recent bull market,
he raised interest rates six times in an attempt to cool off the white-hot
economy. These interest rates, along with other factors, finally took hold
in 2000 and the economy began to slow. Unfortunately, it looked like it
was slowing too fast and headed for a recession. In an effort to prevent the
recession or at least soften its blow, the Fed lowered interest rates in early
2000.
The falling stock market reacted predictably to the interest-rate
hikes and slammed on the brakes. Higher interest rates mean money for
expansion and growth is more expensive. Increased borrowing costs cut
into future earnings. Investors began to worry about the double whammy
of a bear market and a recession. The super hot Internet and technology
stocks began to crumble in the spring of 2000. With a bear market and
recession looming in the near future, investors dumped the former dar-
lings of Wall Street for more secure issues.
As I noted earlier, one of the reasons the economy and the stock
market don’t always move in concert is they are influenced by the same
factors, but from different perspectives.
Caution
Investors once assumed that there would always be “secure” issues to buy
in times of turmoil. Don’t assume past safe havens will remain so in the
future.
LOOKING BACKWARD
The Fed must adjust interest rates based on information from the recent
past, knowing that its actions may take some time to be effective. The
stock market looks at information from the present and attempts to guess
what impact it will have on future earnings and stock prices.
The stock market is so concerned about the future that it won’t wait
for official information. Investors anticipate the information before its re-
lease and act on it. The Fed normally meets on a quarterly basis and de-
cides what to do about interest rates. The stock market makes an educated
guess and moves before the meeting.
Tip
Analysts pore over every clue they can find to guess what the Fed will
do to interest rates. Fed officials must be extremely cautious in public
statements to not send unintended messages.
Normally, the market guesses right; but the Fed can surprise the market.
When this happens, the market may react strongly. The Fed doesn’t have
to wait until its meeting to act. It can act whenever it feels the need. The
stock market always greets these surprises with fevered activity.
WHAT DOES THIS MEAN TO YOU?

Investors are always looking to the future. You invest today in hopes of a
gain in the future. You view the economy through this lens. Rising inter-
est rates will almost certainly affect future earnings. Likewise, inflation
will affect future earnings for most investments. Either rising interest rates
or inflation can cause a bear market. The cure for inflation is raising in-
terest rates. Either way, investors are stuck. In Chapter 4 we will look at
indicators that you can watch for signs of rising interest rates and infla-
tion along with other important indicators.
What you’re looking for is a balance between a reasonable rate of in-
flation, economic growth, and interest rates. One could argue that such a
balance facilitated the bull market and economic expansion of the 1990s.
During this time, inflation averaged around 3 percent and interest rates,
especially toward the end, were relatively low. The economy was growing
at a rate that suggested inflation was a real possibility.
Caution
A booming economy may not be great for the stock market. Rapid
growth is a known cause of inflation, and the Fed watches growth num-
bers very carefully.
THE DEFLATION BEAR MARKET

Deflation, you’ll remember, is the opposite of inflation. It occurs when
prices fall dramatically because of outside factors such as the flood of
cheap products into our markets. While it is unlikely we will face de-
flation anytime soon, the results would be devastating on the stock
market. In the worst-case scenario, prices fall because of competitive
pressure or some other factor. Corporate profits drop because costs don’t
fall along with prices. This squeezes profits, and investors flee to other
investments.
A deflation bear market is more likely to occur in industry sectors
than the total market. International trade agreements are constantly
forged and revised to prevent this type of shock from foreign competitors.
INFORMATION BEAR MARKETS

History has much to tell us about bear markets. However, there have been
dramatic changes in the stock markets and investors between the 1990
bear market and the current one. These changes might lay the ground-
work for a new type of bear market I call the “information bear market.”
Admittedly, there is no scientific basis for this—and it hasn’t happened
yet. However, if you watch some of the cable financial news channels or
visit many Web sites, you may notice how frantic they can make the mar-
ket sound. This makes great drama but distorts reality by focusing on
minute-to-minute market activity.
However, I think it’s important to consider the changes not only in
the technology of investing, but also the investors themselves.
THE TECHNOLOGY OF INVESTING

The process of investing in the stock market has changed dramatically
during the last 25 years. What once was the exclusive purview of a hand-
ful of brokerage houses has become a wide-open market.
Tip
When the market was roaring between 1998 and 2000, day traders at-
tracted lots of media attention with their huge daily profits. After the
bubble burst, they all but disappeared from the radar.
Younger investors may not remember that at one time you had to physi-
cally go to a stock brokerage to open an account to buy and sell stocks.
The brokers fixed commissions at what would now seem criminally high
rates. When these commissions were deregulated, a new type of stock bro-
kerage emerged—the discount broker. The discount broker charged dra-
matically lower commissions, but investors received no research or help
making investment decisions. Still, the lower commissions and the ease of
dealing with the broker over the phone drew more investors into the stock
market.
The next revolution occurred when the Internet gave birth to online
stock brokerages. Their rates were even lower than discount brokers, and
investors could do all their business online. Coupled with a booming
economy and the hysteria associated with Internet/tech stocks, online in-
vesting exploded. Problems with broker Web sites crashing during heavy
volume dulled some enthusiasm, but it didn’t blunt the desire to trade.
With full-service brokers considered by many investors a thing of
the past, investors who opted to trade with discount brokers (both on-
and offline) had to do their own research, which is where the Internet re-
ally changed the playing field. Literally hundreds of Web sites offering
information, research, and advice compete for investors’ attention. You
have access to more information today than at any time in history.
Caution
Not all Web sites are equal. There are a number of great resources on-
line, but there are also a number of thinly disguised sales pitches posing
as “information.”
The downside of this flood of information is the possibility that investors

will panic or make hasty decisions based on information they receive in
nearly real time. There have already been numerous cases of stock fraud
by crooks using the Internet to spread false “news” about stocks in an at-
tempt to manipulate the price. Admittedly, the big institutional investors
and mutual funds are still the ones that dramatically affect the stock mar-
ket, not individual investors.
There is no guarantee that individual investors won’t panic as they
did in the 1929 stock market crash. However unlikely this scenario is, you
can’t dismiss it.
CONCLUSION
Bear markets come in many flavors. Investors armed with information
and education can prepare themselves in advance.
Interest rate increases in response to higher inflation is the cause of
the most dangerous of all bear markets. Investors must prepare in advance
for these problems because once they are upon the market, it may be too
late.
CHAPTER 4
ECONOMIC
I N D I C AT O R S
Economics is known as the “dismal science.” I’m not sure who gave
it this label, but I suspect it was someone like me who’s more com-
fortable with words than numbers. Unfortunately, you can’t be very
effective as an investor without getting familiar with the numbers.
Economic indicators are a selection of measurements used to
understand the relative strength or weakness of the economy. Many
of these numbers directly affect the stock market, so they are im-
portant to investors.
Most of these numbers are indexes, which means they repre-
sent the change from a base year. For example, the Employment
Cost Index represents the change in the cost of labor. Economists
use the numbers from 1989 as the base (1989 = 100). As labor costs
change from quarter to quarter, the number relative to the base year
changes. The number for the last quarter of 2000 was 150.6. How-
ever, the number most investors follow is the percent change. In this
reporting period, that change was a 4.1 percent increase over the
last quarter of 1999.
Plain English
An index is a statistical composite that measures the increase or
decrease of an economic indicator as measured against a base year.
We’ll look at the Employment Cost Index in more detail later; however,
economists report and measure many of the indicators we will look at in
this section the same way. It’s not particularly important that you under-
stand how economists put the numbers together. (If you really want to
know, many Internet sites and books report this information.) What is
important is that you understand what these indicators mean in terms of
your investments and understand how the stock market views them.
The market is always looking to the future. Rather than wait for the
actual numbers, Wall Street economists make their own estimates of what
the numbers will report. Investors, especially big institutional investors
and mutual funds, make decisions based on these estimates. When the ac-
tual numbers differ substantially from estimates, the market will often
react dramatically. A number of Web sites report the estimates and com-
pare them to the actual numbers.
Tip
A number of Web sites, including TheStreet.com, publish a calendar of
report dates for a variety of economic indicators. If you are interested in
a particular indicator, the calendar will let you know when to look for
the information.
Not every economic indicator has an important affect on the stock mar-
ket, so we will stick with those that do.
INFLATION INDICATORS
As noted earlier, inflation is the most feared economic condition short of
a depression. It robs value from just about every sector of the economy.
Economists call inflation the evil tax because it takes value not only from
your earnings but also from your principal. The Fed has demonstrated a
willingness to go to great lengths to keep inflation in check. During the
last leg of the recent bull market, the Fed raised interest rates six times in
response to signs of impending inflation.
The following indicators represent the most important tools econo-
mists use to gauge the relative strength of inflation.
E C O N O M I C I N D I C AT O R S 37
EMPLOYMENT COST INDEX

The Employment Cost Index (ECI) is an important measurement of in-
flation: It measures the change in the cost of employing workers and in-
cludes wages and employee benefits paid for by the employer. The Labor
Department issues the report quarterly, and its change from the previous
month and previous year is one of the best inflation barometers.
Economists attempt to predict the change from previous reports.
Observers incorporate these expectations, along with other information
and estimates, into market decisions. Analysts compare the actual num-
bers to the estimates. If there is a large difference, one way or the other,
the market may react dramatically, since unexpected changes may affect
the Fed’s decisions regarding interest rates.
Let’s look at the numbers reported for the last quarter of 2000 and
see how this report may have affected the market. The Labor Department
reported fourth-quarter numbers for 2000 on January 25, 2001. Econo-
mists estimated there would be a 1.1 percent increase in the fourth quar-
ter from the third quarter. The actual increase was only 0.8 percent.
When combined with a 0.9 percent increase from third quarter 2000, the
numbers were a pleasant surprise for the market, showing that the ECI,
or wage inflation, was slowing, and that it handily beat the estimate of 1.1
percent.
■ Third quarter 2000: 0.9 percent
■ Forecast fourth quarter 2000: 1.1 percent

■ Actual fourth quarter 2000: 0.8 percent
This news justified the Fed’s decision to lower interest rates, and further
rate reductions may be possible. The market could feel good about the fu-
ture of further rate reductions.
Of course, this is just one component of many that market econo-
mists consider along with the Fed in forecasting higher or lower inflation.
Assuming no other indicators pointed in a different direction, you might
consider investments that do well in an environment of lower or steady
interest rates. Admittedly, long-term investors should probably not adjust
their portfolios on just one quarter’s information. However, a steady in-
crease in the ECI suggests the Fed may raise interest rates.
The ECI began a fairly dramatic rise in the first quarter of 1999 and
did not retreat until the fourth quarter of 2000. It isn’t surprising that the
Fed increased interest rates during this period.
PRODUCER PRICE INDEX

The Producer Price Index (PPI) reflects the prices received by producers.
It includes the price of commodities at all stages of processing. The Labor
Department issues the measure, with a base of 1982 = 100, monthly.
There are two variations of the measure. The “core” measurement is the
most important. It excludes highly volatile food and energy components,
which can skew the results on a seasonal basis. The other measure in-
cludes these components but is considered unreliable because food and
energy costs are so volatile.
Coupled with other inflation indicators, this number always affects
the market. The PPI for December came out before the Employment
Cost Index and was higher than expected, which created some concern
that it might cause the Fed to keep its interest rate cut to one quarter of
a point instead of the hoped-for one-half point reduction.
Caution
Economists forecast indicators to factor them into investment decisions
before they happen. However, some indicators are so volatile that in-
vestors are reluctant to place too much value on estimates.
CONSUMER PRICE INDEX

The Consumer Price Index (CPI) may be more familiar to the public than
some of the other indicators. The Labor Department releases the figures
monthly. The index (1982–1984 = 100) reports the change in cost of a
composite of such items as food, housing, energy, transportation, hous-
ing, clothing, education, entertainment, and healthcare. Like the PPI, the
CPI “core” number excludes energy and food costs; economists believe
the core number gives a clearer picture of inflation.
This is a significant measure of inflation and the stock market
watches it closely. Market watchers consider the CPI a broader picture of
inflation because it contains more components than the PPI, which does
not include services.
The December 2000 number, reported in mid-January 2001, came
in just where the economists estimated, with the core number slightly
under estimates. This was good news for the market because it confirmed
that inflation was under control.
Now we have three numbers for inflation during the month of Jan-
uary 2001. The Fed’s regularly scheduled meeting at the end of the month
would consider interest rates. What would they do? A CPI moving up
over several months is a cause for concern. The Fed is likely to either raise
interest rates or leave them the same. In a bear market, raising interest
rates to combat inflation would prolong the bear’s visit. Good news on
the inflation front likely means lower interest rates, which are good for
stocks and bonds.
Tip
The Fed funds rate is a base rate that banks use when they lend to each
other overnight. It is the short-term rate upon which other rates (mort-
gages, consumer loans, and so on) are set.
It would seem that the indicators favored a controlled inflation. If these

were the only numbers used by the Fed, it would be safe to assume that
interest rates won’t be going up soon.
MORE ECONOMIC INDICATORS

Economists follow many other economic indicators, and those that fol-
low can have a significant influence on the stock market. Even though I
have not included them under the inflation indicators, many would fit.
EMPLOYMENT REPORT
The Employment Report is one of the best measures of the economy’s
health. There are actually four numbers: the unemployment rate, new
jobs created, length of workweek, and average hourly wages. The Labor
Department issues this report monthly, and market observers watch it
with anticipation.
Changes in these numbers can move the market dramatically.

Strong numbers in these reports indicate a growing and healthy economy,
which is a good thing. However, if the economy appears to be growing
too fast, it can lead to inflation.
Tip
The unemployment rate stayed at record low levels for much of the lat-
ter 1990s. As the economy began to slow, the rate began to creep up-
ward.
A healthy economy has a low unemployment rate, creates new jobs, in-
creases the workweek, and raises hourly wages. An economy growing too
fast in these categories creates inflation. On the other hand, a slowing
economy has rising unemployment, fewer new jobs created, short work-
weeks, and falling hourly wages. The stock market may not view numbers
that look good for the economy in a positive manner. Low unemploy-
ment is a sign of a healthy economy; however, it can mean higher labor
costs for employers, which can cut into profits.
The Fed must do an incredible balancing act between keeping in-
flation under control and keeping the economy moving at a positive pace.
Raising interest rates to slow inflation may have the effect of slamming
the brakes on the economy. The Employment Report is critical to their
deliberations. The stock market wants lower interest rates, but not at the
expense of inflation.
Caution
Changing the direction of the economy is like steering a large ship; it
usually takes some time before any changes are apparent.
The fear in the stock market as 2000 became 2001 was that the economy
was decelerating too rapidly. A bear gripped the stock market and in-
vestors were afraid a recession would only make things worse. Inflation
was clearly in check, so the Fed cut interest rates twice in January 2001
for a 1 percent decrease. However, even this was not enough to lift the
market and economy in a substantial way—at least not yet. Interest rate
moves take some time to filter through the economy. It may be several
months after a change in interest rates before the effect spreads through-
out the economy.
It is important to remember that bad numbers in the Employment
Report can lead to higher or static interest rates. The market may react
swiftly to an interest rate decision, but it will take some time for the rate
changes to affect earnings.
PURCHASING MANAGERS’ INDEX

The Purchasing Managers’ Index (PMI) is the most important indicator
of the manufacturing sector. The National Association of Purchasing
Management produces the PMI and reports their findings at the first of
each month. They survey some 300 purchasing managers from manufac-
turing companies for the index. The PMI numbers are different from the
other indexes we have discussed: The index is neutral at 50; any number
over 50 is a sign of expansion, and any number under 50 is a sign of con-
traction.
There are a number of components to the PMI, but your concern
is with the expansion or contraction of the manufacturing sector. The
PMI gives you a good picture of the economy on a month-to-month
basis. Scores above 50 indicate the economy is growing; however, a strong
number above 50 may signal an overheated economy. Along with the
Durable Goods Orders Report, the PMI is a major barometer of the econ-
omy’s health.
A look at the 2000 PMI numbers shows an almost unbroken string
of declining numbers. The December 2000 number of 43.7 was far below
estimates and sent a strong signal that the economy was stalling faster
than expected—this was the lowest score since 1991. The run continued
in January 2001 with a 41.2 PMI. This 13-month decline signals a slow-
ing economy, and the corresponding bear market confirms the strong tie
between manufacturing and the stock market.
DURABLE GOODS ORDERS

The Durable Goods Orders Report tracks orders received by manufac-
turers of products designed to last three years or more. “Durable goods”
include automobiles, factory machinery, airplanes, consumer appliances,
and so on. The Census Bureau reports this number monthly.
This is an important economic indicator for the manufacturing

component of the economy. Although not a large component of our
economy, its health is of major importance, and soft or declining num-
bers in this report signal a weakening economy. Fewer orders for durable
goods means companies that provide supplies to manufacturers will
see reduced demand for their products and services; workers along the
supply chain are no longer working overtime—and may lose their jobs;
workers facing uncertain earnings cut back on spending to preserve cash;
and so on. It’s not uncommon for the Employment Report and the
Durable Goods Orders Report to move together.
Caution
A slowdown in manufacturing can ripple through the whole economy.
Whole towns have suffered terribly when factories closed because of the
wages—and expendable income—those workers have lost.
The Durable Goods Orders Report is highly volatile. Many observers

back out the transportation component, which can skew the results. For
example, the December 2000 report showed a 2.2 percent increase in new
durable goods orders over November 2000. This surprised analysts who
expected a 1.7 percent decrease for the period. When observers adjusted
the report for a large commercial aircraft order, it showed that new
durable goods orders actually fell 1.4 percent.
These reports gave the Fed freedom to reduce interest rates further,
which they did at the end of January 2001. Market observers noted that
by mid-February 2001, Fed Chairman Alan Greenspan gave a speech
warning of a rapidly slowing economy. This led some to believe the Fed
may be considering further interest rate cuts. As noted earlier, interest rate
changes may have an immediate affect on the stock market, but they may
not offset a slowing economy, which suggests lower earnings and lower
stock prices.
Caution
Interest rates grease the wheels of the economy, but rate adjustments
aren’t a “silver bullet” that solve all economic problems.
INDUSTRIAL PRODUCTION AND CAPACITY

UTILIZATION
The Industrial Production and Capacity Utilization Report adds the third
leg to the important manufacturing sector reports, measuring changes in
production at factories and analyzing the capacity and utilization of our
factories, mines, and utilities. The Federal Reserve issues the report
monthly.
The percent change from month to month paints a picture of where
the manufacturing sector is heading, and the December 2000 number
shows a decline of 0.6 percent. The Federal Reserve also reported that in-
dustrial output contracted at a 1.1 percent annualized rate. Like the PMI
number, this was the first contraction since 1991.
The information for December 2000 I used to illustrate the three
manufacturing measures reveals a consistent and troubling picture: All
three reports suggest a dramatic slowing of the economy and build a
strong case for further intervention by the Fed on interest rates. Hard
numbers like these make it easier to understand why corporate earnings
are suffering and stock prices are in a bear’s grip.
Caution
You can always find market commentators on the Internet and else-
where who want to paint a picture of the economy to suit their own par-
ticular prejudices. Unfortunately, numbers are stronger than words. You
can’t wish away bad news.
RETAIL SALES
The Retail Sales Report totals sales at retail stores, but it does not include
services. The Census Bureau issues this report monthly, usually within
two weeks of the previous month’s end.
Consumer spending is a strong force in our economy, so market ob-
servers closely watch this report, which has significance for the market in
the short-term and contributes to the larger picture of economic health.
Strong retail sales signal a healthy economy. Slowing retail sales may in-
dicate consumers are contemplating tighter times ahead and are putting
off nonessential spending. (You would expect to see low unemployment
correlate with a good retail sales report.) A dramatic slowing of retail sales
can hasten an economic slowdown and a strong increase in retail sales can
help pull the economy out of a downturn.
The December 2000 Retail Sales Report showed a small 0.1 percent
increase. The two previous reports showed declines, combining for a
shaky prognosis for 2001. This fits into the picture we have drawn using
December 2000 numbers for the major economic indicators.
GROSS DOMESTIC PRODUCT

The Gross Domestic Product (GDP) is the measure of how fast the econ-
omy is growing or shrinking. The Commerce Department issues the re-
port on the change in the price of all goods and services produced by the
economy on a quarterly basis. The advance report is first; the preliminary
is the revision of the first estimate; and the second revision is the final re-
port. There is about one month between each report.
The GDP is an important piece of the economic indicator puzzle.
Market analysts closely watch the GDP since it represents how fast the
economy is growing, which relates directly to the stock market. If the ac-
tual GDP numbers differ significantly from estimates, the market may
react strongly. The GDP is widely reported in the media, although they
seldom give you enough information to understand whether it is good
news or not.
Continuing our look at economic indicators reported in January
2001, we find the GDP released on the last day of the month for the
fourth quarter of 2000 showed the economy growing by only 1.4 percent.
Market watchers had forecast a 1.9 percent increase and were surprised at
how much the economy was contracting. The 1.4 percent growth was the
lowest since 1995.
Caution
Investors expect companies to keep growing and increasing the value of
their investment. During slowing economies, many companies have
trouble maintaining growth rates. This can spell trouble if the company
has spent heavily building an infrastructure to support growth. If
growth slows, the revenues to pay for the infrastructure may drop and
cause profits to suffer.
A slowing economy, as represented by the economic indicators above,

spells trouble for corporations that need to maintain a growth rate or raise
their earnings. On the other hand, a GDP that is rising too fast can indi-
cate an economy that may produce inflation. Either way, the GDP is im-
portant to watch.
CONCLUSION
Is your head swimming? This was probably a lot more about economic in-
dicators than you wanted to know, but the relationship between the econ-
omy and the stock market is important to your investment decisions.
Understanding what’s happening in the economy can suggest sound in-
vestment strategies.
CHAPTER 5
MARKET
I N D I C AT O R S
You would think with all the economic indicators we just plowed
through in Chapter 4 and all the numbers that spew forth from the
Internet, that only an idiot couldn’t see a bear market coming.
But if it were that easy, you wouldn’t need this book! Unfor-
tunately, bears are hard to spot. Sometimes they come in the front
door, and sometimes the back. We have also learned in earlier chap-
ters that certain influences completely outside the market, such as
war, can invoke a bear. Nevertheless, it’s important to keep an eye
on market indicators for warning signs. The stock market gives off
all kinds of signs; interpreting which ones are real bears and which
are bear traps is as much an art as a science. The prudent investor
hopes for the best and prepares for the worst.
In this chapter, we will look at some of the market indicators
that can help us spot a bear market. We’ll look at some of the more
common indicators as well as some that aren’t so well known. Like
the economic indicators from the previous chapter, no single sign
clearly foretells an approaching bear. Like pieces of a puzzle, these
indicators construct a picture that previously was a jumble of ran-
dom signs.
Tip
Warning signs are of no importance if you are not prepared to act. Every
investor should have a plan for every asset you own, whether it is an in-
dividual stock or a mutual fund.
MAJOR MARKET INDEXES

The “roaring ’90s” drew a tremendous amount of media attention to the
stock market, which drew a number of new investors. Dazzling reports of
dot.com billionaires and day traders dominated the news. “The Dow,”
“the S&P 500,” and “the Nasdaq” became household words as they set
one record after another.
Let’s look beyond the numbers to see what these and other major
market indexes can tell us. There is no way to accurately predict the fu-
ture direction of these indexes, and even though individual stocks do not
necessarily follow major indexes, the reality is that many do. Understand-
ing what part of the market they represent is helpful in getting a sense of
what the future holds for your investments, and helps you understand
why one index is rising while another is falling.
Caution
You can buy futures contracts on most of the major indexes. Some in-
vestors use these to protect themselves against market swings. Futures
contracts, options, and other derivatives are valid investment tools, but
only in the hands of the most experienced investors.
Watching indexes can lead to a short-term mindset. Investors are still di-
gesting the emergence of more than one “market.” Although this situation
has been around for some time, the recent skyrocketing and subsequent
crash of the Nasdaq has focused more attention on understanding the dif-
ferences between multiple markets.
In many ways, you get a clearer picture of what is happening from
the economic indicators we discussed in the last chapter. Nevertheless,
what follows is a quick overview of the major indexes and some sense of
how they fit into the overall picture. Some of the tools listed below will
M A R K E T I N D I C AT O R S 49
help you understand what the market is doing over time, and more tools
are available if you’re interested in pursuing technical analysis further.
THE DOW JONES INDUSTRIAL AVERAGE

The Dow Jones Industrial Average is the oldest and most widely reported
of the major market indexes. If a news outlet reports only one indicator,
it will be the Dow. When people speak of the broad market, they are often
referring to the Dow.
The Dow covers just 30 stocks. You may find it difficult to accept
that 30 stocks can represent “the broad market.” However, these stocks
are all leaders in their respective industries. As a broad generalization, sec-
tors tend to follow their leaders. When you hear the term “blue-chip
stock,” think of the Dow. Leaders lead, and if you own stocks or mutual
funds, watching the Dow is an important part of your work.
Plain English
A “blue-chip” stock is a premium investment. These are well-established
and respected companies with lengthy histories of good returns. The
term “blue chip” comes from poker, where the blue chips are worth the
most.
The Dow also plays an important role in registering the “mood” of the
market. You cannot take emotion out of any market observation; the mar-
ket (Dow) reflects the optimism or pessimism of the investing commu-
nity. A 20 percent decline in the Dow over a sustained period qualifies as
a bear market.
THE NEW YORK STOCK EXCHANGE

COMPOSITE INDEX
The New York Stock Exchange (NYSE) Composite Index covers all the
stocks traded on the exchange. Although not as widely quoted as the
Dow, it is a good indicator of how larger companies are doing.
Obviously, its coverage of a large number of stocks gives it greater
claim to representing “the broad market.” The NYSE stocks tend to be
older, more established companies. The listing qualifications exclude
smaller companies. Small, startup companies led the late-1990s bull mar-
ket. For this reason, the NYSE probably didn’t represent the heart of the
bull market.
This index will track the Dow, although its broader coverage re-
duces some of its volatility. This makes the NYSE a widely used proxy for
“the market.” It takes more than a few bad reports on individual stocks to
move the NYSE index.
STANDARD & POOR’S 500

Standard & Poor’s 500 (S&P 500) is the most widely used index by in-
vesting professionals. It represents 500 of the largest companies, and
many believe it is the best “broad market” indicator. Investment profes-
sionals, particularly mutual fund managers, compare their performance to
the S&P 500.
Its broader coverage makes it more accurate than the Dow, and be-
cause of its focused approach to selecting components, it is more repre-
sentative than the NYSE Composite Index.
Tip
Mutual-funds managers in particular use the S&P 500 as a benchmark
for their funds performance. When they beat the S&P 500, managers
proudly display the fact in the annual report. If they don’t beat the mark,
look for many excuses.
The relative health of “the market” is of little consequence if your invest-

ments tank. The S&P 500 is a measure of where the mainstream market
is at any one time. The prudent investor should find most of their in-
vestments in or close to “the market.” Fringe investments usually are the
first casualties of a downturn.
THE NASDAQ COMPOSITE INDEX

The Nasdaq Composite Index covers the 5,000-plus companies in the
Nasdaq market. These companies are, for the most part, smaller than
their counterparts on the NYSE. (Nasdaq originally was NASDAQ,
which stood for National Association of Securities Dealers Automated

Quotations. It has since evolved into a complete stock market and is now
simply the Nasdaq National Market.) However, Microsoft, the off-and-
on largest company in the world, is on the Nasdaq.
That’s the appeal of investing in smaller companies. One day they
may grow up to be the next Microsoft. The Nasdaq is where the dot.com
boom flourished in the late 1990s. Companies went from an idea to mar-
ket caps in the tens of billions of dollars, seemingly overnight.
This makes the Nasdaq highly volatile, because those small compa-
nies can go from boom to bust to boom in the blink of an eye and be-
cause a handful of Microsoft-like companies can drive the index in either
direction. The Nasdaq topped 5,000 and, then in less than a year, lost al-
most 50 percent of its value. If one of the tech leaders falters, you can be
sure the Nasdaq will not react well. For this reason, the Nasdaq is not a
reliable short-term indicator of the general market.
Caution
What goes up must come down. That may not always be true; how-
ever, when a market overheats as the Nasdaq did in the final years of the
last bull market, a severe bear is almost inevitable.
WHAT DO MARKET INDICATORS TELL US

ABOUT BEARS?
As I noted earlier, bear markets seldom follow a direct line of declining
market numbers. They are often marked with ups and downs that some-
times are simply corrections. Market observers watch the movement and
look for lower lows and lower highs as signs of market momentum mov-
ing from bull to bear.
These observations should cover several days to avoid bear traps of
sharp declines followed by rebounds. Lower lows and lower highs mark a
definite and visible trend. The opposite would be true when the market
moves out of a bear and into a bull frame of mind. There will be higher
highs and higher lows.
VOLUME SIGNS
Watching the market volume (the number of shares traded) can give you
additional confirmation as to the “lower lows and lower highs” approach.
As the market hits these marks, take note if volume is increasing or de-
creasing. If volume is increasing from one lower low to the next (within a
couple of days), you may be looking at a bear. What you are seeing is
downward momentum, and it can be a powerful force in the market.
Unsupported lows may be a bear trap. On the other hand, when the
market hits new lower lows and lower highs on increasing volume, you
are looking at a dangerous trend downward.
The opposite works for emerging bull markets. Higher highs and
higher lows mark the way out of a bear market if volume is increasing
along the way.
Tip
Rising volume indicates more people and more issues are participating
in the market. This positive signal reflects the fact that once the market
moves strongly in one direction, it takes extreme measures to reverse its
course.
Volume of shares traded is a good indication of the market’s feeling about

the short-term future. It is important to remember that the market is al-
ways thinking ahead. When investors note the market indexes rising on
ever-increasing volume, it is a sign of optimism. The market is saying
things are going to get better. However, the opposite is also true. When
volume rises on a declining market, investors are saying they’re concerned
about the short-term future.
ADVANCE-DECLINE SIGNS
The advance-decline line is another tool that investors use to gain some
sense of where the market’s heading. The A/D line is a way to measure the
market’s breadth: a graphical representation of the market’s strength of
movement relative to the number of stocks advancing and the number de-
clining.
The calculation is to take the number of issues advancing minus the

number of issues declining. Add the result to a cumulative total for plot-
ting. When more stocks are declining than advancing, the line heads
downward; when there are more advances than declines, the line rises.
(The number isn’t important—we’re just looking for a direction.) At a
glance, investors can see which way the market is headed, how long it has
been moving that way, and so on. The A/D line may be more accurate for
identifying market strength than the indicators we’ve already discussed,
and you can use it with any major index. (StockChart.com is a great place
to build these charts with relative ease.)
The A/D line can also point out anomalies in the market. This oc-
curs when the A/D line for a major index is headed one way and the index
is headed another. The following illustration from Equis.com shows the
A/D line for the Dow leading up to the 1987 disaster. The A/D line is
heading downward while the Dow is still trying to hit new highs.
Advance Deadline Line 20000
15000
10000
5000
DJINDUSTRIAL IDX
2500
2000
1500
1985 1986 1987 1988 1989
The A/D line and Dow going opposite ways.
When the A/D line and the index are moving in opposite directions, it’s
called a divergence. Divergences usually indicate a change. The index usu-
ally follows the A/D line. Looking at this chart would send chills down
the back of investors who followed the A/D charts.
The problem with following the A/D line is that it doesn’t look for-
ward. You can’t know what it is going to look like next week by looking
at it this week.
Several other indicators are built around the advancing and declin-
ing issues, including one that measures not the number of issues but the
volume. Market watchers calculate the volume of advancing issues and
the volume of declining issues and chart this line. I suggest you visit Equis
(www.equis.com) for more information on these indicators and how you
can use them.
TECHNICAL ANALYSIS OF THE MARKETS

Many investors rely on technical analysis to tell them about the health of
the market. Technical analysis attempts to predict the movement of the
market using volume, prices, new highs and lows, and other market data.
Investors using technical analysis rely on charts to display trends of issues
like momentum, volume, and other information that gives them a clue
about market direction.
Investors use technical analysis as a way to predict price movement
of individual stocks. The adherents use charts to watch a stock’s move-
ment, looking for buy or sell signs. Technical analysts pore over charts
with the zeal of an explorer looking for the “X” that “marks the spot.”
Technical analysis has much to offer, but it’s not the final answer; it’s
just another tool for examining a complicated picture. It’s not particu-
larly good at predicting long-term trends, so most investors find that
combining elements of technical analysis with other observations makes
more sense than relying on just one tool.
A comprehensive look at technical analysis is beyond the scope of
this book, so we’ve just touched on a few popular tools. There are a num-
ber of resources at the end of this book that you can use for more
information.
EARNINGS FORECASTS
Investors are concerned primarily with the future. One of the strongest
positive signs for investors is a market leader reporting positive earnings
estimates. This is welcome news to investors even if they don’t own those
individual stocks; good news in the earnings estimate report means com-
panies are optimistic about the near-term health of their company.
One company reporting bad earnings estimates may not move the
market, but when other market leaders start warning that they may not
hit earlier estimates or release new estimates that show a decline in earn-
ings, the market takes notice.
Tip
When companies begin making or revising earnings estimates lower
than the market anticipated, you can bet the stock will fall. If several
stocks that are leaders drop, the whole market may retreat.
The other number investors watch closely is growth in sales, especially

for young companies that may not be profitable yet. Growth estimates
reflect health in the company’s market; declining growth signals trouble
ahead.
Neither earnings estimates nor future growth are widely reported
in the aggregate for the market. However, when talk in the media is of
declining earnings estimates or growth figures, the future is cloudy at
best.
WHAT DO BOND INVESTORS TELL US?

Bonds, like stocks, are bets on the future. Although they differ in many
ways, both stocks and bonds hope to capitalize on the future.
If you buy a newly issued 10-year Treasury bond, you expect to earn
a higher interest rate than if you bought a 1-year Treasury bond. The rea-
son is that bonds are very interest-rate sensitive: As interest rates go up,
bond prices go down. For example, if your 10-year bond had an interest
rate of 8 percent and open interest rates went to 9 percent, you would
have to discount the price of the bond to sell it.
However, as interest rates go down, bond prices go up. Your 10-year
bond with an 8 percent interest rate would command a premium when
market interest rates drop to 6 percent.
Tip
Bonds may do well in a bear market if the Fed is dropping interest rates
to soften the landing.
Bond yields reflect the current price of the bond and its coupon interest
rate. You would expect long-term bonds to have a higher yield than a
short-term bond. (Long-term bonds are at a higher risk from inflation
and other economic problems than short-term bonds.) When the yield of
short-term bonds exceeds those of long-term bonds, a recession and bear
market are definite possibilities. This “inverted” yield curve expresses pes-
simism about the future.
CONCLUSION
This brief introduction to market indicators is meant to show you that in-
vestors need to keep their eyes open to changing conditions. As you’ll see
in later chapters, this will help you prepare for bear markets or severe cor-
rections.
No set of magic indicators will tell you what the market will look
like next month, much less next year, but you can lower the odds that a
bear will blindside you at the worst possible time—when you’re
unprepared.
PA R T 2
BEAR TRAPS
I’m a big advocate of the “buy low, sell high” theory of investing. It
has been my experience that you can make money doing this. Un-
fortunately, the theory has one small problem: It doesn’t always
work. It doesn’t work because it relies on correctly buying at the
bottom and selling at the top, and no one can call the turns with
consistent accuracy.
Investors, even professionals, find market timing too tempt-
ing to resist at times. On the other hand, it takes nerves of steel to
sit on your “buy-and-hold” strategy while watching your invest-
ments sink like a brick in an extended bear market.
Sometimes bad things happen to good investments, but, most
often, bad things happen to bad investments. Either way, you need
an exit plan when you see a bear market coming or when you find
yourself in the middle of an unstable market that is throwing off
confusing signals.
You need a plan to deal with falling prices before they start
falling. This part of the book looks at market timing and how to
avoid this particularly nasty bear trap. We will also spend some time
on developing a strategy for selling a stock and a mutual fund. The
strategies for selling stocks and mutual funds differ in some respects
because of the difference in the two investments, but there are also
many similarities.
CHAPTER 6
MARKET TIMING:
THE TWO MOST
DANGEROUS
WORDS IN
INVESTING
Two hikers are on their way up a mountain trail when a large bear
spots them and charges. One hiker immediately drops to the
ground, pulls her running shoes out of the backpack, and begins
taking off her hiking boots.
“Are you crazy?” her companion shouts. “You can’t outrun
a bear!”
She looks up at him and says, “I don’t have to outrun the bear.
I just have to outrun you.”
You can’t outrun a bear market either. It’s tempting to think
you can, by timing your entry and exit in an unstable market, but
the overwhelming evidence is that market timing doesn’t work con-
sistently, and leaving may be more harmful than doing nothing.
There are two forms of market timing: intentional and unin-
tentional. Both are deadly to your portfolio.
INTENTIONAL MARKET TIMING

It seems so simple. Buy when stock prices are low and sell when they are
high. Thousands of investors are unable to resist the temptation: All they
need do is look back at the stock that went from $10 per share to $50 per
share to see how easy this is.
Unfortunately, 20/20 hindsight doesn’t help you look forward. It
doesn’t help you identify the stock that went from $10 to $50 any more
than it warns you about the stock that went from $50 to $10.
MARKET TIMERS
Market timing has its proponents. You don’t have to look very far or hard
to find folks who will gladly call the market turns for you if you subscribe
to their service. Some of these market timers are very sincere about their
approach and believe they can provide a real service.
Others, however, are just short of frauds. One of their tools is trot-
ting out “historical” data that shows how their system called the market
correctly for the past 10 years, or whatever. They base many of their sys-
tems on back testing, which takes a trading system and applies it against
historical market data. Done objectively, there is nothing wrong with this
approach. However, if you manipulate the system to produce the best re-
sults based on the historical data, you have crossed the line between test-
ing and moved into the realm of shell games: You can’t duplicate their
results because they tweaked the system to work with a market that won’t
exist again.
Caution
Save your money and don’t invest in expensive newsletters that offer to
predict market turns. There is no credible evidence that they work.
The sincere proponents of market timing don’t promise triple-digit re-

turns every year. Instead, they hope to improve your odds by suggesting
possible market turns based on fundamental and technical analysis.
Most market timers appear to be do-it-yourselfers. A striking exam-
ple of this band of hardy souls is the day trader. You remember day traders
don’t you? In the waning years of the 1990s, they were the hottest act on
MARKET TIMING 61
Wall Street. You couldn’t open an investing publication or cruise the In-
ternet without reading about a former cab driver making $50,000 a week
day trading at his kitchen table in his underwear. When the dot.coms be-
came dot.bombs, the day traders disappeared from the media. The untold
story, even during their peak, was that very few day traders were making
money even when the market was red-hot.
Another form of market timing that ran rampant during this pe-
riod was the IPO craze. Just about any new Internet or tech company that
went public experienced huge run-ups of its stock almost overnight. This
was the origin of the dot.com billionaires who became so famous. Most
of their wealth was in the stock and stock options they held. Investors
tried to cash in on the huge gains, and some managed to do so by buying
early and getting out quickly with a reasonable profit, but the market
wasn’t very kind to those who got in late and didn’t get out quickly. The
super-high prices for most of these stocks didn’t hold, and people lost
much of their investment.
Caution
The IPO craze drove people to pay incredible prices for young compa-
nies with no track record. In fact, many of the companies had no prof-
its and no working products.
For example, I am aware of a company that went public around $20 per
share. Within a short period, the stock was selling for over $100 per share.
It didn’t stay there long and fell to $14 per share. All of this happened in
less than 12 months. (As I write this, the stock is trading for $23 per share
less than two years after it went public.)
The sad truth is that many of the hot IPOs were trading at or below
their offering price within six months to one year. After the Nasdaq melt-
down that began in the spring of 2000, many of these former high-flyers
have disappeared altogether.
THE UNINTENTIONAL MARKET TIMER

The unintentional market timer is the investor who jumps into the mar-
ket without much of a plan and has no idea what to do when things turn
sour. People are very emotional about their money—especially when
they’re losing it. They jump in impulsively and bail out without much
more consideration.
The late-1990s bull market made making money look so easy, and
attracted many investors with little or no experience in the market. In-
vestors and potential investors watched the Internet/tech stocks go crazy
along with the Nasdaq index. Typically, they waited until the market was
way up before investing; then, deciding the bull market was going to be
around for a while, they charged into the market. With no real knowledge
of market dynamics, they bought overpriced stocks that ultimately proved
to have only one way to go with any momentum—and that was down.
When the market turned and their stocks began to fall, they watch
helplessly as their money evaporated. Some cut their losses quickly or
even took a small profit. Others froze like deer in the headlights. Perhaps
they convinced themselves that a “buy and hold” strategy would see them
through. When prices didn’t bounce back, they sold in frustration and left
the market in disgust. But not just the novices suffered. A number of sea-
soned professionals also took big hits because they put aside their disci-
plined approach to investing and ran with the excitement.
Caution
The heady days of the Internet/tech bull market were full of optimism
and a sense that anyone could make a fortune in the market. Unfortu-
nately, when the bubble broke, many watched the market fall, sure it
would bounce back any minute. Markets do fall, and they can fall much
farther than you think.
THE TRUTH ABOUT MARKET TIMING

The truth is that market timing, intentional or otherwise, doesn’t work.
No one can consistently call market turns and neither can you. (I can’t ei-
ther.) Here are some simple truths about market timing:
■ No one knows what the market will do tomorrow, next week, or
next year.
■ Unless index funds make up your portfolio, there is no guarantee
that your investments will turn with the market.

MARKET TIMING 63
■ In most cases, you are probably better off invested than not: Buy
and hold.
■ Timing the market takes a lot of time.
■ Timing the market often builds huge tax bills.
NO ONE KNOWS THE MARKET

No matter how many numbers you crunch, there is no way to figure out
what the market is going to do next with any degree of accuracy. For all
the numbers and analysis, stock prices are still reflections of expectations.
If investors expect a company to be more profitable in six months, today’s
price reflects that expectation. But a lot can happen in six months. Active
investors (those who trade often) even have another layer of expectations:
What stock will everyone else want in six months?
Add in unanticipated factors outside the market, and you can see
why knowing the market’s next move is so complicated.
Tip
It is hard not to be impressed with some of the Internet pundits writing
and making predictions about the market, but if you check the site
archives, you may find that their track record is not so great.
Anyone who tells you what the market is going to do next month is guess-
ing. When you guess, sometimes you are right, and sometimes you are
wrong.
YOUR INVESTMENTS MAY NOT FOLLOW

THE MARKET
Although the majority of stocks will follow a bear market to lower prices,
it is not true of every stock or even every stock sector. Historically, utili-
ties and dividend-rich stocks have done better in slowing markets than
other sectors. Food and consumer staples tend to hold up well in bear
markets. (People still need to eat and brush their teeth.)
You can’t be sure that your investments are going to drop at the
same rate as the market. Some (such as technology stocks) may drop con-
siderably faster and farther than other sectors.
Plain English
Index funds are mutual funds that attempt to mimic a particular mar-
ket index. An index fund based on the S&P 500 buys representative
shares of the index, so the fund rises and falls with the index.
Some advisors suggest that you put your money in a good stock index
fund and forget about it. An S&P 500 index fund is going to rise and fall
with the market. If you have a long time horizon before you need your
money, this is an easy way to ride out down markets. That is not always
the best strategy, however, especially if you’re approaching a financial goal
such as retirement.
YOU’RE BETTER OFF INVESTED

There is significant evidence that staying invested in common stocks
or stock funds is a good defense against a bear market. Investors who
suffered through the super bear market in 1973 and 1974 were sorely
tested. It must have been difficult to watch the market bleed out almost
50 percent of its value.
The investment community has a lot of respect for the “buy-
and-hold” strategy. Unfortunately, investors don’t always listen to the
full strategy; they assume that if they buy a stock they should hold it for-
ever. Simply put, if you buy a piece of junk today, it will still be a piece
of junk in 10 years. “Buy and hold” assumes you acquire quality invest-
ments and they remain quality investments during the holding period.
In Chapters 7 and 8, we will discuss when it is time to sell a stock or
a mutual fund. As I said earlier, bad things happen to good stocks. When
they do, you need a plan and methodology for deciding when to sell.
The buy-and-hold strategy also assumes you have a long-time hori-
zon before you need these investments for a financial goal. As we saw in
Chapter 1, it can take years to recover from a bear market. If you are look-
ing at retirement in a few years, you cannot afford to wait through a
lengthy bear market and lengthy recovery. Unfortunately, your options
are more limited if a bear catches you unprepared. In Chapters 8 and 9,
we discuss preparing your portfolio for retirement by moving assets into
more secure investments.
MARKET TIMING 65
What can you do? First, don’t panic. Now is the time for some very
careful decisions. Too many investors react in an emotional manner and
take themselves out of the market. You cannot afford to abandon the mar-
ket completely. Remember, you may have 20-plus years of retirement to
support. The market has historically returned close to 12 percent, and you
will need some significant returns to make your remaining assets stretch.
Don’t make the gambler’s mistake of “doubling up to catch up.” In
other words, high-risk investments may have gotten you into this mess,
but they won’t get you out. Consider moving into lower-risk products like
bonds, real estate investment trusts, and income-producing (dividend)
stocks.
The hardest decision of all may be to go back to work or not retire
immediately. Delaying retirement or going back to work will give you
much-needed cash and give your investments a chance to recover. The
longer you delay withdrawals from your investments, the longer they will
earn a return for you.
You will do yourself a big favor by contacting an investment profes-
sional to review your situation before making any big steps. The right
course of action depends on the assets you’re holding and many other fac-
tors unique to each investor. Make this move quickly to minimize the
damage.
TIMING THE MARKET TAKES TIME

If you feel you just have to try market timing, be prepared to spend most
of your time staring at your computer screen. You need patience and prac-
tice to find the perfect moment to trade. Ask any day trader how much
time they spend watching for those moments. In the end, you will still be
wrong more times than you are right.
A number of software packages and online services will help you
spot trading times. Most of the tools used by market timers involve tech-
nical analysis: studying price movement and volume numbers of individ-
ual stocks. The goal is to find a moment when a stock’s high is not going
to hold or when the stock has hit bottom and is on the way up. Techni-
cal analysts plot the numbers on charts and analyze them for patterns. A
number of Internet sites construct and update charts on selected stocks.
Tip
Technical analysis is an important tool in deciding when to buy and sell
an investment; however, you should use it in connection with a funda-
mental analysis of the investment for maximum effectiveness.
I believe technical analysis can provide valuable information to investors,

but it’s not a science with foolproof results. Purists trade stocks of com-
panies they know nothing about other than that the charts look good.
This seems to violate one of the important rules of investing: Know what
you are buying.
YOU HAVE TO PAY THE TAX MAN

I have an agreement with my tax-attorney friends that I repeat in all my
books: I don’t practice tax law, and they don’t sue me. So far, it’s working
out pretty well.
Active investors, folks that trade frequently, are almost by definition
market timers. They are looking for an opportunity to jump in, take a
profit, and retreat. They may not trade as often as day traders, but they
trade much more frequently than the average investor. These frequent
trades can create a hefty tax bill.
Investments held less than one year are subject to tax just like regu-
lar income. You will need to pay any federal, state, or local taxes; Social
Security and Medicare taxes; and any other applicable tax. Factor in bro-
kers’ fees and any services you pay for, and it becomes clear you need to
be very good at market timing to keep your head above water.
AVOIDING SNAP DECISIONS

As I noted earlier in this chapter, the unintentional market timer is prone
to making snap decisions on when to enter the market and when to exit.
These decisions are usually wrong, and if they aren’t wrong, you just got
lucky.
There is no substitute for doing your homework before you buy a
stock or mutual fund. There are numerous books (including Alpha Teach
Yourself Investing in 24 Hours, Alpha Books, 2000) that will give you the
tools and information you need for successful investing.
MARKET TIMING 67
Caution
Investing can involve a considerable amount of emotion. Try to keep
your decisions based on information, not hunches.
Equally important but often overlooked is a notion of how and under

what circumstances you will sell the investment. We will cover that topic
in detail in the next two chapters. The bottom line is that you should have
a reason for buying an investment—overhearing a conversation in the el-
evator doesn’t count. Equally important, you should have a plan for sell-
ing the stock if necessary.
VALUE TIMING IN A BEAR MARKET

I hope you have concluded by now that I am not a fan of market timing.
Almost no one with expertise in investing believes it works. However, bear
markets do offer an opportunity to take advantage of bargains. We will
discuss bargain shopping in detail in Chapter 15, “Fatten Up on Bear.”
Down markets are very tempting times to pick up bargains—at
least, so the conventional wisdom goes. What I call “value timing” is the
notion that you can grab some real bargains at the bottom of the market
and take a nice profit on the recovery.
Here’s the problem: You can’t be sure where the bottom of the mar-
ket is. As the Nasdaq began dropping off its high of 5,000-plus, when
would you have called the bottom of its drop?
At 4,000, a 20 percent drop?
As I write this, the Nasdaq index is barely above 2,100.
You see, the problem with fishing off the bottom is that you can
never be sure where the bottom is. Few, if any, investors believed in 1999
the Nasdaq would fall this far or this fast.
Tip
Buying or selling an investment on price alone is often too narrow a cri-
terion for long-term successful investing.
The hard lesson is: Don’t invest on price alone. If the investment doesn’t
make sense based on its fundamentals or, most importantly, on how it fits
into your plan, don’t risk your money.
ALWAYS ANOTHER DEAL

One of the other dangers of market hysteria, whether it’s a bull or a bear
market, is the sense that you have a “once-in-a-lifetime opportunity.” If
you don’t act now, you will never have another chance.
The recently deceased bull market of the late 1990s may be one of
the strongest in history, but it won’t be the last one. There are plenty of
opportunities for profitable investing every day the market is open. Some
days you just have to work harder than others.
The point is that you should never jump into or out of an invest-
ment because you feel that failing to act will cost you the opportunity of
a lifetime.
Don’t believe it. There is always another deal.
CONCLUSION
Market timing doesn’t work. Research shows you are better off invested
in the market than jumping in and out in an attempt to improve your
return.
Always buy and sell within an overall investing plan. You will do
better and will avoid impulsive buying and selling.
CHAPTER 7
WHEN IT’S TIME

TO SELL A STOCK
The best time to sell a stock is when you have made the maximum
possible return on your investment, and before it crashes. That’s not
so hard, is it?
Unfortunately, the market doesn’t like glib answers any more
than you do. Deciding when to sell is often more difficult than fig-
uring out when to buy, but you’ll hear a lot more advice on when
to buy a stock than on when to sell one. Establishing a bear defense
means shedding stocks that no longer fit your financial plan or
move you closer to your goals. In later chapters, we will look at the
process of asset allocation. Asset allocation depends on getting the
correct mix of investments. Learning to sell stocks correctly is as im-
portant as learning to buy them correctly. This chapter and the next
provide an introduction to the tools you need.
There is no definitive system, no “best way” to arrive at the
sell decision. Investors should develop their own exit plan for get-
ting out of a position. Without a plan, you may make snap deci-
sions, as we discussed in the last chapter.
What follows in this chapter are summaries of some of the
many strategies used by professional investors. Some of the strate-
gies contradict others; some investors sell quickly, while others say
if you buy correctly, you should almost never have to sell.
Find one that makes sense to you, or combine a few for your own
plan. Either way, never buy a stock without some clear idea of when you
need to get out of it. Hunches, instincts, and planetary alignments are not
strategies. The key to making your strategy work is to work your strategy.
That is, decide on your exit criteria and when a stock meets those points,
sell and don’t look back.
SELLING ON PRICE
Many successful investors have absolute rules about selling a stock whose
price has fallen, and they don’t vary from these rules for any reason. The
rationale is that you have a better chance of long-term success if you keep
your losses to a minimum.
It’s hard to argue with the math: If you lose $5,000 on a stock, you
have to make $5,000 plus (to account for commissions, taxes, and so on)
on another stock to break even. If you had cut your loss at $1,000, then
your $5,000 gain works out to be a net of $4,000 in round numbers.
What is the magic number for selling? For some investors, an 8 per-
cent drop from the purchase price is reason to sell. Others put it at 10 per-
cent. Either way, they don’t let losses get out of hand.
Caution
Investors use selling strategies to counteract the emotional aspect of sell-
ing. It’s too easy to convince yourself that if you hold on a little while
longer, the stock will surely bounce back.
The danger in this strategy is that unstable markets and volatile stocks
may force you to sell in a correction just before the stock takes off. Of
course, proponents point out that you don’t know the stock is going to
take off after a drop. It could just keep dropping, which is probably the
case more often than not.
That is why this approach requires discipline. Keeping your losses
to a minimum undoubtedly helps your portfolio stay profitable. If you
miss a couple of big scores on stocks that turn around, that’s better than
watching losers sink below the horizon.
WHEN IT’S TIME TO SELL A STOCK 71
This strategy takes a very conservative approach to investing. Bear

markets may drag down stocks that are fundamentally sound. This is not
a strategy for “buy-and-hold” proponents, but if the thought of losing
even a small amount of money is troubling, you may find it a comforting
game plan.
The type of “selling on price” that most often occurs is after a stock
has dropped by significant amounts and investors become frustrated and
frightened. They sell at or near a bottom. A disciplined selling strategy
prevents a “sell low” reaction to bad news in the market, but you might
also be divesting prematurely from a fundamentally sound stock.
NOT SELLING ON PRICE

On the other hand, there are investors who say that selling on price alone
is short-sighted. They suggest that unstable markets produce odd swings
in price that may have nothing to do with the individual company; if
nothing has fundamentally changed about why you bought the stock in
the first place, then selling in a correction is wrong.
Price by itself doesn’t tell you anything about the company. Bad eco-
nomic or market news shows up in prices quickly. Unless something is
wrong with the company, it is unlikely to keep falling for no reason.
Quality companies do well over time; they’re your best chance for invest-
ing success if given time to outperform the market, which they will do.
Investors who jump out of a good stock because the price dips have
given up the power of time in long-term investing.
PROTECTING YOUR PROFITS

This is another “sell on price” guideline, but it’s on the other side of the
equation. The first one suggested you should cut your losses early. This
one says don’t let profits disappear.
If you have a stock that is up substantially, you may want to sell part
of your holdings to take all or part of your money out. For example, you
bought 1,000 shares of XYZ for $20, and a year later it is trading for $45
per share. This guideline suggests you sell 450 shares ($20,250) to recap-
ture your original investment. Whatever the stock does after that is pure
profit.
This defensive strategy keeps bears from eating your profits. It re-
quires investors to keep a close eye on the market. If you don’t get greedy,
it can protect your profits from a bear’s bite. If a bear forces you to sell
some or all of the investment to protect your profit, be very careful how
and when you reinvest the cash.
Of course, the contrary point of view suggests you let your winners
run as long as they can.
IT’S GETTING TOO EXPENSIVE

This is one of the more emotionally difficult selling disciplines. It usu-
ally happens when a stock grows rapidly and the price follows. On the
surface, this doesn’t seem like a bad thing. You want your investments to
increase in price, right?
The problem is when the company’s earnings don’t grow as rapidly
as the stock’s price. In analytical terms, the price part of the P/E ratio is
growing faster than the earnings part. The P/E ratio is a simple tool that
tells investors what they are paying in a stock’s price for the earnings of
the company.
The P/E ratio should be a low number, say, under 25. If the stock
price is rising faster than the earnings, the ratio will rise. If you bought the
stock because it was cheap, a rising P/E ratio is cause for concern. Over-
priced stock can fall rapidly on any bad news. (Remember the Internet
stock bubble, where stocks were trading with triple-digit P/E ratios.)
Plain English
The price/earnings ratio is computed by taking a company’s stock
price and dividing it by the earnings per share. The resulting number
tells you roughly what investors think of the expected growth in earn-
ings. A higher number says investors are willing to pay more for the
stock because they expect higher earnings.
One advantage of a selling discipline is that it takes the emotion out of

decision-making. It’s too easy to get comfortable with a stock, especially
one that has done well for you. However, if you’re a value investor look-
ing for a good relationship between price and earnings, this stock is off
your screen. A selling plan that kicks in when a stock’s P/E ratio hits a tar-
get number can help you move on to better values.
This is the value of having a plan for disposal when you buy a stock.
You know exactly why you are investing, and when that reason no longer
exists, you move on to another stock that meets your plan. This strategy
will exit you from a stock before it reaches its top, but it will also keep you
on plan, not worrying about whether the stock is going to keep rising.
You don’t care because you’re focused on your total investing plan.
Of course, you can hedge your bets somewhat by putting in a stop-
loss order on the stock. This lets the stock rise some more if there is any
price increase left. However, when the stock retreats to your price, your
broker or trading system executes a sell order.
Plain English
Investors use a stop-loss order to trigger a sell order, usually to protect
a profit or avoid a loss. The investor places the order below the current
stock price. If the stock stays the same or rises, nothing happens. If the
price falls to the stop-loss order price, it becomes a market sell order and
the stock is sold without any instructions from the investor.
You should look at other valuation markers in connection with the P/E to
get a better picture of the stock’s situation.
REBALANCING YOUR PORTFOLIO

Rebalancing your portfolio is part of the asset-allocation process we will
discuss in Chapter 9, “Asset Allocation: The Two Most Important Words
in Investing,” but it’s worth noting here. This may be one of the toughest
sell decisions, because it often involves a stock that has done really well.
You never want one stock to dominate your portfolio; however, this
is what happens when you hit a big winner. Although it is tough to sell a
big gainer, your portfolio is more secure when no one investment occu-
pies a large percentage. Typically, you will want to consider selling part of
any investment that exceeds 10 percent of your portfolio. Retirement ac-
counts, such as 401(k) plans and individual retirement accounts (IRAs),
are notorious for becoming unbalanced.
Caution
If one or two stocks heavily weight your portfolio, you are in real dan-
ger if the stocks tumble. You are particularly vulnerable during a bear
market because your asset allocation is out of whack.
There are some obvious drawbacks to this rule. First, you reduce the po-
tential for gain if the investment is still climbing. Second, you introduce
some tax considerations. However, there is ample evidence that a balanced
portfolio has a better chance of surviving unstable markets than one that
is too dependent on a single investment. You trade some potential for
growth for some protection on the downside.
THEY MISSED THEIR EARNINGS

ESTIMATES
The growth or potential for growth in earnings is the most important sin-
gle factor in many investors’ decision to buy or sell a stock. There are a
number of “earnings” numbers for each company, most of which measure
the company’s earnings relative to its stock price (price/earnings ratio, or
P/E). However, one of the most important numbers investors watch is the
earnings estimate.
Companies project their earnings out a year or so for the investing
community, and are required to be as accurate as possible in these esti-
mates. These numbers give investors an idea of what the company expects
in the near future—and a warning if something is on the horizon (like
lower sales) that may affect the stock price.
Stock analysts who follow individual stocks develop another set of
numbers for estimates. These are usually close to the company’s figures,
but they may reflect a different interpretation of the economy, market, or
some other factor.
Caution
Be aware that some companies play games to keep their earnings up
when the core business is suffering. A quick look at the income state-
ment shows where the company’s income is originating, and will tell you
if it’s the business or the accounting department that’s making money.
Every quarter, companies report their actual earnings (usually expressed as

earnings per share, EPS) to the public. When a company misses these es-
timates more than once, it may mean that management has lost touch
with the market or is having trouble controlling expenses. Either way,
companies that miss estimates, especially two in a row, are good candi-
dates for trading.
When financial news is abuzz with warnings of missed earnings
and estimates of lower future earnings, beware of the bear. Nothing turns
a market south faster than market leaders forecasting lower earnings.
This is a good time to check your portfolio for bear-resistant products.
See Part 3, “Bear Assets,” for tools and strategies to protect your in-
vestments.
THEY’RE RESTATING EARNINGS

A company restates its earnings when it has reported numbers that were
incorrect. Restating earnings is a way of saying, “We don’t know what
we’re doing.” You seldom hear of a company restating its earnings to a
higher number.
Regulators often force companies to restate their earnings, and
whether it’s because of a mistake or some intentional falsehood, many in-
vestors automatically dump the stock.
THE INDUSTRY’S CHANGING

Today’s superstar stock is in tomorrow’s value bin. At least it seems that
way sometimes. The economy is a dynamic environment. Companies
that stake out a leadership role in a particular market and fail to adapt to
change may find themselves out of touch.
Competition is a wonderful thing for creating new products and
services. However, some companies don’t evolve gracefully. They may
stick to their comfort zone in spite of market changes that are moving
away from their products. A company that doesn’t move with the market
risks its position in the industry.
Tip
Changes in markets, competition, and economic environments can
cause problems with profits. Great companies don’t just adapt to
change, they lead it.
In the 1970s and 1980s, IBM dominated the mainframe computer

market. They were so dominant that within corporate information-
technology departments the rule was: “No one ever got fired recom-
mending IBM.” However, the market changed when personal computers
and distributed processing became the rule in corporations. Ironically,
IBM helped undo its position by developing the personal computer and
making it popular with corporations. IBM still sells mainframe comput-
ers, but most of their business now comes from service and software for
Internet solutions. They adapted to an evolving industry.
When your investment shows no sign of moving with its industry
(or better yet, leading the pack), it’s time to move on to another stock.
IT NO LONGER MEETS YOUR NEEDS

If you bought the stock correctly, there was a specific reason you invested
your money: The stock met some need in your portfolio. When that con-
dition changes, it may be time to move on to another investment. Here
are some examples:
■ You bought a growth stock that isn’t growing anymore.
■ You bought a market leader that has lost its dominance.

■ You wanted a value stock and now it is no longer a value.
The reason you bought the stock should form the basis for measuring the
investment’s role in your portfolio. This is not to say you can’t be pleas-
antly surprised when a stock seems to slip out of the role you assigned it
and into one of great potential.
However, that’s usually the exception. Companies go through bad
times and do stupid things. Don’t hesitate to cut a stock if it no longer
meets your needs. When the bear comes knocking, these are among the
first stocks you should consider selling and moving the cash into some-
thing more appropriate. Don’t lose money on a stock you didn’t want
anyway. Put the money to better use, either for sitting on the sidelines
waiting for the dust to clear or for picking up a stock you do want at a
bargain price.
THERE ARE FUNDAMENTAL CHANGES

We live in a world that has accelerated the product cycle dramatically.
Companies can no longer count on selling a proprietary product indefi-
nitely. Manufacturers can introduce a hot new product and watch sales
soar for a while, but soon the market is flooded with knockoffs and look-
alike products. Proprietary products are unique. If you want their form or
function, there is only one place to get it. The drug Viagra is proprietary
thanks to patents. However, when the legal restraints are lifted, a number
of “generic” duplicates will appear.
Personal computers used to be proprietary products of just a few
manufacturers. Now dozens of companies are making computers, and
they’re all pretty much the same “under the hood.” Personal computers
have become commodities distinguished only by the shape and color of
their containers.
Caution
Profit margins drop when products become commodities. Companies
that can control costs and gain market share will survive. Those that
can’t compete in a high-volume, low-margin arena will fail.
When a company’s products become commodities, it may be time to

move on. The dynamics of operating a company with a leading-edge
product and a company that produces a commodity are quite different—
as are the growth prospects.
MANAGEMENT IS INCOMPETENT
OR CORRUPT
A company’s management is often its most important asset. A great com-
pany has great management. Great management doesn’t make many mis-
takes and they quickly reverse it when they do make a mistake. Leadership
with vision and drive can make an average company a winner. Unfortu-
nately, some CEOs lack the skill and vision to help a company succeed.
Executive ego is often at the root of business blunders. The media is usu-
ally quick to point out problems in management. Too many questions
about management decisions and directions may be a sign that trouble is
on the horizon.
Tip
Remember the great New Coke fiasco? The company redid the formula
for the most popular soft drink in the world, only to find that everyone
still wanted the “old” Coke. New is not necessarily better. The company
quickly brought back the old formula—except now it was “Classic”—
and moved forward.
Corrupt management is obviously a problem. It is usually too late to sal-

vage much when the market learns that a company’s management is cor-
rupt. However, never give them a second chance.
YOU MADE A MISTAKE!

One of the most expensive mistakes you can make is to not admit you
made a mistake with a stock. You can limit your mistakes by careful buy-
ing, but there will inevitably come a time when you kiss a frog and it turns
out to be … a frog.
Ego and pride can get in the way of correcting mistakes if you are
not careful. Analyzing a stock is complicated, and, in the end, you are in-
vesting in the future. Bear markets can reveal mistakes quickly. If you
don’t want the stock after the market returns, don’t wait to unload it. That
future may not turn out the way you hoped. Whatever the reasons, cut
your losses on a mistake, make note of the lesson learned, and move on
to the next deal.
TECHNICAL COLLAPSE
Technical analysis of stock is an exercise in identifying buying and selling
points and is another whole book by itself. However, even the casual chart
user can look for warning signs that a stock may be in trouble.
One major sign is a stock’s price climbing rapidly for no apparent

fundamental reason. You may be seeing hyperactive buying activity be-
cause the stock is the “hot” pick du jour. During the Internet bubble ex-
pansion, this was common. Remember earlier I talked about a stock that
went from 20 to over 100 and back to the teens in less than a year?
Tip
When a stock’s price begins to drop on increasing daily volume, it may
be time to run for cover.
Unbridled buying may be a sign that a fall is near on the first negative
news. Watch your charts for double peaks where the stock has twice failed
to break through to a new high.
YOU NEED THE MONEY FOR

A BETTER DEAL
Obviously, this is not a completely objective decision point. If you find
yourself looking at an attractive opportunity with no money to partici-
pate, take a hard look at your portfolio and see if you have a stock with
less upside potential than your hot new deal. This is a somewhat risky
business, but it’s worth working the numbers if you believe in your new
opportunity.
Before you sell one stock to buy another, you have to consider a
number of assumptions and costs. First, you have to get at the true cost
of the transaction, which includes calculating commissions and capital-
gains taxes. Second, you need to estimate the anticipated returns from the
old and new stock. Next, you must construct a “best case, worse case”
comparison between the old stock and the new stock over a five-year pe-
riod. At the end of five years, was it worth dumping the old stock to buy
the new one? Is the worse-case scenario for the new stock better than the
best-case scenario for the old stock?
A marginally better deal in the future is not worth dropping an ex-
isting investment to free money for the new deal. Be reasonably sure the
new stock will substantially out-perform the old stock to allow for devia-
tions from the expected returns.
Bear markets can reduce valuations on stocks to levels that make

them attractive. A company that you deemed a great but expensive in-
vestment may come down to a price you like. If you think you want to
own this company for the long haul, take advantage of the opportunity to
dispose of a ho-hum stock for a great one.
POOR FINANCIALS
The “buy-and-hold” strategy that a number of investors advocate doesn’t
mean “buy and put in a drawer and forget.” It’s important to keep track
of what’s going on with your investments on at least a quarterly basis.
Great companies become also-rans, and industry leaders fall from leader-
ship roles. For a variety of reasons, balance sheets and income statements
deteriorate. Understanding the reasons for declining financial strength
may mean the difference between holding and selling.
For example, currency-conversion problems can hurt companies
with significant international operations if a foreign country suffers prob-
lems. That can cause a company to miss earnings estimates. Understand-
ing that the missed estimate had nothing to do with the day-to-day
operations of the business can ease your mind about holding on to the
stock.
Signs of weakness that raise red flags for investors are slowing sales
and declines in margins. Slowing sales may mean competition is eating
into the company’s customer base or its products are losing market ac-
ceptance. Companies in a weakened financial condition may not be able
to keep up in the technology necessary to remain competitive.
Check the financials for problems on a regular basis. More than
likely you worked through the financials before you decided to invest in
the company. Are the ratios still strong? Is debt rising, and, if so, why? Are
profit margins evaporating?
Tip
You should always have a standard for comparison when you invest.
Whether it is a market index or other companies in the same industry,
a rule to gauge performance is important.
It is also helpful to watch others in its industry. The slowdown may be

across the board, not the result of some other indicator.
MERGERS AND ACQUISITIONS

Companies usually position mergers and acquisitions as being in the best
interest of the two companies and their stockholders. If one of your in-
vestments is involved in a merger or acquisition, take a hard look at the
resulting organization. Does it still meet your investment needs and
objectives?
You can often figure much of this out before the actual transaction.
Don’t assume the companies know what is best for your portfolio.
DONATE TO CHARITY
Sometimes, you have the opportunity to help yourself and others at the
same time. Although not an investment discipline, donating stock to
charities can accomplish several goals at once.
You may be able to take a tax deduction for the value of the stock
(consult with your tax advisor). At the same time, a worthy cause can use
the stock for a greater good. That’s not a bad deal all the way around.
FOR SOME FUN

Here’s a selling tip to break every investing rule you know! Sometimes a
good reason to sell a stock is to enjoy the money.
A life spent squirreling away every nickel you can misses the point.
Enjoying some of the fruits of your success is perfectly acceptable, as long
as you do it in a reasonable and prudent manner that does not threaten
your retirement or other important financial goals.
Rewarding yourself and/or your family with a great vacation is
worth every penny. Investing is a means to an end, not the end itself.
Tip
You will find numerous trading strategies in my book Alpha Teach Your-
self Investing in 24 Hours. (Shameless plug!)
CONCLUSION
There are many reasons for selling an investment. You should know why
you bought the stock and what has to happen that will trigger your sell
order.
Many investing professionals counsel caution in buying to prevent
panic in selling. That’s good advice—unfortunately, not every investment
turns out the way we planned, and bear markets can undo your best
plans.
When that happens, a selling discipline will take some of the emo-
tion out of letting go of a stock you liked but that didn’t perform as ex-
pected. Find a selling strategy that makes sense to you and stick with it.
CHAPTER 8
WHEN IT’S TIME

TO SELL A
MUTUAL FUND
Mutual funds are supposed to be a low-maintenance investment

(at least that’s what their marketing material suggests). You turn
your money over to professional managers who make all the hard
decisions for you. For many investors, mutual funds are the perfect
buy-and-hold vehicle because they give you instant diversification
and expert management in one package.
We all wish it were that simple. Mutual funds are ideal in-
vestments for people who don’t want to spend a great deal of time
researching stocks or bonds. Individual stocks in great companies
historically outperform most mutual funds; however, that assumes
you buy great companies at great prices and you don’t need your
money during the middle of a bear market.
Buying mutual funds involves the same type of research as
buying individual stocks. Like stocks, mutual funds can and do go
bad for a variety of reasons. As we found in the previous chapter on
selling stocks, there is much more information available on buying
a mutual fund than on selling one. Investors make the same selling
mistakes with mutual funds as they do with stocks. In some ways,
it is harder with funds because we come to rely on professional
managers to overcome any problems. However, there are problems
that managers can’t or won’t overcome that signal it’s time to move on to
another investment. Even market professionals running mutual funds
have trouble in bear markets. Don’t assume that they have all the answers.
A well-thought-out selling strategy is an important tool in your in-
vesting arsenal. Your selling strategy will tell you when it’s time to sell and
will take some of the emotion out of the situation. In this chapter, we’ll
look at some strategies, and at those situations when it is appropriate to
sell a fund and move on to something else. You will find many of the con-
ditions similar to the ones outlined in the previous chapter. However,
some conditions are unique to mutual funds. (Note: When I refer to
stocks, bonds, or cash in this chapter, I mean stock mutual funds, bond
funds, or money-market funds.)
THE FUND LOSES TOO MUCH

This may seem like a “no brainer,” but it’s a little more complicated than
it might initially appear. Of course, you can and should set some per-
formance goals. The catch comes in setting the goals to an appropriate
standard.
Mutual funds represent a sector or segment of the market, such as
growth stock funds or small cap funds. Unlike individual stocks, you can
measure funds against other similar funds or indexes.
■ Growth stock funds. Mutual funds that invest in growing com-
panies look for stock price appreciation. Growth companies are

typically younger firms that put growth above current profits.
■ Small cap funds. Mutual funds that invest in smaller companies
hope they will eventually become bigger. These include very young
companies and most recently, high tech companies. Investors are
hoping to find another Microsoft before it becomes a true growth
stock.
■ Large cap funds. Mutual funds that invest in large companies are
looking for the leaders in different industry segments. Market seg-

ment leaders are always large companies.
However, you buy mutual funds, like individual stocks, to fill a particu-
lar niche in your investment plan. A fund that is at or near the top of its
sector but still losing ground may not be a candidate for selling.
WHEN IT’S TIME TO SELL A MUTUAL FUND 85
Mutual funds use market indexes to measure their performance. For

example, large cap mutual funds usually use the S&P 500 index as the tar-
get they want to beat. The S&P 500 represents the largest 500 companies
in the market. There are also many resources on the Internet that meas-
ure large cap funds against each other. The best source for this informa-
tion is Morningstar.com.
During a bear market, you want your fund to do as well as or bet-
ter than its peers. If it is not, that may be a signal to sell. On the other
hand, if funds in the sector are posting double-digit gains and your fund
is losing money, it may be time to move on to another fund that meets
your portfolio needs.
THE FUND GAINS TOO MUCH

Can your investments ever gain too much? That doesn’t seem a likely rea-
son to dump a fund, but there are some valid reasons. If your fund is the
opposite of the last example—earning double-digit returns while its peers
languish on the sidelines—something is probably wrong.
What could be wrong with posting big gains? The problem could be
that you don’t own what you think you do. Mutual funds can be very cre-
ative with their names. Just because the fund name indicates it is one type
of fund doesn’t mean it is that type of fund.
Mutual fund companies are not above stepping outside the niche
their name implies to boost returns. Morningstar.com has some excellent
tools for analyzing a mutual fund based on what it actually does as op-
posed to what the name might imply.
Tip
The best defense against a bear market is a well-diversified portfolio ap-
propriate to your age and financial goals. Part 3, “Bear Assets,” will help
you design a portfolio that meets these qualifications.
The problem with this situation is that your asset allocation could be all
out of alignment because the fund you thought was covering one area
is actually overlapping somewhere else. This may leave your portfolio
vulnerable without you knowing it. Morningstar.com has an excellent

free service that will help you “x-ray” your mutual fund to see exactly
what makes it tick.
You may not need to sell a misnamed fund, especially if it is doing
very well. You can shift it in your asset allocation plan to the area where
it really belongs and find a new fund to cover the now-vacant sector.
THERE IS A STRATEGY CHANGE

This situation is similar to the one above except there is a conscious effort
by the fund manager to change the focus of the fund.
A manager might change strategies for a variety of reasons. Maybe a
new fund’s original concept just wasn’t working, or it was unable to attract
new investors. Funds that focus on a particular industry segment may
find that consolidation leaves them with too few companies to sustain a
fund.
Whatever the reason, this is an important time to reevaluate why
you own this fund and whether its new strategy will serve your needs.
UNDERPERFORMING FUNDS
Not all managers are equal. Some managers can look at the same indus-
try segment and carve out a profitable mutual fund while other managers
can’t seem to find the handle.
Fund managers are extremely important; a later section of this chap-
ter is devoted to mutual fund managers. If your fund is consistently in the
bottom half of its peer group, that may be a sell signal.
Underperforming is not the same as losing too much money, which
we discussed earlier. An underperforming fund may actually be making
money. However, if it is consistently in the bottom half of its peer group,
that isn’t good enough. You shouldn’t settle for an underperforming fund
when there are usually many others to take its place.
I wouldn’t be too concerned about slips in performance over one or
two quarters. Any manager can have some slippage from time to time.
Caution
Jumping from one fund to another for a few one hundredths of a point
is a losing game. Fees and taxes will consume any additional gain in re-
turn.
YOU SET NEW GOALS

You will have better results over the long-term by buying and holding on
to quality funds. However, your life is not static. Things change, and you
can develop new financial goals and obligations. You certainly need to re-
assess your portfolio under these circumstances. At various stages, such as
retirement, you should rethink your holdings. There are times to be very
aggressive and other times when that is not prudent.
Asset allocation is the process of dividing your portfolio among
stocks, bonds, and cash based on your stage in life and financial goals.
In Chapter 9, “Asset Allocation: The Two Most Important Words in In-
vesting,” we will talk more about asset allocation.
Tip
There is no magic formula for asset allocation. There are some sugges-
tions, but as with any investment advice you should temper them with
your own tolerance for risk and investment goals.
REBALANCING YOUR PORTFOLIO

This selling strategy recognizes that, over time, funds that do exception-
ally well may occupy a greater percentage of your portfolio than is appro-
priate.
For example, you may want your portfolio to reflect the following
allocation:
60 percent stocks
30 percent bonds
10 percent cash
A large run-up in one of these areas could throw your portfolio out of bal-
ance. If you had owned a fund focused on Internet/tech stocks in the late
1990s, you might have experienced a big increase. This increase could re-
sult in your portfolio looking like this:
80 percent stocks
15 percent bonds
5 percent cash
You can get your portfolio back in sync by selling off some stock funds
(laggards would be a good choice) or by putting more money into bond
funds and money market funds.
Bear markets are prime candidates for throwing your portfolio out of
balance. Take the time to reexamine your position or you may find your
diversified portfolio shield has some holes. It is important to watch your
tax situation when selling funds. Unfortunately, the tax liabilities funds
generate have to do with how often the manager buys and sells within the
fund. Funds distribute capital-gains taxes to shareholders, usually toward
the end of the year. Selling before the distribution may make sense from a
tax point of view, but, as always, consult your tax professional for advice.
AVOIDING OVERLAP
This selling strategy follows rebalancing your portfolio to return the assets
to the proper proportions. Mutual funds come in many flavors and with
names that don’t necessarily reflect their composition.
Caution
One of the major strengths of diversification is that parts of your port-
folio will react differently under the same market conditions. If your
funds overlap, you may not have the diversification you thought.
If you’re not careful, you may find that you own several funds that are
investing in the same types of companies and possibly even the same
companies. This defeats the purpose of diversification. You can use free
tools on Morningstar.com to analyze individual mutual funds and com-
pare several funds for overlap. Morningstar categorizes funds by what
stocks they actually buy, as opposed to how the fund might categorize
itself. This way you get an objective view of a fund and can decide if it
still fits your portfolio.
Another service from Morningstar called, appropriately, X-Ray can
look at several funds and compare holdings. A premium service shows
you where two or more funds overlap in holdings. A quick comparison of
two funds, Oppenheimer Main Street Growth and Income A Fund, and
the Domini Social Equity Fund, reveals that both funds have significant
holdings in some major large growth stocks. Owning these two funds
would not satisfy your diversification needs; the overlap between them in-
dicates that they would probably move in the same direction in response
to market conditions. This would be a time to sell one of the funds and
move on to another sector in your portfolio. This can be a rude awaken-
ing during a bear market. Overlapping funds move in the same direction
at just the time you need diversification the most.
THE MANAGER LEAVES

Managers play an important role in the life of a mutual fund—so much
so that when one leaves it is an automatic sell signal to many investors.
There are many legendary managers of funds with impressive records of
consecutive market-beating gains. When they move on or retire, the
funds often flounder through one or more new managers. Just as some
horseracing fans bet on the jockey, some investors watch where winning
managers go and follow with their money.
A departing manager is not an automatic sell for all investors; how-
ever, it is always a heads-up that things may change. There are a couple of
exceptions to the automatic sell rule. The first is that passively managed
funds are much less dependent on the manager. For example, an S&P 500
index fund requires much fewer manager decisions than an aggressive
stock fund. Index funds follow a rigid set of guidelines that take much of
the decision-making out of the manager’s hands. A manager leaving may
not hurt this type of passively managed fund.
The second situation where a manager’s departure may not have a
significant impact is with large mutual fund families. Companies that
manage 25 or more funds usually have large and talented staffers who can
take over when a manager leaves. When you have funds with a smaller
management company, you need to be more concerned about the depar-
ture of a manager.
Tip
It’s not a bad idea to keep an eye on a hot manager who leaves one fund
for another. If he or she is taking over a similar fund, it might be worth
it to consider following the manager with your money.
THE FUND GETS TOO BIG

Size in the investing community has its advantages but also its disadvan-
tages. Some funds have a difficult time maneuvering when they grow too
big. During intense periods like the Internet/tech stock explosion in the
late 1990s, money poured into the market in unprecedented amounts.
Mutual funds that invested in large cap, growth stocks had little trouble
investing the money. However, some of the small funds that targeted
small cap, tech stocks were also flooded with money. The problem they
faced was where to put all the money flowing into the fund.
Small cap, tech stocks are highly vulnerable even in the best of
times. Managers of these funds usually face two choices: They could
broaden the holdings outside the small-cap stocks, or they could close the
fund to new investors.
Funds that require nimbleness and flexibility are most at risk from
becoming too large. These funds are big, fat targets for bear markets. Big
funds that must sell off stocks during a declining market may add pres-
sure to the sell-off in a bear market.
Tip
Mutual funds that focus in “hot” sectors, like the Internet/tech funds,
may not perform as well as the market. When the underlying stocks
move, it is usually all in the same direction.
PROTECTING YOUR PROFITS

There is a great debate between investors who believe you should let your
profits run and those who feel it is wise to take some or all of your prof-
its to protect your invested capital. The folks who believe you should let
your profits run see no reason to cut short a profitable investment. Folks
on the other side feel they could reinvest some or all of the profits else-
where to better use.
Tip
If you can protect a profit in a bear market by selling some or all of a
winner, you can put that money to use by picking up a fund that is cur-
rently depressed but has great potential.
For example, if you had a $5,000 profit on a $5,000 original investment,

they would suggest to take out the original $5,000 and reinvest it in an-
other fund. The $5,000 remaining in the fund is pure profit, and they are
free to withdraw it or let it continue to grow.
Like individual stocks, mutual fund profits need protection, and a
bear market may be the best time to take some profit and run to safer
havens until the market settles down.
POOR MANAGEMENT
Poor management is one of the best reasons to sell a mutual fund. There
is no reason to stick with a fund that has poor management. A poorly
managed fund is not going to get any better except by luck, and that’s not
very comforting for investors.
A poorly managed fund will exhibit some or all of the following
characteristics:
■ A history of underperforming similar types of funds or indexes
■ Higher than normal fees

■ Higher than normal turnover (buying and selling stocks)
■ Confused signals on the direction the fund is taking
MISTAKE AT PURCHASE
The Securities and Exchange Commission has expressed concern over
the way management companies name mutual funds. They feel that
some of the names are misleading investors to believe they are buying
one type of fund, when that is not the case. You wouldn’t be the first in-
vestor who thought they were buying a value fund, only to discover most
of the investments were in growth stocks. You also wouldn’t be the only
investor who bought a fund only to realize that a fund they already
owned covered the same type of stocks.
It is never a mistake to correct a mistake. If you picked the wrong
fund for your asset-allocation plan, you are vulnerable until you correct
the mistake.
YOU NEED MONEY FOR A BETTER DEAL

It is not to your long-term benefit to jump in and out of mutual funds,
although this seems more popular than ever. Mutual funds have made it
easy to switch funds within families of funds.
However, there are times when you have spotted an attractive situ-
ation and need money to take advantage of the opportunity. This is a
good time to check the performance of your funds and weed out any that
are underperforming or lagging in some manner.
Before you dump one fund for another, be sure the potential return
of the new fund is significantly greater than that of the old fund. If not,
you may be better off sitting tight. Bear market are great times to pick up
funds that have had their share values beaten down but remain solid in-
vestments.
FUND IS TOO VOLATILE

Some investors have a difficult time accepting losses. If this describes you,
don’t feel like you have to own any fund whose price fluctuates wildly. If
your stomach is not up to some gut-wrenching volatility, you need a fund
that is less explosive and more predictable. The point of investing is to se-
cure a financial future; it may not be worth it to you to wrestle with a
highly volatile stock fund just to achieve some financial goal.
Many funds offer very attractive returns without betting the farm
on every trade. Stick with what makes you comfortable, and don’t worry
about not owning the latest and greatest fund.
Tip
There are too many good funds for you to be stuck with one that churns
your stomach with its wild swings. If you are losing sleep over a fund,
lose the fund.
DONATE TO CHARITY
Are you sitting on a mutual fund that is not really going anywhere? Why
not consider donating it to a charitable cause? There are some good “win-
win” reasons for making donations. More than likely, you can take a de-
duction for the appreciated value of the fund, and the charity gets an asset
they can let grow or cash in for current needs.
FOR SOME FUN

Never let investing become so all-consuming that you have no time to
enjoy life. There is no good reason you shouldn’t enjoy the fruits of your
labor from time to time. As long as you aren’t threatening your retirement
or other important financial goal, take some of your hard-earned and in-
vested money and do something good for yourself.
A family vacation or other diversion may be the best investment
you can make. Selling a fund is a serious step, but rewarding yourself and
your family with a vacation or some other luxury makes working hard
worthwhile.
CONCLUSION
You’re clearly better off in the market than out of it, even in a bear mar-
ket. That doesn’t mean you should be stuck with funds that aren’t pulling
their weight.
Careful planning and research when you purchase a fund eliminates
many problems down the road. However, life and the markets have a way
of not following your most careful plan. When that happens, you need an
exit strategy. This plan should be in place when you buy the fund and not
made up as you go.
Selling can be harder emotionally than buying because, in some

cases, we have to confront our own failings and put our ego aside. An exit
strategy that makes sense to you will help take some of the emotion out
of selling a fund you may like, but that no longer fits your needs.
PA R T 3
BEAR ASSETS
This part of the book focuses on the practice of asset allocation.

Many investment professionals believe properly allocating your as-
sets (stocks, bonds, and cash) is more important than the actual
asset selection. I’m not sure I would go quite that far, but if you
don’t practice asset allocation, you’re leaving your portfolio vulner-
able to bear attacks.
We will also look at how asset allocation works during periods
of recession, inflation, and deflation, and how different types of
stocks and bonds respond to bear markets and economic down-
turns. Finally, we’ll take a brief look at the different sectors of the
economy and how they fare in a bear market.
CHAPTER 9
A S S E T A L L O C AT I O N :
THE TWO MOST
I M P O R TA N T W O R D S
IN INVESTING
Simply put, asset allocation is how you split up your portfolio

among the three asset classes: stocks, bonds, and cash. Investors
plan their asset-allocation strategy to achieve the best returns in any
circumstances, which means an asset-allocation strategy should be
dynamic and subject to change as other factors change.
You need to know up front that no magic formula will com-
pletely protect you from every bear market. Asset allocation is as
much an art as it is a science; there is no single “right” way to do it.
(In fact, some proponents believe you should only consider stocks
and bonds in the scheme.) Your goal is to achieve the best return for
your individual situation in the present market, which is not the
same as achieving the best possible return.
Asset allocation isn’t particularly hard, but it’s complicated be-
cause it’s composed of many variables. The difficulty in identifying
a bear market in advance further compounds the problem. The
“super bear” market we discussed in Chapter 1, “Bear Markets,” was
a good case in point. There was no perfect allocation of assets that
completely protected investors. The best investors could hope for
was to not lose as much as the rest of the market; even converting every-
thing to cash wasn’t the answer because inflation was eating away at the
value of everything.
In this chapter, we are going to look at asset allocation in a general
context. As we move deeper into the book, the focus will become more
and more specific. In this discussion, the terms “stocks,” “bonds,” and
“cash” refer to the class alone: When I use the term stocks, unless other-
wise noted, I mean both individual stocks and stock funds. Same with
bonds—I am referring to individual bonds or bond funds. Cash can be
any form of savings, from money market funds to money market ac-
counts. This is not the cash you should have on-hand for emergencies,
usually enough to cover three to six months’ expenses. (When it’s impor-
tant to make distinctions, I will do so.)
ASSET ALLOCATION IN CONTEXT

Many market professionals believe that getting your asset allocation right
is more important than the individual assets you buy. The theory is that
different asset classes react differently under the same market conditions,
so the right allocation will flatten out the peaks and valleys in your port-
folio over time.
By definition, this means you will not get the “best” return that cor-
rectly timing the market brings—but we’ve already seen that no one can
consistently time the market correctly, and you will also avoid the worst
losses.
Tip
If you have substantial assets, or find this all too overwhelming, you may
want to engage a financial planner to help you with your asset alloca-
tion. If you finish this book, you’ll be ready to ask the important ques-
tions an advisor should answer.
MORE THAN DIVERSIFICATION

Asset allocation is diversification on steroids. Both strategies offer some
protection in an unstable market. Diversification looks at spreading your
A S S E T A L L O C AT I O N 99
investments over different assets. Asset allocation takes that a step further
and suggests how much of your portfolio to put in each asset class and
how to split it up within each class.
For example, diversification might suggest you have 75 percent of
your assets in stocks. Asset allocation takes that total investment in
stocks and structures the percentage of domestic, foreign, growth, value,
and so on.
Some market professionals don’t make a distinction between diver-
sification and asset allocation. You may read information about diversifi-
cation that sounds just like what this book says about asset allocation. The
specific terms are less important than the strategy behind them.
INVESTING IN HISTORY
There is no shortage of market soothsayers quick to tell you how you
should have profited in the latest market move. Clearly, it’s easy to know
where to invest in the historical market: When the Nasdaq was up 87-plus
percent in one year, where should you have invested your money?
Of course, that’s not the whole picture. Imagine that the 87-plus
percent increase occurred in one 12-month period and had a straight-line
growth rate from the beginning to the end. A graph would show the line
originating at the bottom left and going straight across to the top right,
as shown here. Almost any point along that line would have been an okay
place to buy because the market was always going up.
Market Up 87 Percent in One Year

90
80
70
60
50
40
30
20
10
0
The following graph shows the same final result: The market ended up 87
for the year. However, there was only a brief period at the beginning of
the year when you could get in for less than 87. Any other entry point
and you would have broken even, at best, unless you sold before the year
was out.
Market Up 87 Percent in One Year

160
140
120
100
80
60
40
20
Looking back, it’s easy to see where you should have entered the market.
The same strategy would not have worked for both markets represented
by the two charts. Unfortunately, you can’t invest in history, and neither
chart tells us anything about how the next year is going to look.
Although these charts are obviously for illustration, they make a
point: The market doesn’t move in a straight line like the first chart. The
following chart is very real. It shows the closing of the Nasdaq Compos-
ite Index on the first day of trading of each year. Of course, with just three
data points, we do get straight lines. The point is that your entry and exit
points determine how much you make or lose.
This looks so simple—and that’s the danger of dealing with historical
numbers. The market almost doubles in one year, then loses all its gains
in the next year. Actually, it was even worse than that. On March 10,
2000, the Nasdaq closed at 5048. In the last nine months of 2000, the
Nasdaq Composite lost 2757 points, almost 55 percent. This chart should
be a sobering reminder to those who thought the market could go no-
where but up forever.
Nasdaq Composite
4500
4131
4000
3500
3000
2500
2000 2208 2291
1500
(Source: Nasdaq)
1000
500
0
1999 2000 2001
If you had the time, patience, and data, you could construct a bear-proof
marketing plan for this time frame—but we aren’t going to see this mar-
ket again. And in the unlikely event that we did see this market again, you
wouldn’t know it until it was already over. Looking at historical data can
help you understand how different asset classes perform under different
circumstances, but it’s impossible to know when those circumstances will
appear again.
SETTING REALISTIC GOALS

Unless you just put your portfolio on automatic pilot, you should expect
to do better than the market (S&P 500 index). The problem arises when
investors try to wring every last penny out of the market. The market
timers we discussed in Chapter 6, “Market Timing: The Two Most Dan-
gerous Words in Investing,” attempt to get in at the bottom and out at
the top of a market. Very few do, and then only rarely.
If you aim for returns above the market, over time you will do quite
well. If you aim for huge returns, over time you will probably do worse
than the market.
I’ve told the following story in other books, so if it seems familiar,
“bear” with me. One year, when I was a youngster playing Little League
baseball, my friend’s father decided to help the two of us with our hitting
before the season. He had played major league baseball in his younger
days, so he knew what he was doing. We worked on our hitting for sev-
eral weeks, and his instruction took hold.
My batting average that year was a league-leading .797. For you non-
baseball fans, a .300 batting average is good for professionals. Another way
to look at it is for every 10 times I came to bat, I got a hit eight times.
The professional had taught me to focus on just making contact
with the ball. That season I never hit a home run, and I had only one
triple. In fact, most of my hits were singles. The point is that my “un-
spectacular” year was the best in the league, because I focused on small
gains rather than large ones.
The analogy isn’t perfect, but the lesson is right on: Aim for better-
than-average gains, and over the long term you have a much better chance
for success than trying to hit a home run every time. Market timers swing
for home runs. Investors focus on their long-term success.
VARIABLES OF ASSET ALLOCATION

Asset allocation is more than just dividing your portfolio into different
asset classes. The two main variables of asset allocation are risk tolerance
and time horizon, and these variables prevent a single asset allocation that
is right for every investor. The asset allocation for a 30-year-old single
woman may be quite different from the mix that is right for a 60-year-old
man hoping to retire soon.
Your risk tolerance will either open or close some possibilities in
asset allocation and selection. Your time horizon also has a tremendous
impact on finding the right asset mix.
Tip
Your financial goals will require different asset-allocation models. Don’t
be concerned if one model is radically different from the others because
of the time involved.
Many investors have more than one financial goal (I assume retirement is
a common goal). College for the kids, a vacation home, or other goals will
need their own asset allocation because of the time frame and definable
financial needs. Let’s look at these variables individually.
RISK TOLERANCE
Risk tolerance describes an investor’s willingness to take risks with invest-
ments. Higher-risk investments should offer higher potential returns than
low-risk products, and with the higher potential return comes the possi-
bility of a larger loss if things go badly. There’s nothing wrong with hav-
ing a small percentage of your portfolio in higher-risk products, but
there’s no rule that says you have to.
The meltdown of the Nasdaq and Internet/tech stocks that began in
the spring of 2000 illustrates an important point about risk tolerance: A
super-heated bull market masks high-risk investments. The market al-
lowed investors who normally would avoid stocks with huge P/E ratios to
convince themselves the stocks were really not that risky. When the mar-
ket started crumbling, investors couldn’t believe the bull run was over and
ignored normal sell indicators, hoping the market would reverse course
and return to previous heights and beyond. Investors with large positions
in this sector saw their holdings vaporize and were tempted to take even
greater risks to get back their lost wealth.
Of course, the market didn’t force investors to do any of these
things. That is why in Chapters 7, “When It’s Time to Sell a Stock,” and
8, “When It’s Time to Sell a Mutual Fund,” we discussed the importance
of planning your exit and sticking to your plan. A well-thought-out asset-
allocation plan places you in investments that meet your risk-tolerance
levels. Plan your exit strategy in advance, and avoid the emotional traps
of dealing with a loss.
TIME HORIZON
Another critical factor in your asset-allocation plan is the time horizon
you have to meet your financial goal. Your time horizon and risk toler-
ance work together to give you an indication of which investments are ap-
propriate and which are not. As we saw in Chapter 1, bear markets can
last months if not years. It may take the market years to recover ground
lost in a bear market.
Caution
Time can be your best friend in investing because it compounds its
power. However, it can work against you if a rapidly approaching fi-
nancial goal is threatened.
Aggressive growth stocks may be very appropriate as part of a young per-

son’s portfolio, but very inappropriate for someone entering retirement
and adverse to risk. They can be the first to stumble if the total economy
or their sector begins to slow, which is what began in the spring of 2000
with the Internet/tech stocks.
Five years is about the minimum you should give yourself to recover
from a bear market. This means as you approach retirement, you need to
adjust your asset allocation for protection first and growth second.
The problem with asset-allocation models of the past is they did
not anticipate people living as long as they do today. Many older mod-
els would have pulled you out of all but the most conservative, income-
producing stocks as you neared retirement. Today, people who retire at
age 65 may enjoy another 15 to 20 years. That’s too long to be absent
from stocks, even some growth issues.
Tip
The increased life span modern medicine is giving us has radically
changed and will continue to change many of the social and financial
structures of our society. For example, longevity is a major reason Social
Security is threatened.
Yes, you might miss some of the big rallies, but you’ll stay above the deep
valleys—at least that’s the goal. As you approach some financial goal,
think about how to protect those funds. Chapter 13, “Age-Appropriate
Strategies,” focuses more on the issue of using asset allocation later in life.
THE RIGHT MIX

Most folks consider finding the right mix a matter of assigning percentages
to stocks, bonds, and cash. Older allocation models followed this princi-
pal. One common rule still talked about is to subtract your age from 100
to equal what percentage of your portfolio should be in stocks. For exam-

ple, a 60-year-old would have 40 percent invested in stocks under this for-
mula. However, a person this old may have 20 to 25 years still to go.
The biggest financial threat to retirees is that they will outlive their
money. Even if inflation holds at 3 percent per year, what costs a dollar
today will cost $1.80 in 20 years. They can invest too conservatively and
have to drain their principal to cover rising costs. On the other hand, they
can be too aggressive and lose ground in a substantial bear market. Some
financial-planning professionals suggest that the formula be updated to
110 minus your age. This supposedly addresses the issue of longer life
spans.
While there is much agreement that asset allocation is important,
there is no such agreement on how to slice up the pie.
Caution
It is not unheard of for market professionals to suggest that asset alloca-
tion is unnecessary. What they mean is if you do nothing else but watch
the market all day, and have been doing it for 30 years, you probably can
get by without asset allocation. For the rest of us, it’s extremely important.
Another approach to finding the right mix is more concerned with the re-
lationship between aggressive investments and conservative investments.
This makes a lot of sense when some bond types act more aggressively
than stocks at times. The general rule is that individual stocks are more
risky than bonds, which are more risky than cash, but there’s less truth to
that statement than some want to admit.
It may be easier for you to think in terms of more or less aggressive,
or you may find the percentages work better. Either way, your asset-
allocation plan needs to reflect a degree of risk that is comfortable for you
and appropriate for your financial goals.
THE BALANCING ACT

As I mentioned earlier, asset allocation is a dynamic process. That doesn’t
mean you need to tweak it every week or even every month. You should
review your asset allocation plan at least once a year, or more often if there
has been a major shift in the market.
For example, if you were carrying 75 percent stocks before the Nas-
daq collapsed, you may find that your stock percentage is 60 percent or
less. When this happens, it’s time to rebalance your portfolio. You can do
this one of several ways:
■ Add money to stocks. This is easy if you have the extra cash avail-
able to bring up the percentage by buying more stocks.
■ Sell some bonds to reduce its percentage, and use the cash to raise
the percentage of stocks.
■ If you include cash in your mix, use some of it to purchase stocks.
If you sell some bonds and use the money to buy stocks, be careful of the
tax implications. Taxes aren’t an issue if you’re trading in a retirement ac-
count, but if not, look for bonds or bond funds with a loss or the small-
est gain to reduce your tax hit.
If mutual funds are part of your portfolio (and they should be),
make sure you don’t defeat yourself by buying funds that buy the same
stocks. Two different funds with “growth” in their names may have very
different investment styles; even worse, two funds may sound completely
different but are investing in the same stocks. Your goal of diversification
is defeated when this happens. Morningstar.com assigns mutual funds to
specific categories based on what the fund actually buys, rather than its
name, so that’s a good place to check. You can go even deeper and look at
the major holdings of each fund to see if there is any overlap.
CHANGING THE MIX

You should change your allocation mix in small increments over time.
Think of a knob you can gently turn to move your portfolio from ag-
gressive to conservative. You can monitor the different assets on a regular
basis and make changes when appropriate, such as when a mutual fund
just isn’t working.
Changing the actual mix is appropriate as you get older and your fi-
nancial goals change. It is also appropriate in response to or in anticipa-
tion of a major shift in market direction—in other words, if you fear a
bear is lurking around the corner. The next three chapters discuss alloca-
tion in different bear markets.
CONCLUSION
The right asset allocation for you is a combination of your tolerance for
risk and your time horizon to reach a financial goal.
Asset allocation will not guarantee you a profit or prevent a loss, but
it will help you achieve reasonable goals in unstable markets and is your
best protection against a bear market.
CHAPTER 10
A S S E T A L L O C AT I O N
IN A RECESSION
BEAR MARKET
The unraveling of the stock market beginning in the spring of 2000

started a long slide that many thought was just a correction. After
all, we were on a decade-long bull-market high, and nothing could
stop the momentum of the Internet/tech juggernaut. There was a
brief rally in the summer months, but by September, the Nasdaq
was on a roller coaster going down.
Meanwhile, the economy kept humming along at a torrid
pace. Clearly, a recession didn’t cause this bear market. Not until
later in 2000 did the “R” word begin to pop up in news stories on
the economy, and even then, terms like “soft landing” were pre-
ferred over “slowdown.” But a few analysts were beginning to worry
that the soft landing might turn into a hard landing.
The damage continued into 2001, when signs of a recession
began to get more attention. How should investors prepare their
portfolios?
RECESSIONS
A recession is negative economic growth for two consecutive quar-
ters. The economic indicators we looked at in Chapter 4, “Eco-
nomic Indicators,” can point to signs of a slowdown in economic
growth that will affect future earnings. To the stock market, however,
those indicators are just a record of the past—it’s more concerned with
how bad news from economic indicators is going to shape the future.
When economists officially proclaim a recession, it’s like closing the
barn door after the cows get out. Whether a slowdown technically quali-
fies as a recession doesn’t really matter to investors, except that use of the
“R” word tends to further erode consumer confidence.
Caution
There’s an old saying in the stock market that the majority is wrong
most of the time. You might also say that when the herd starts moving
in one direction, it’s hard to change course. No one wants to be a party
pooper when things are going well, despite signs that the party is about
to end—then suddenly, everyone leaves at once.
It may be helpful to remember that a recession isn’t the cause of a slowing

economy—it is the result of a slowing economy. A slowing economy af-
fects the stock market in adverse ways: it eats into corporate profits, which
makes future earnings suspect, which causes investors to reduce the price
they are willing to pay.
Our last recession began in 1990; ironically, during the beginning
of a bull market and the end of a bear. The conditions that shaped that
recession had less of an impact on the market than many anticipated.
WHAT HAPPENS WHEN THE ECONOMY

GOES SOUTH
A slowdown in the economy is more than just some numbers that econ-
omists record: It’s a tangible indicator of weakness, and some would sug-
gest, a natural part of the economic cycle.
Recessions and economic slowdowns don’t have to follow an identi-
cal pattern. Some recessions may include rapid inflation, while others
might see the opposite—deflation. Here are some of the factors found in
recessions and how they might affect the stock market.
A S S E T A L L O C AT I O N I N A R E C E S S I O N B E A R M A R K E T 111
SLOWING GROWTH
The gross national product is the sum of all goods and services produced
by the country. When this measure declines for two consecutive quarters,
economists announce that we are in a recession.
When the market for goods and services is contracting, businesses
don’t grow as fast (if at all) as in an expanding economy. Investors are always
buying either future growth or earnings. A company that has been growing
at 20 percent per year might only achieve 10 percent growth thanks to a
contracting economy. This slowing growth rate will usually lower stock
prices.
Companies that produce discretionary (nonessential) consumer
items are among the first hit. Other casualties include companies that pro-
vide goods and services to other companies and the more risky, smaller
companies. Generally, companies involved in staples, like food, hold up
better than the market. People don’t stop buying toilet paper during a
recession.
INFLATION CONCERNS
Inflation may or may not accompany a recession. In fact, as we’ll see later
in the chapter, inflation can lead the economy into a recession. Neither
inflation nor its cure (higher interest rates) are good for the stock market.
Inflation concerns mean interest-rate hikes are likely, which isn’t good for
business or the stock market. Increased borrowing expense directly affects
earnings and growth.
Bonds also tend to do poorly in periods of rising interest rates.
Other interest-rate sensitive sectors include financial services, construc-
tion, and manufacturing concerns. Mutual funds that focus on hard as-
sets like real estate may do better than the rest of the market during
periods of rising inflation.
RISING UNEMPLOYMENT
As businesses slow down in response to the economy, companies lay off
workers and create fewer new jobs. Rising unemployment isn’t always a
bad thing from the employer’s point of view. It means there may be more
potential employees for those companies still expanding, and wages are
driven down by the demand for jobs.
On the other hand, fewer consumers are spending as freely as in the

past. This has a direct affect on producers of discretionary items, such as
televisions and sports equipment.
Tip
Companies like computer makers rely on business expansion to create
demand for their product. When things begin to slow, this business
model suffers almost immediately.
DECLINING CONSUMER SPENDING

Consumer spending is a powerful engine for our economy. Consumer
spending is so important to our economy that it can lead into a recession
by itself. When consumers are nervous about inflation or job security,
they tend to put off nonessential purchases.
Declining spending can be like tipping over the first domino in a
row and watching the chain reaction. Reduced spending hurts retailers,
which causes them to lay off workers and cut back on new orders. Whole-
salers then cut orders from the manufacturers, and manufacturers reduce
production and cut staff.
Nothing does very well in a reduced consumer-spending cycle.
Companies that make “luxury” items like boats, sports equipment, and
home electronics suffer from declining consumer spending, along with
clothing makers and entertainment industries. Utilities and basic trans-
portation companies may have a better chance of not losing ground in
this environment than other industries.
Tip
Investors used to consider utilities to be stable, conservative investments
that paid dividends, but were otherwise boring. Don’t make that as-
sumption anymore. Deregulation and other market forces have changed
the face of some utilities dramatically. Bad business decisions make some
utilities risky investments at best.
OTHER RECESSION RAMIFICATIONS

No two recessions are exactly alike, because no two economies are ex-
actly like. The conditions associated with recession that we’ve discussed so
far are the primary ones you will normally see, but there are other factors
to deal with also.
For example, rising fuel costs are not a result of a recession, but they
can certainly contribute to a recession. Rising fuel costs over several quar-
ters is always a cause of concern, adding extra expense to just about every
industry in the country, figuring into virtually every product and service
as well as family budgets. As such, they are highly inflationary.
Prices for gasoline and diesel fuel rose dramatically in the late 1990s
and into 2001. Where I live, gasoline has jumped from a low of $1 per
gallon in 1998 to almost $2 per gallon in the summer of 2000. It has mo-
mentarily settled at around $1.50 per gallon. That’s a tremendous increase
in a very short period. Businesses and families have had to absorb those
costs into their budgets, and most families don’t have a way to pass those
costs on to someone else.
Businesses restrain from passing on all extra costs for fear of pricing
their products and services out of the market, but if they can’t pass on all
of the extra fuel costs, it comes out of earnings.
ASSET ALLOCATION IN A RECESSION

BEAR MARKET
In the best of all worlds, you would see the recession bear market coming
and switch out of aggressive growth stocks and into holdings that are more
defensive. However, as we have already discussed, identifying a bear mar-
ket is neither easy nor straightforward. Once you find yourself in a bear
market, it may be too late to switch investments without taking a loss.
You could adopt a permanently defensive posture, but you’d be giv-
ing up most of your upside in a bull market. There are dangers in being
too conservative just as there are in being too aggressive.
What you do about asset allocation in a recession bear market and
how you do it is largely a matter of personal preference, risk tolerance,
and time horizon. In later chapters, we will look in detail at specific asset-
allocation strategies for a variety of circumstances. It will be impossible to
describe an asset-allocation model for every situation, but some examples

can help you formulate your own program.
MODIFIED MARKET TIMING

If you enjoy following the market, you may be interested in an asset-
allocation plan that comes close to market timing without stepping over
the line. The goal is to leave your growth stocks in the market as long as
you can before they begin to turn down. Letting your profits run is a great
way to build wealth fast in the market, but if you sit and watch the mar-
ket crater and do nothing, you’re leaving all your profits on the table.
This approach requires a disciplined selling strategy and a willing-
ness to stay on top of market and economic indicators. You need to keep
an eye out for signs of a bear market emerging from or before a recession;
it can be on top of you in a moment.
Tip
Active investors love to trade. However, for most of us we simply don’t
have the time or expertise to be active traders, so it’s better to buy and
hold or leave the trading to mutual fund managers.
You set sell points at some level above your purchase price and the mar-
ket price. If you are optimistic about the market and economy, set the sell
points fairly high. Once you see the economy heading south, move your
sell points just under the market price to protect any profits in the in-
vestment.
This may sound easy, but it’s not. Most investors who try this strat-
egy will be worse off at the end of the bear market than when they started.
You’ll either bail out too early and miss more growth or stay too late and
find others looking for safety have already bid up the defensive stocks you
wanted.
As you can tell, I’m not a big fan of this strategy. It’s too reliant on
you correctly predicting a bear market recession. What if the recession de-
velops, but the bear market doesn’t? You also have to consider the possi-
bility that a bear market will precede a recession.
A DEFENSIVE STRATEGY
There are always analysts who are sure a bear market is around every cor-
ner, and with signs of a recession on the horizon, they will run for cover.
They suggest you adopt a permanent “prepare for the worst” portfolio an-
ticipating a recession bear market.
A defensive strategy would focus on traditionally more stable
income-producing investments such as utilities, bonds, and preferred
stock. Growth investments would only occupy a small portion of the total
portfolio.
Tip
The object of investing is to make your money work for you. You are
generally better off in the end staying in the market than jumping in
and out of investments.
The problem here is obvious. This asset-allocation plan would have

watched the biggest bull market in history from the sidelines. If you don’t
give yourself the opportunity to profit in the market, why bother to in-
vest at all?
A MIDDLE - GROUND APPROACH

If the Modified Market Timing and Defensive Strategy approaches repre-
sent the extremes, where is the middle ground?
A recession bear market presents a special challenge in that very few
sectors are going to do well. As noted earlier, staples such as food prod-
ucts may fair better than other sectors. Hard-asset based investments such
as real estate provide no help.
You will find that much advice on bear markets ends up in the same
place: Do nothing and wait for the market to come back. It may be best
to focus on maintaining your position rather than racking up gains. If
your holdings are solid companies simply caught in the sinking economy
along with everything else, then your best course of action may be to sit
tight.
Caution
Timing is always a critical consideration in asset allocation. Two people
may approach the same problem with entirely different solutions based
solely on the difference in time horizons.
I’m a proponent of the buy-and-hold investing philosophy, but a com-

pletely passive approach to a recession bear market may be dangerous. If
you are approaching your financial goal, staying put may put you at risk
of not having time to recover before you need the money.
Remember, bear markets and recessions don’t necessarily move in
tandem. Consider the frightening prospect of a bear market developing
first, followed by a recession. Weakened stocks face an economy that is
contracting. Without energy in the economy, how are stocks going to
rebound?
A REASONABLE APPROACH
Asset allocation is about planning your participation in the market. That
plan needs to include contingencies for dealing with a weakening econ-
omy and a bear market to accompany it.
Throughout the rest of this book, we will discuss specific recom-
mendations and ideas about asset allocation for a number of different cir-
cumstances. For now, let’s stay with the philosophical for a short time
more.
Earlier, I said that you could visualize asset allocation as a knob,
which you could turn from more to less aggressive (or the other way). It’s
the same visualization for dealing with a bear market and a recession. You
will want to move from a more aggressive stance to a less aggressive stance.
If you can do that before the market gets ugly, you will go a long way to-
ward protecting your position.
Tip
Actively trading in a nonqualified account may generate more costs in
commissions and taxes than it saves. Be careful that you don’t give all of
your profits to the government.
If you own primarily individual stocks, realigning your portfolio can be

an expensive and a taxing proposition (assuming you are not working in
a qualified retirement account).
You may be reluctant to dump depressed but otherwise healthy
growth stocks for bonds or cash instruments. The good news is that if you
have a relatively well-diversified portfolio with good allocation, you may
not have much to do beyond strengthening your conservative side. We
will explore specifics in upcoming chapters.
CONCLUSION
Finding what works in a recession bear market is not easy. An aggressive
strategy might hurt more than it helps, and a conservative strategy may
not help enough.
Common sense may suggest the best strategy is to do nothing.
However, given the length of some bear markets that may not be as safe
as it may sounds.
CHAPTER 11
A S S E T A L L O C AT I O N
I N I N F L AT I O N A N D
D E F L AT I O N B E A R
MARKETS
Inflation is evil. We all agree on that. Deflation is the opposite of

inflation, so deflation must be good, right? Wrong. Deflation is just
as evil as inflation, if not more so, but most of us aren’t familiar with
the evil it can do. Deflation hasn’t afflicted the economy in over 70
years, but that doesn’t mean it can’t come back; in early 2001, sev-
eral well-respected market commentators began to sound warnings
about deflation.
The problem in understanding deflation is that our first reac-
tion is to think it’s the opposite of inflation. We think in terms of
hot and cold, left and right, up and down, black and white. If you
ask 100 people to do a word-association with these terms, almost all
of them will give you the second term. Our natural reaction, then,
is to think that inflation and deflation are opposites. They are, but
they aren’t complete opposites—because they both are devastating
to the economy.
To understand deflation, we need to get a grip on its defini-
tion and what it means in practical terms. I have included both
deflation and inflation in the same chapter because it’s easier to un-
derstand one in the context of the other.
DEFINING INFLATION
When we think of inflation, we see rising prices and interest rates. You
often hear inflation discussed in terms of the rising prices of goods. In
truth, the value of goods does not rise, but the value of money declines
because it takes more money to buy the same item. We talk about inter-
est rates and rising prices, but you don’t hear much about the root cause
of inflation: too much money chasing too few goods.
Here’s a recent example. Before the dot.coms became dot.bombs,
housing in Silicon Valley was at a premium. The tremendous growth of
Internet/tech companies in the area caused a dramatic rise in housing
prices. Houses weren’t for sale, they were up for bid—sellers were in the
enviable position of having buyers try to outbid one another. It wasn’t un-
common for a modest house to sell for several hundred thousand dollars
over the asking price.
That’s inflation. Too much money chasing too few houses caused a
tremendous increase in prices. The house’s value continues to skyrocket,
and it takes more money to buy it. Inflation causes things, especially hard
assets like real estate and gold, to become more valuable than money.
Inflation is great if you are selling real estate, but it’s not so great for
everyone else. Consider the bank lending money to a customer for a new
car. If inflation continues, the money the customer pays back to the bank
is worth less than when the bank lent it. The bank attempts to compen-
sate by charging higher interest rates on its loans. That may discourage
some buyers from borrowing.
Caution
Whether it is real estate, stocks, or Beanie Babies, any item bid up in
price beyond a sustainable level is bound to fall eventually.
This is what the Fed does when it raises interest rates to cool rising infla-
tion. Higher rates mean fewer people are borrowing and there is less
money chasing goods. Higher interest rates effectively take money out of
the market.
ASSET ALLOCATION IN INFLATION AND DEFLATION MARKETS 121
DEFINING DEFLATION
If inflation causes the value of money to fall, then deflation should cause
the value of money to rise. That doesn’t seem like a bad thing, but the re-
sult is dramatically falling prices. When there is too little money chasing
too many goods, prices drop. Deflation officially occurs when prices fall
enough to cause a sustained decline in the Consumer Price Index (CPI)—
although some observers believe the CPI is hopelessly flawed and isn’t
valid as a measure to predict the immediate future. Companies slash
prices to move goods, which squeezes profit margins. The more goods a
company produces, the worse the situation becomes.
Caution
When our money becomes more valuable, the prices of foreign goods
drop dramatically. If they flood the market, domestic competitors may
face dramatic reversals.
In a deflation scenario, money increases in value and goods decrease.

Consumers want money—or, more precisely, cash—because it will be
worth more tomorrow while goods will be worth less. Consumers avoid
spending precious cash on depreciating goods. This drives down prices.
Businesses find it hard to make a profit, and their stock suffers.
Deflation as an economy-wide event is virtually unknown in mod-
ern times. The last time we suffered a serious deflation was in the De-
pression of the 1930s. When the stock market crashed, 90 percent of its
value disappeared in a matter of a few days. All of this wealth simply went
away. Cash became the precious resource, and people struggled to get it
any way they could. Men selling apples on the street and children selling
pencils are some of the enduring images of the Depression.
Tip
Pundits are fond of saying a market crash like the one that preceded the
Great Depression can’t happen again. However, we have seen several in-
stances where prices have declined dramatically in a short period.
SOME MODERN EXAMPLES

How does all of this relate to the stock market and protecting yourself in
unstable times? Depending on whom you talked to in early 2001, a re-
cession combined with inflation or deflation was upon us.
Remember, recession and inflation or deflation are not mutually ex-
clusive. We have had both recessions (and depressions) with either infla-
tion or deflation.
RECENT INFLATION
Earlier I noted that the Fed is not responsible for the stock market. That’s
true, but it doesn’t mean the Fed is unconcerned with the market. Dur-
ing the height of the late-1990s bull market, the Fed raised interest rates
six times in order to cool off the economy. The Fed attempted to take
money out of the economy by discouraging borrowing.
One factor the Fed considered before raising interest rates was the
incredible “wealth effect” created by the exploding Internet/tech stocks.
During the last few years of the bull market, companies were issuing IPOs
like there was no tomorrow. Companies that a few months earlier had
been an idea on a bar napkin suddenly had market caps in the hundreds
of millions of dollars. Some soared into the billions of dollars as their
stock went from, for example, $25 per share to $125 per share almost
overnight. Employees, directors, and investors held options for tens of
thousands of shares at pennies per share.
Caution
Although there has been a tremendous shakeout in the Internet/tech
sector stocks, don’t dismiss the survivors out of hand. Some of them
could be the leaders in the next bull market.
Imagine that one day you’re sleeping in your clothes because you’ve been
working around the clock to launch a new Internet product or service,
and the next day you’re worth $300 million dollars. The company you
started has a market cap in the billions of dollars, and it has never gener-
ated a nickel of revenue. That’s the wealth effect, and it’s very inflation-
ary. The people who bid for houses have the wealth effect.
The huge run-up in Internet/tech stocks is a good illustration of in-

flation. Investors couldn’t throw money at the stocks fast enough. Adding
new stocks (IPOs) only increased the amount of money flowing into the
market. Too much money chasing too few goods: Investors believed the
stock would be worth more tomorrow than today.
The Fed’s interest-rate hikes aimed in part at taking some of the
money out of the market, since many investors were using margin ac-
counts to increase their holdings.
RECENT DEFLATION
Can you see what’s coming? When the Nasdaq cratered beginning in
March 2000, the Internet “bubble” burst in a rather dramatic fashion.
The market lost over 57 percent of its value in one year. For many of the
dot.coms it was even worse. Many lost up to 90 percent of their value,
and some just disappeared.
When the Nasdaq loses 57 percent of its value, it’s a huge sum of
money. Where did it go? It vaporized. To get an idea of how much value
vaporized, consider the Nasdaq 100 Index, which is 100 of the top Nas-
daq stocks. In a one-year period beginning in early 2000, the companies
represented in the index lost $2.2 trillion in value (market capitalization).
You could argue that that wasn’t “real” money but paper profits that
were unrealized. That’s not really material to this discussion. The stock
had value, and stockholders expressed that value in dollars. When in-
vestors challenged that value, they began a panicked retreat from stock to
cash. The turn from boom to bust represents a turn from acquiring stock
at almost any cost (inflation) to selling stock at any price (deflation).
Tip
The huge amount of wealth created in the Internet/tech boom was
much more than paper profits. If you sold before the bust, you got real
money; some employees who held certain classes of options had to pay
taxes on them even if they were unexercised.
The Fed lowered interest rates twice in January 2001 with more cuts
hinted in the near future. If raising interest rates keeps inflation under
control, then lowering rates should check deflation, although no one at

the Fed was talking about deflation at the time of the cuts. Lowering in-
terest rates adds money to the economy by making it easier and more
cost effective to borrow. Businesses borrow to finance expansion, and
consumers borrow to acquire assets such as cars and houses.
It will take more than a few interest-rate cuts to turn around a roar-
ing bear market, but many saw the initial cuts as a positive sign.
WHAT YOU CAN DO WHEN

INFLATION HAPPENS
Investors face some tough choices in figuring out what is going on with
the economy even in the best of times. Will the market lead the economy
or follow it? If inflation causes a bear market, how can you deal with its
effect on your portfolio?
Except in extreme cases of inflation and tough bears, there are mar-
ket assets you can use to help offset the effects of inflation. Large cap
stocks normally will outperform inflation. In other words, if inflation is 6
percent, you can expect a greater than 6 percent return from large cap
stocks. Of course, not just any large cap stock will do. The company or
mutual fund must be growing at a substantial and sustainable rate to over-
take and pass inflation. This may be hard in a bear market when investors
are discounting certain sectors.
Tip
Whether the government declares the official beginning of inflation or
deflation is of little importance. Investors can feel the bad effects of the
two conditions without any official declaration.
Unfortunately, even the large cap stocks may not keep up with inflation,
which was the case in the late 1970s. The rate of inflation and how
quickly it appears also contribute to the success or failure of your strat-
egy. Plan for a long-term return, because in the short-run, few common
stocks are going to outperform inflation.
Bonds are particularly at risk in inflation, mainly for the high inter-
est rates and reduced earnings power. The interest rate a bond pays will
soon be uncompetitive if newer bonds boast a higher rate.
For example, say you bought a $10,000 bond paying six percent in-
terest at maturity. At maturity, the issuer pays you $10,600. However, in-
flation was 4 percent for the year; so instead of getting back $10,600, you
actually receive $10,176 in purchasing power.
Bond price: $10,000
Interest: $600
Due at maturity: $10,600
Less 4% inflation: ($424)
Value of cash return: $10,176
Buyer’s return: 1.76%
Now, suppose you wanted to sell the bond after one year on the open
market. Inflation has driven up interest rates and eaten into the return. To
sell this bond, you will have to discount it so the buyer’s return takes into
account the higher interest rates and diminished purchasing power. In-
stead of selling the bond for $10,000, you can only get $9,000.
Bond price: $9,000
Interest: $600
Discounting the bond’s price from $10,000 to $9,000 raises the actual re-
turn to 11.95 percent. The amount of loss to inflation is the same for
both because it is on the bond’s face value and interest. The “value of cash
return” is what you receive at the bond’s maturity from the issuer, so it re-
mains the same. The buyer’s return is what the holder receives less the lost
purchasing power from inflation.
Tip
Gold has been a traditional safe haven from inflation. In the 1970s and
1980s, many people bought actual gold bullion or coins. However, don’t
assume that a hard asset like gold or real estate will hold its value when
inflation subsides—in most cases it won’t.
In Chapter 12, “Bear-Proof Assets,” we will look at specific tips and tools
for investing during an inflation bear market.
WHAT YOU CAN DO ABOUT DEFLATION

Deflation poses some difficult problems for investors. For one thing, it is
virtually unknown to modern investors. There are no past periods to look
back on for guidance or suggestions.
A bear market caused by deflation would be a particularly tough sit-
uation. Falling prices would affect virtually every sector of the economy.
Consumers might be afraid to part with precious cash to buy anything
but the necessities. Businesses would struggle under the weight of reduced
demand and falling prices. Investors should avoid borrowing and invest-
ing in common stocks that don’t pay dividends. Real estate and other hard
assets like gold will not do well in deflation.
Deflation rewards lenders, since the debtor repays with money that
is worth more than the original note. Fixed-income products and
dividend-paying stocks would do better than other investments.
Caution
Avoid borrowing during a deflationary period if possible. You will be re-
paying the debt with money that is worth more than when you bor-
rowed it.
Bonds would be a logical choice for investors to use as protection against

deflation. In normal markets, long-term bonds are more risky than
short-term instruments because there is a greater chance interest rates
will rise over time. During deflation, however, the interest and principal
you receive at maturity are worth more over time. Let’s look at our bond
example from the inflation section.
In the deflation scenario, the value of the bond increases, thanks to
money buying more than in the past and interest rates falling if you hold
it to maturity.
Bond price: $10,000
Interest: $600
Your actual return in terms of buying power is boosted by the 4.24 per-
cent deflation factor (6% + 4.24% = 10.24%). This is a dramatic illus-
tration of the effect deflation would have on the market. Anyone with
cash to lend could command the best deals. Obviously, the interest rate
on new bonds would drop to something less than 6 percent.
Let’s continue our example and look at selling the bond during de-
flation. The assumption is that you bought this bond in a “normal” mar-
ket and six percent was a reasonable return. Falling interest rates to
combat the deflation raise the value of this bond by increasing its sale
price in the secondary market.
Bond price: $10,500
Interest: $600
In this case, the buyer on the secondary market might settle for this in-
terest rate knowing that deflation was adding 4 percent per year to the
value of her cash return.
CONCLUSION
Bear markets brought on by either inflation or deflation are devastating
to the economy and the stock market. Both represent a weakness in our
monetary system. In other countries that have faced these two challenges,
economies have crumbled under the distrust this weakness generates.
Distrust in the money system is dangerous. Investors face the
quandary of where to put their money so that it is safe. Hoard money
during inflation and it will lose its value. Invest your money during de-
flation and what you buy will be worth less tomorrow than it is today.
In Chapter 12, we are going to look at a number of financial sce-
narios and examine what products work best in those circumstances.
CHAPTER 12
BEAR-PROOF
ASSETS
Investing is about uncertainty. You don’t know for sure what the
stock market is going to do next year, next month, next week, or
even tomorrow. Unless you are 100 percent invested in U.S. Trea-
sury Bonds, there are virtually no guarantees on the future value of
your holdings.
Your goal as an investor is to put together a portfolio that of-
fers the best possible return for today’s market and tomorrow’s
uncertainty. This means you need to understand how certain in-
vestments normally fare in different market conditions. For exam-
ple, how will stocks, bonds, and cash react to an expanding market?
What can you expect if the market is contracting?
In the interest of full disclosure, the title of this chapter is
more marketing than factual. There is no way to completely protect
your portfolio from the ravages of a bear market and still stay in-
vested. Hiding places may be hard to find in the midst of a reces-
sion marked by high inflation and interest rates. Investors in the
“super bear” market of 1973 and 1974 couldn’t find a rock big
enough to hide under for protection. The best they could hope for
was damage control.
This chapter looks at all varieties of investments and how they
might fare in a bear market, to help you decide which tools work
best for your asset-allocation model. We have seen that bear markets come
in several shapes, so what might work in one bear market won’t do well
in another. A well-diversified portfolio is your best defense.
STOCKS IN A BEAR MARKET

Conventional wisdom says that most stocks will fall in a bear market. This
assumes a market-wide bear situation, which occurs less frequently than
bear attacks on industry sectors.
Obviously, there is more than one type of stock, just as there is more
than one type of bear market. Historically, large cap stocks (generally con-
sidered $5 billion and over) have performed better than smaller stocks.
Larger companies have more resources to weather bad economic cycles
often associated with bear markets. Given the meltdown of more than a
few large or near large cap Internet/tech stocks, we should amend the des-
ignation to read large, established companies.
Caution
No company is immune from the ravages of bear markets and eco-
nomic instability. Some get back on their feet quickly, while others
never seem to recover completely.
However, even well-established large companies can suffer hard times,

whether in response to a bear market or due to changes in the competitive
environment. Three of the leaders in the Internet/tech market boom,
Microsoft, Intel, and Cisco Systems, suffered huge stock losses when the
dot.com era came crashing down. What happened? How could Microsoft,
whose operating system is in 95 percent of the personal computers; Intel,
whose chips power most of those computers; and Cisco Systems, whose
networking devices were the backbone of the Internet, falter?
There were several reasons, including a general slowing in the econ-
omy that indicated slower growth for these growth stocks. The growth of
the personal-computer market slowed as fewer people became first-time
owners. This meant fewer computers, fewer chips, and fewer fees for soft-
ware. New producers of networking equipment and computer chips
added pressure.
BEAR-PROOF ASSETS 131
When growth stocks don’t grow as fast as the market thinks they
should, stock prices fall. Will Microsoft, Intel, and Cisco Systems be
around after the bear market disappears? Almost certainly; however, they
may not reclaim their place as absolute market leaders.
THE INDUSTRY SECTOR IS

IMPORTANT, TOO
It’s not enough to know how different types of stocks might act in a bear
market. The other important piece of information relates to the compa-
ny’s industry sector. Different sectors handle the causes of bear markets
(for example, inflation, recession, deflation, and so on) with various de-
grees of success.
Later in this chapter, we will look at the main industry sectors and
which ones offer possible shelter and which ones to avoid. Let’s look at
how some different types of stocks might fare in an unstable market.
LARGE CAP STOCKS

Large cap stocks have market capitalizations in excess of $5 billion. Before
the Internet/tech bubble, it would take a company many years to achieve
this size.
As noted, larger companies typically have the resources to weather
bear markets, especially those associated with recessions. Their stocks may
be battered, but when the market turns up, they’re in a better position to
regain lost ground.
Plain English
You compute the market capitalization by taking a stock’s price and
multiplying it by the number of outstanding shares. For example, a
company has 1,000,000 shares outstanding and its market price is $100
per share. The market cap is $100 million.
Not all large cap stocks are equal. As we will see in the later discussion of
industry sectors, being large is not always a shield against determined
bears.
GROWTH STOCKS
Growth stocks are particularly vulnerable during a recession/bear market.
The usual reason for investing in a growth stock is to participate in its fu-
ture growth. When a growth stock quits growing or even slows down, in-
vestors may jump ship for other opportunities. A recession or slowing
economic growth can hurt most growth companies.
The PC industry was facing this problem even before the
Internet/tech bubble burst in the spring of 2000. The computer industry
experienced tremendous early growth; however, once the middle- to
upper-income market was saturated, growth began to slow. Although
prices have dropped dramatically, computers are still a stretch for many
households with modest incomes. There is still good volume in replacing
older computers, but new growth is getting harder and more expensive
(lower prices and margins).
A recession or slowing economic growth gives bears all the incentive
they need to look for safer ground. Just as growth stocks may be the first
hit in a bear market, they often lead the way out. For this reason, investors
must carefully weigh the value of owning the stock through difficult
times. When the bulls return, is this stock going to lead the charge? If you
believe the company is fundamentally sound, you may want to buy more
at a bear market discount. You will learn more about this in Chapter 15,
“Fatten Up on Bear.”
DIVIDEND-PAYING STOCKS
Companies pay dividends based on the performance of the company, not
the stock. Many established large cap stocks pay regular dividends. This
income-producing benefit may make them attractive in bear markets.
Even if the stock has fallen into a bear-market slump, the company will
often continue paying dividends; as a rule, these stocks are less volatile in
good times and in bad.
Inflation is not kind to companies paying dividends, since rising
prices erode the value of the dividend. On the other hand, deflation
makes these stocks especially attractive since the value of money rises in
deflation.
VALUE STOCKS
A value stock trades close to its true market value. For example, when
some growth stocks are sporting P/E ratios of 35 and above, a value stock
might come in with a P/E in the low teens.
By definition, value stocks don’t have much of an inflated price and
may not move as much as growth stocks in a bear market. Bear markets,
however, often create value stocks out of growth stocks. It is likely that in
a bear market, you may find some good bargains on stocks that the mar-
ket has treated badly.
Despite their bad reputation, some of the surviving Internet/
tech stocks have moved into the value category from their once lofty and
wildly inflated P/E ratios. Some market watchers were saying in early
2001 that these beaten-up companies deserved a look at their more rea-
sonable valuations.
Tip
Value is in the eye of the beholder. Just because a stock is off by 60 per-
cent doesn’t mean it’s a bargain. You determine valuation by the com-
pany’s fundamentals, not by how far it has fallen.
OTHER LARGE CAP STOCKS

Market professionals apply a number of other classifications to stocks,
such as “classic growth,” “speculative growth,” “hybrids,” and so on.
Rather than going through each one and undoubtedly leaving some out,
let’s look at the commonsense way to decide if a stock is a bear killer or
bear bait.
In broad terms, a bear market usually signals a move by investors
from aggressive to conservative. Stated another way, investors look for sta-
bility in the midst of uncertainty. Remember, it’s not the bear market that
cripples a company, but the underlying causes of bear markets such as in-
flation, deflation, and/or recession. Companies that were speculative be-
fore a recession or slowdown may be in serious trouble early in the cycle.
When we look at actual asset-allocation formulas later in the book,

the amount of risk (or aggression) you can tolerate will play a large role
in devising your plan. Some investors with long time horizons and a high
aversion to risk stick with traditional “blue-chip” stocks for security. In-
vestment advisors refer to these stocks (think of the stocks in the Dow) as
“widows and orphans.” This means these stocks would be suitable for in-
vestors with a low tolerance for risk.
Large cap stocks are certainly one class you can look at in the face
of a charging bear market. However, if the bears are eyeing industry seg-
ments, like when they attacked the Internet/tech segment, you had best
get out of their way.
MID CAP GROWTH STOCKS

Mid cap stocks have market capitalizations of $1 to $5 billion. They rep-
resent companies that have moved out of a startup mode and into the
maturing process. They are also prime candidates for mergers and acqui-
sitions because they have established their business model, technology,
and/or market penetration.
A few mid cap stocks will make it into the large cap range, but most
will stay at this size if not bought or merged. In general, size plays an im-
portant role in determining how risky a stock is relative to industry peers.
Mid cap stocks, on this basis, are by definition more risky than large cap
stocks.
That statement breaks apart when comparing two companies. There
are large cap stocks that are certainly speculative, as there are mid cap
stocks on the more conservative side.
Mid cap growth stocks represent an attractive target for investors
hoping to spot a new industry leader still in its emerging stage. Mid cap
stocks, especially those in a “hot” sector, are prime candidates for spec-
tacular growth. Investors with a moderate tolerance for risk find the
stocks appealing because they have moved into a more established posture
but haven’t nearly exhausted their growth potential.
However, mid cap stocks may be more vulnerable to conditions be-
hind a bear market like inflation, deflation, or recession. The bear market
may be particularly cruel to mid cap stocks.
Tip
Mid cap stocks represent a moderately aggressive investment and should
occupy that spot in your asset-allocation strategy.
Investors looking for safety and stability often dump mid cap stocks in
favor of more secure investments in larger cap stocks or other vehicles,
like bonds. However, investors face the same question as holders of large
cap growth stocks. Will the underlying causes of the bear market perma-
nently injure the company, or does it have the resources to catch an up-
turn?
Your personal investment situation and asset-allocation model will
help you decide on the risk of riding out a bear market. If you are con-
cerned about an approaching bear market or conditions that suggest a
slowdown in the economy, you may want to think carefully about how
much of your portfolio is in mid cap stocks.
OTHER MID CAP STOCKS

Other types of mid cap stocks (value, hybrid, speculative growth, and so
on) face the same influences as large cap stocks; however, these companies
have fewer resources to weather a poor economy.
It’s not unusual to see mid cap stocks begin to slide when the mar-
ket and economy look unstable. Investors know that smaller companies
are likely to find continued growth difficult in tough economic times.
Excellent research is important in deciding whether to hold on to a
mid cap stock or let it go. You can be certain General Electric is going to
survive a recession. However, smaller companies that depend directly or
indirectly on consumer demand may find a protracted recession or other
economic instability an extraordinary burden.
These companies, assuming they are fundamentally sound, are
merger or an acquisition candidates. Stepping under the financial um-
brella of a much larger company may give them the breathing room
needed to flourish. Mergers and acquisitions under these conditions may
not be at any market premium—I wouldn’t hold stock in these compa-
nies hoping that a merger or an acquisition will be at a large premium.
Caution
Mid cap companies are vulnerable to a takeover during a bear market or
if the business is threatened by a sour economy.
SMALL CAP STOCKS

Investors should double every concern and warning about mid cap stocks
for small cap stocks, which have market caps of $1 billion and under.
These small companies are frequently very young and unproven in the
marketplace. Their mortality rate is high, especially in technology and
other highly competitive industries.
Investors are attracted to small cap stocks because of the tremendous
growth potential, but with this potential comes an appropriate amount of
risk. Economic downturns can prove disastrous for small cap companies
that lack the financial resources to ride out a prolonged period of infla-
tion, deflation, or recession.
However, a slowing economy may not dramatically affect a small
company running on cash from a recent IPO. It could be in a great posi-
tion when the market turns upward again.
Tip
Small cap stocks offer the possibility of significant growth along with
the corresponding danger of significant loss.
Small cap stocks are highly speculative under almost any circumstance.
You should carefully evaluate their place in your portfolio relative to your
tolerance for risk and time horizon.
FOREIGN STOCKS
It is easier to invest in foreign companies now because more information
is available, and most investment professionals believe foreign stocks have
a place in every well-diversified portfolio after core investments are in
place.
Foreign stocks carry some additional risks, such as political instabil-

ity, that aren’t real factors in domestic stocks. However, foreign stocks may
also be a source of strength during a major bear market: Our economic
problems may not affect another country. I say “may” because the world
economies are more intertwined than ever before, and, as globalization
continues, that interdependence will continue to rise.
BONDS
Bonds are traditional core investments used to add stability to the volatil-
ity of stocks in portfolio. Bonds are more conservative than stocks because
of their fixed return and guaranteed principal in some cases. U.S. Treasury
issues are the most secure investment because they are backed by the “full
faith and credit” of the U.S. government. Later in the book, when we dis-
cuss specific asset-allocation strategies, you will see the key role bonds play
in the process.
Tip
Bonds appear boring to many investors because they lack the sense of ur-
gency stocks have based on how the media reacts. Interestingly enough,
there is more money in the bond market than the stock market.
Investors flock to bonds during periods of instability. On most days when

the market is down significantly, you will see a rise in the amount of
money flowing into the bond market. You normally give up some return
for this stability, but not always. The 10-Year Treasuries, which are the
bond market’s benchmark, gained over 14 percent in 2000, while the
S&P 500 lost over 9 percent.
Their predictable returns make bonds a good choice in most situa-
tions. One notable exception is during periods of high inflation. The Fed
will typically raise interest rates to cool inflation, and bonds react nega-
tively to rising interest rates because their return is fixed. If you can buy a
$10,000 bond with an 8 percent interest rate, what would you pay for a
similar bond with a 10 percent interest rate?
Caution
Bonds are not as easy to research and trade as stocks. If you are going to
actively trade bonds, you may want to seek the help of a professional.
The longer term the bond has, the higher the coupon or interest rate will
be. This is because, over time, interest rates are likely to rise and force the
bondholder to sell at a discount to be competitive. In Chapter 5, “Mar-
ket Indicators,” we discussed the problems with selling bonds in a period
of rising interest rates.
You can approach bonds from two directions. First, you can be an
active trader, buying and selling them on the open market. In this sce-
nario, the bond’s price relates to its coupon interest rate and the prevail-
ing market interest rates for the same type of bond.
Second, you can buy bonds with the notion of holding them until
maturity. This takes the fluctuation out of the picture because you are
more concerned with receiving your full principal at maturity on a spe-
cific date. This strategy is common when investors need a certain sum of
money at a specific time (for college tuition, say). When you employ this
strategy, you are not concerned with the market fluctuation. Your concern
is having money available when you need it.
You are better off establishing a minimum bond presence in your
portfolio and adding to it if economic and market conditions call for
more protection. When we look at specific strategies later, you will see
how timing bonds’ maturities can add a new dimension to your portfolio.
MUTUAL FUNDS
Mutual funds, except for sector and other specialized funds, tend to be
more stable than individual stocks because of their diversification. The
operative word here is diversification, because you can’t always assume
you are buying a diversified portfolio in a particular mutual fund.
A large cap stock fund loaded with technology stock is not going to
perform the same way as a large cap stock fund that truly spreads invest-
ments across several industry segments. We have already noted that you
can’t always judge mutual funds by their names. You should look into
Morningstar.com for information about what the fund actually holds, in-
stead of what the name implies.
Index funds, especially those targeting major indexes like the S&P
500, are down in a bear market and back up when the tide turns. They
are a way through bear markets with some assurance they will follow the
market up.
Bear markets offer an attractive dollar cost–averaging opportunity to
the committed index fund investor. If individual stocks post peaks and val-
leys of performance, diversified stock mutual funds tend to be rolling hills.
BOND FUNDS
Bond funds are popular with investors for many of the same reasons eq-
uity funds are popular. They offer professional management and diversi-
fication. In the case of bonds, mutual funds are much easier to buy and
sell than individual bonds. Bond funds may be an attractive safe haven in
bear markets, but if you need a specific sum of money at a specific time,
you should consider individual bonds.
Because bond funds buy issues with different maturities, you cannot
count on them to return your principal intact on the date you need it.
Tip
Mutual funds come in many varieties and attempt to address many dif-
ferent investment needs. There is a danger in trying to micro-manage
your portfolio by loading up with very specialized funds. Most invest-
ment professionals caution that owning too many funds is overkill.
HYBRID FUNDS
Hybrid or balanced funds invest in both stocks and bonds, as well as cash
instruments. They spread money across all three areas and move it around
as market conditions suggest.
For example, if technology stocks are hot, the fund will move money
out of bonds and cash and into hot stocks. Likewise, they may take a more
conservative stance if stocks are weak and the market uncertain.
Hybrid funds have differing approaches, so make sure you know
what the fund manager’s strategy is before you invest. One of the negatives
about investing in hybrid funds is they can run up some significant fees
and taxes.
BEAR FUNDS
It might not surprise you to know there are mutual funds designed to
deal with bear markets. These funds employ a variety of strategies to
move in the opposite direction of a bear market. The fund managers use
tools like shorting stocks that they believe will decline in a bear market.
They may also short index futures and other derivatives. The downside
with these funds is they have a bad habit of missing the boat when the
market turns upward.
MARKET NEUTRAL FUNDS

Market neutral funds look to hit a target return, no matter what the mar-
ket is doing at the moment. They invest in undervalued stocks, hoping to
ride them up, and short overvalued stocks they believe will fall.
This strategy rests on the managers picking the right stocks, and
that is a difficult task under any circumstances.
BEAR RANKING FUNDS

Morningstar.com has a tool that allows you to rank a fund based on how
it will likely do in a down market. Although not foolproof, it is a useful
screen for narrowing down funds to examine.
You can find the tool under their “Quicktakes” section and rank
funds by market volatility. The ranking examines funds for performance
during previous downturns. This ranking will tell you how well the fund
weathered previous downturns and is a helpful tool. However, like all
tools that examine past performance, it can’t forecast future performance
with certainty; too many variables can change from one down market to
the next.
Caution
There are no magic funds that are going to protect you completely from
a bear market. Common sense and a well-diversified portfolio are always
your best defense.
SECTORS
I’m from Texas, so believe me when I say size matters. However, it is not
the only consideration. Industry segment is also important. A company
in the “wrong” industry segment or sector is also likely to fall during a
bear attack on other members of the segment.
Industry segments such as technology, durable goods, real estate,
and so on behave differently in a bear market. The proper mix in your
asset-allocation plan is a big step toward bear-proofing your portfolio.
Caution
Predicting a sector’s performance during a bear market is not a sure
thing. Underlying economic factors can change predicable behavior.
Investors traditionally look to some sectors for shelter during bear mar-
kets and unstable economies. These are general guidelines only; bear at-
tacks can take many forms, and a sector may not always respond the way
you think it should. There are many segments, but most market observers
cluster them into just a handful for convenience. These include …
■ Consumer durable goods. This sector includes major appliances
and items with an expected life of more than three years. It will
suffer in a prolonged recession marked by high interest rates.
■ Nondurable goods (staples). This sector includes food, clothing,
and other items necessary for daily life, which are consumed im-
mediately or have only a short period of usefulness. This has been
a favorite hideout because it seldom suffers dramatically in a re-
cession.
■ Energy. Energy is a very volatile sector, in part because foreign in-
terests exert so much influence over prices, and domestic produc-

ers are highly regulated.
■ Industrial cyclicals. These stocks are not usually a good haven be-
cause they flow with the economy. When the economy is down,
they will be among the first to fall.
■ Services. Services have become a huge part of our economy. It’s
not normally a very volatile sector, but it offers no real protection

either.
■ Real estate. Real estate is extremely interest-rate sensitive, so de-

clining interest rates will spur growth. If the Fed is fighting off a
recession or deflation, it will use interest-rate cuts. However, if in-
flation is the biggest fear, interest rates will rise, and that will slow
consumer demand. Commercial real estate thrives in inflationary
periods because it increases in value with inflation.
■ Technology. Technology is no haven from bear markets. An ex-
tended downturn in the economy thwarts growth, and that nega-

tively affects technology stocks, which are almost all growth stocks.
■ Financial services. Financial services are also interest-rate sensitive
(if consumers and businesses aren’t borrowing, financial companies

suffer). There is more to the sector than banks and savings and
loans; however, falling interest rates are good news for them all.
Watch out for rising rates if the Fed smells inflation.
■ Utilities. Utilities used to be the favorite hideout for risk-adverse
investors. For the most part, they are stable, solid companies that
pay handsome dividends. Today, some of these same conservative
utilities are venturing into a variety of other businesses (telecom-
munications, for example). Others are facing deregulation and a
variety of new competitors that didn’t exist before. If you include
the telecoms in this sector (as opposed to technology), you’re look-
ing at a group of highly leveraged companies that have expanded
at breakneck speed, primarily on debt. Not the safest place to be.
■ Healthcare. Healthcare firms have ridden the market up and
down, but if you’re looking for stability, look elsewhere. Rising
costs that are outpacing payments put healthcare providers in
tough circumstances.
■ Retail sales. Retail sales are not the place to avoid bad economic
news. Even though people still buy items, recessions tend to take
the confidence out of buyers.
Caution
Investing in sectors, whether through mutual funds or individual stocks,
can be dangerous. That strategy defeats the purpose of diversification.
Sector investing is a high-risk maneuver.
Traditional investment thought believes each sector has certain character-

istics that suggest how it will react in a bear market. For example, utilities
are considered very conservative investments. Many still are, but deregu-
lation and other changes have challenged this broad stroke. Some utilities
have diversified out of traditional areas, while others are struggling under
massive debt incurred to replace aging facilities.
BEAR ATTACKS
Although bears sometimes attack the whole market, they are often more
selective, picking out a particular sector to ravage. The bears attacked the
Internet/tech sector in the spring of 2000, which led to a widespread bear
attack on most of the market.
Morningstar.com has an interactive chart on the lead page of their
stock research. This chart tracks several indicators and one of them is 10
sectors they follow. In March 2001, I set the time frame on the chart for
one year and looked at their sectors. Each of them was up, except for tech-
nology, which was down 50-plus percent for the 12-month period. This
shows how the broad market remained up even though it was declining
toward the end of 2000, while technology was in a nosedive.
When I change the time frame to “year-to-date,” all of the sectors
are down except consumer durables. This indicates a general decline in
the market consistent with a broad-based bear attack.
CONCLUSION
Stocks and bonds react differently to a variety of economic and market
uncertainties. There is not always a clear strategy that will work every
time. It is important to understand the basis for the bear market. Infla-
tion often draws interest rate hikes while deflation and a general eco-
nomic downturn usually indicate interest-rate cuts are coming.
Certain sectors are safer havens than others are. Your best defense is
always a well-diversified portfolio.
PA R T 4
BEAR TRACKING
Part 4 looks at how investors can devise strategies for making age-
appropriate decisions about bear market protection. People are liv-
ing longer, and some of the old rules about asset allocation haven’t
kept up with the times.
We will also look at how to deal with the need to park cash or
meet short-term goals. A short-time horizon is the riskiest of all in-
vestment problems. If you’re too conservative, you may not meet
your goal; however, if you’re too aggressive, the bears may make you
sorry.
Bear markets can also be an opportunity to pick up some bar-
gains when the bears hammer basically sound stocks along with
everything else. This gets dangerously close to market timing, so
beware.
CHAPTER 13
A G E - A P P R O P R I AT E
S T R AT E G I E S
As we grow older, our focus and priorities constantly shift. Obvi-

ously, a 25-year-old single person has much different needs and
concerns than a 55-year-old person with a family to support. What
isn’t always so obvious is how your asset allocation should shift as
you age, to strike the right balance between aggressive and conser-
vative investing.
Your best protection against a bear market and economic
uncertainty is a well-thought-out asset-allocation plan. As noted
earlier, asset allocation is a dynamic process. Your plan should take
into consideration your tolerance for risk, your age, the time hori-
zon, and your main financial goal, and you should review and ad-
just your allocation periodically. Your time horizon is the number
of years until you will need money out of your investments—for
example, at retirement. The proximity of your time horizon may
have a profound affect on your asset-allocation plan.
In this chapter, we will focus on age-appropriate strategies,
which will include components of risk tolerance discussed in ear-
lier chapters, and look at how your plan will shift as your time hori-
zon approaches.
DISPELLING SOME MYTHS

As you begin thinking about protecting yourself from a bear market, you
may run into a couple of mythical rules of asset allocation:
■ The “100 minus your age” rule
■ The “very conservative retiree” rule
These, of course, are “rules of thumb,” not hard-and-fast restrictions. For

years, financial advisers have used the “100 minus your age” rule to de-
termine how much of your portfolio should be in stocks. Here’s how it
works: A 55-year-old would have 45 percent of his portfolio in equities,
while a 30-year-old would have 70 percent of her portfolio in equities.
The problem with this model? It’s too simple. It doesn’t take into ac-
count a number of variables, all of which we’ll discuss in this chapter:
■ People are living longer
■ Risk tolerance varies from person to person
■ Time horizon to financial goal
The second rule suggests that a person approaching retirement should re-
treat into very conservative investments. Although it’s appropriate to back
off some aggressive investing patterns as retirement approaches, it’s possi-
ble to be too conservative and risk outliving your money. A person retir-
ing at age 65 could easily live another 15 to 20 years or more. That could
be a long retirement to fund, especially considering that the cost of living
will continue to rise.
We have seen how bear markets can be vicious and prolonged. Pro-
tecting against such an attack becomes more important as we approach
major financial goals.
WE’RE NEVER OUT OF THE WOODS

It is no secret that the population of America is getting older. The baby
boomers are beginning to think very hard about retirement and how
they’re going to make it.
The fastest-growing age group in our population is 85 and older.
Thanks to medical advances and a relatively healthy environment, we can
all expect to live longer than our parents and grandparents. That’s a good
A G E - A P P R O P R I AT E S T R AT E G I E S 149
thing, but it also poses serious investment problems. The biggest problem
is how to protect your portfolio from bear markets and economic uncer-
tainty and not run out of money before your hourglass runs out of sand.
Bears love old people because they are so vulnerable. Older people don’t
have the time: the weapon that bears can’t defeat.
Some people address this issue by working after retirement. They
may take a part-time job or do consulting work to keep some cash com-
ing in. This extra income supplements retirement benefits and may mean
they don’t have to reach into the principal as quickly. A second group of
retirees has moved past the age when work is an option. They are living
exclusively on retirement benefits, such as a pension and Social Security.
Both groups have concerns about their retirement portfolio, however they
address them.
On the other end of the spectrum are young people just getting
started in their careers. They may be married or will be shortly. Retire-
ment is many years away. They’re more concerned with building a fam-
ily, buying a house, and all the other trappings of adulthood.
Bears love young people because they can be too aggressive on short-
term goals and step in a bear trap just before they need the money for a
down payment.
STRATEGIES THROUGH THE AGES

Now that we have bracketed the age question, let’s look at specific age
groups and some strategies for avoiding bear bites. The following are good
starting points for you to examine and modify to fit your personal situa-
tion.
First, some of the logic behind the plans. I have built in some gen-
eral assumptions for all categories:
■ You have a moderate tolerance for risk.
■ You are market-neutral, meaning you are neither overly optimistic

nor pessimistic about the direction of the market in the near future.
■ You’re about average in terms of net worth and annual income for
your age group.
■ These strategies are for long-term and major goals; I discuss short-
term strategies in Chapter 14, “Short-Term and Mid-Term Strate-
gies.”
■ Each age group has four models: three for your investment port-
folio and the other for your retirement portfolio, which will be
conservative by definition.
■ The assets are heavily weighted toward mutual funds because I be-
lieve most people don’t have the time, patience, or interest to buy
individual stocks. If you would rather buy individual stocks, use
the fund definitions to guide you toward the correct equities.
■ I include a cash component, which can be a money market ac-
count, money market mutual fund, bank certificate of deposit, or
other instrument.
You can “tune” the plans to be more or less aggressive to your own tastes.
The age groupings are arbitrary; feel free to judge whether you belong in
a higher or lower group depending on your own situation. As we work
through the age groups, I will include any additional information that is
particular to that group but may not apply to all age groups.
This is not an exact science and is subject to much interpretation.
Any two financial advisers might suggest two different plans. Some ad-
visers don’t include a cash component, but I believe people tend to ignore
the need for emergency cash unless you build it into an overall plan.
AGES TWENTY TO THIRTY

This age group is transitioning from young person to young adult. You
are into your first or second real job and are beginning to build a nest and
acquire the trappings of adulthood. There are two important decisions
you need to make immediately:
■ A commitment to fund your retirement from day one on the job
■ A commitment to pay yourself first through an automatic invest-
ing program
These decisions will build habits that, if you stick to them, will almost
guarantee you a nice retirement nest egg and an embarrassingly high net
worth before you reach age 50.
If your employer offers a 401(k) or other similar retirement program,
commit to participating at the maximum or as close to it as possible. If
your employer has a matching program, absolutely participate in the plan
to the limit of the matching dollars. This is the best investment deal you
will ever find that doesn’t involve the risk of jail time.
At the same time, begin an investment program that automatically
deducts a specific amount from your checking account every month and
invests it in a mutual fund. Put $50 a month into a mutual fund and in
30 years you will have over $140,000 (before taxes and assuming the 11
percent historical rate of return by the market). The best part of this is if
you start now, you will never miss the money out of your budget. Every
time you get a raise, bonus, tax refund, or other income boost, put all or
part of it in your investment account.
At this age, you really don’t have to worry too much about bear mar-
kets. You have plenty of time to recover from any downturns. However,
you may want to consider some protection if market or economic condi-
tions look threatening.
Here are some models to fit different investors. Obviously, if you’re
just getting started, it will take a while to put this mix together. How-
ever, if you start early, you could have a large investment and consider-
ably more in your retirement fund. If your employer does not offer a
401(k) or similar program, start an IRA fund and put some extra in your
investment account. Remember, these are just to get you started and are
not written in stone.
The four models suggest a way to allocate your assets based on how
conservative or aggressive (risk-tolerant) you are in investing.
Assets Regular Conservative Aggressive Retirement

Growth fund 20% 15% 30%
Index funds 25% 35% 15% 50%
Aggressive growth 50% 40% 20%
fund
Stocks 15% 25%
Cash 10% 15% 5%
Short-term bonds 30%
Medium-term bonds
Long-term bonds
Total: 100% 100% 100% 100%
The Regular model shows your assets spread over several instruments with
varying degrees of aggressiveness. The idea is to balance your portfolio
with holdings in different asset classes. This is a modestly aggressive
model, appropriate for a young adult with many years of investing to
come.
The Conservative model drops the two most aggressive assets, the
aggressive growth fund and individual stocks, in favor of more money in
cash and a significant investment in short-term bonds. This is a very con-
servative model for a young person, but if it helps you sleep at night, it’s
worth it. The downside is that if inflation returns with higher interest
rates, the bonds will suffer.
The Aggressive model puts 65 percent of its assets into the aggres-
sive growth fund and individual stocks. You could argue that this model
doesn’t go far enough in its aggressiveness. The downside is obvious: A
bear market will eat this portfolio alive.
The Retirement model splits between growth (the aggressive growth
fund and growth fund) and a market-following index fund. Some would
consider this model too conservative for a young person. It is also unlikely
a person in this age range invests just for retirement, but I included it to
give you an idea of how a retirement account might be allocated separate
from other investments.
AGES THIRTY TO FORTY

Many people in this age range are beginning to advance in their career.
They may have a family to support, and their income is increasing. They
may be facing some serious financial goals such as home ownership, be-
ginning a college fund, and so on.
Their investment needs are not very different from the previous
group, but their total investments may be reaching the point where some
protection from bear markets is appropriate.

Index funds 25% 35% 20% 20%
fund
Stocks 15% 25%
Cash 5% 10%
Short-term bonds 35%
Medium-term bonds 15% 20%
Long-term bonds 15%
Total: 100% 100% 100% 100%
The Regular model for this age group spreads out the portfolio over more
assets and is more conservative than the 20 to 30 Regular model. I added
a growth fund and reduced the aggressive growth fund percentage. Stocks
remain the same, but I reduced the cash to reflect a more appropriate per-
centage of the overall portfolio, which should be quite a bit larger than
the previous age group’s total. I have added medium-term bonds, which
are moderately aggressive and may take advantage of falling or stable in-
terest rates.
The Conservative model remains unchanged from the previous age
group. It still reflects the position that a bear market will damage your
growth fund more than the market as a whole. Leaving the growth fund
in the portfolio gives you some upside over the index fund in the event
the bear is weak or doesn’t appear at all.
The Aggressive model reflects a slightly less robust stance by in-
creasing the participation in the index fund and adding long-term bonds
to the mix. The long-term bonds are fairly aggressive—and volatile—in
an environment of changing interest rates. I have eliminated cash from
the portfolio on the theory that you can put it to better use in an aggres-
sive portfolio.
The Retirement model remains conservative; however, I have
dropped the percentage in the aggressive growth fund and added medium-
term bonds for some diversification.
AGES FORTY TO FIFTY

You are entering your years of increasing income and responsibilities at
work and at home—which is good, because the financial pressures are be-
ginning to bear (there’s that pun again) down. Your investment and re-
tirement portfolios may be getting impressive by now if you haven’t been
ravaged by a bear market. If you’ve taken a hit, there’s still time to re-
cover, but your portfolio should probably be getting more conservative
than previous age groups.

Index funds 30% 35% 25% 20%
fund
Stocks 15% 25%
Cash 5% 5%
Short-term bonds 40% 15%
Medium-term bonds 10% 15% 15%
Long-term bonds
Total: 100% 100% 100% 100%
Our Regular model shows a modest shift toward a more conservative pos-
ture. The aggressive growth fund drops and the growth and index funds
increase. I have also increased the medium-term bond percentage. This
portfolio still represents a diversified look at the market but is moving
away from the most aggressive assets and toward those more associated
with the center.
This Conservative model shifts money out of cash and into short-
term bonds. It retains the percentages in the growth and index funds. To
make this model even more conservative, shift more out of the growth
fund and into short-term bonds.
This Aggressive model reflects the need to back off slightly as you
get older. Some might argue that it is still too soon for conservative meas-
ures, but use your own judgment based on your tolerance for risk. This
model differs from the previous age group in that the index fund partici-
pation increases slightly, the aggressive growth fund decreases slightly, and
it moves from the long-term bonds to medium-term bonds.
Our Retirement model continues to move away from the aggressive

growth fund and increases participation in the short-term and medium-
term bonds. We still have some upside potential with the growth and
index funds, while stabilizing the downside with a greater percentage in
bonds.
AGES FIFTY TO SIXTY

This is when most of us get serious about retirement—despite my rec-
ommendation that you get serious at a young age. You’re probably at the
peak of your earning power. You may have kids in college or nearly there.
You still have a mortgage and other expenses, but retirement is beginning
to seem very real.
This is when financial experts advise caution, but there is a danger
of being overly cautious and missing out on needed growth. Your port-
folio is at its largest, and any compounding will produce some significant
increases.
I have added a new asset for this stage, a stock income fund, which
reflects the need for reasonably predictable income in your retirement
account.

Stock income fund 20%
Index funds 30% 25% 25% 20%
Aggressive growth 10% 25%
fund
Stocks 10% 20%
Cash 5% 5%
Short-term bonds 15% 55% 25%
Medium-term bonds 10% 30% 15%
Long-term bonds
Total: 100% 100% 100% 100%
This Regular model reduces your participation in the aggressive growth

fund and stocks, while increasing your exposure in bonds by adding
short-term bonds to the mix. You are still 70 percent invested in equities,
which may seem high to some; make an adjustment if you feel this is too
aggressive for your risk-tolerance level.
This Conservative model shows a strong move away from equities
and into bonds. With 40 percent invested in equities, the portfolio still
has some room for growth, but it’s taking root in bonds for stability and
principal protection.
This Aggressive model keeps you in 70 percent aggressive equities
(contrast with the Regular model where the equity investments are much
more conservative). A 30 percent stake in medium-term bonds provides
some stability, although bonds in this maturity range can be volatile.
This mix for a Retirement fund may surprise some of you who ques-
tion 60 percent in equities. However, if you have a normal life span, you’ll
have another 20 to 30 years of living to finance. The bond investments
should provide some stability and, along with the stock income fund,
some current income for reinvestment. The idea here is to build a posi-
tion in income-producing assets to help with post-retirement expenses.
AGES SIXTY TO SEVENTY

Retirement is at hand! I hope you prepared for it, because it’s tough to
start now. Many people try to get their financial house in order so retire-
ment is less stressful. A good place to start is to look at any outstanding
large obligations. What can you do to get them off your plate? Are you
holding any assets in your investment portfolio with losses? If so, now
might be a good time to cash them in and take a tax loss. Use the pro-
ceeds to pay down or off any major debts.
On or about your sixtieth birthday, you need to figure out what you
need to live on after retirement, even if you plan to work. If you have a de-
fined benefits plan (pension) instead of a 401(k) or similar retirement plan,
visit your pension representative and discuss how much you can expect.
No matter what kind of retirement plan you have, you will soon
be facing some major decisions about its distribution. Tax laws are con-
stantly changing, so talk to an expert in this area to devise a plan.
You are entering a period when you are most vulnerable to a bear at-
tack. Don’t be too cautious; however, remember that you may have to fi-
nance 20 more years of living.

Stock income fund 20%
Growth fund 30% 15% 25% 20%
Index funds 30% 15% 25% 20%
Aggressive growth
fund
Stocks 20%
Cash 5% 5%
Short-term bonds 25% 65% 40%
Medium-term bonds 10% 30%
Long-term bonds
Total: 100% 100% 100% 100%
This Regular investment model takes a defensive stance as you enter the
years just preceding your retirement. You have reduced your exposure to
60 percent equities. Your position in bonds is now 35 percent. If you are
nervous about this model’s aggressiveness, reduce your equities and add
the percentage into bonds.
Your Conservative model continues a shift out of equities and into
bonds. Bonds provide a stability that may be reassuring at this point in
life and probably offer the best protection against a bear market.
This Aggressive model takes you out of the aggressive growth fund
and moves you into a regular growth fund. Even though you still may
want to be in the market, it’s time to take your foot off the gas. You’re still
70 percent invested in equities, but they’re more conservative than previ-
ous age groups.
How you configure your Retirement fund will depend on when and
how much you withdraw. This is one suggestion that keeps you in the
stock market.
This is such a complicated area. You will do yourself a great favor by
hiring a professional to construct a plan for withdrawing money from
your various accounts. I suggest a fee-based financial planner who spe-
cializes in retirement, or a CPA.
AGE SEVENTY-PLUS
From this age on, generalized plans are meaningless. If you haven’t sought
professional counsel before now, please do so soon. There’s no room for
error at this point. A bear market could mean the difference between the
retirement you dreamed of and the retirement from hell.
You worked hard all your life and deserve the best in retirement.
Don’t let a last-minute bear spoil your “golden years.”
CONCLUSION
Constructing model investment and retirement portfolios is an exercise in
suggestions. Temper these suggestions by your tolerance for risk and will-
ingness to monitor your assets.
Five financial professionals can look at the same individual and con-
struct five different plans to protect his or her portfolio from bear mar-
kets. None of them will be necessarily right or wrong, and none of them
can guarantee how they will do in a real bear market. However, if you
don’t make some plans, the bears will eat you alive.
CHAPTER 14
S H O R T- T E R M A N D
MID-TERM
S T R AT E G I E S
A mid-term financial goal, about 5 to 15 years out, is the most dan-

gerous kind for an investor. You may be saving for college or a down
payment on a house, or you may be nearing the end of a longer
process, such as retirement. Short-term goals (one to five years) can
be even more dangerous if you rely on the market to meet your
needs. A bear can jump out of the bushes and attack before you
know what happened, leaving you without enough time to recover.
Here is a real-world example: A nonprofit group received a
gift from the estate of a supporter. The board of directors decided
to use the money to endow a program and placed the money in a
mutual fund. The program could operate from the conservative es-
timate of investment income and the principal would remain intact.
All went well the first year, when the market was healthy, but
in the second year, the board was shocked to learn the principal had
negative growth in a very down market. (Managers use the term
“negative growth” instead of “we lost our shirts.”) The situation
forced the board to raise additional money to continue the pro-
gram. The moral: If you need a certain sum of money relatively
soon, look for alternatives that bears can’t chew.
In Chapter 1, “Bear Markets,” we looked at historical bear markets

and how long they lasted. There is no rule or guideline for how long bears
live; however, we know it can run into the months and years.
SHORT-TERM GOALS: TROUBLE AHEAD

Bears find short-term goals particularly attractive because investors don’t
have time to recover. You need a strategy that will help you reach your
goal and protect the account from a bear market.
You may find yourself in one of two situations:
■ You have the money already, and you need someplace out of harm’s
way to protect it.
■ You don’t have the full sum and need to continue investing to
reach the short-term goal.
The first situation is the easiest since you don’t need to earn any more to
reach your goal. You need a safe place to put the money for a short time.
The second poses a more serious problem: How do you keep building to-
ward your goal and still have some assurance that a bear market isn’t going
to eat your earnings and then some?
Protecting a short-term position is very important. There are nu-
merous examples, including the one at the beginning of this chapter, of
why you can’t afford to take chances with a short-term goal. Never take
for granted that past performance is any indicator of future returns.
Things change and you have to stay informed. You can better meet a pre-
cise financial goal in a short period with a fixed-return instrument.
There is nothing worse than finding out the $20,000 you put into
the market for your daughter’s college tuition is now $16,000. Unfortu-
nately, if you were in the market around the middle of March 2001, that
fund might be even less. You need $20,000 in one year. Where do you
park your money so that you know the full $20,000 will be there? There
are some fairly obvious answers, any of which will work for the short
term:
■ Bank CDs
■ Money market accounts

■ Bonds
S H O R T- T E R M A N D M I D - T E R M S T R A T E G I E S 161
But the nonprofit organization in the example at the beginning of this

chapter needed a certain sum returned from the investment to fund their
program. How do you guarantee a specific amount of income from your
investment? The safest way is to use one of the instruments just described,
with the possible exception of the money market account. You can buy
both CDs and bonds with fixed maturities and interest to match your
needs.
This strategy is simple and straightforward. Best of all, it’s all done
with instruments bears can’t touch. The downside is that if you need the
same amount of return each year, you may find inflation is reducing the
value of your principal and its income. At some point, the bond or CD
will mature, and you will need to reinvest the principal. You may not be
able to get the rate you need in the future. Another problem is CDs lock
up your money. If you need it before maturity, it will likely cost you a
penalty. The market may discount bonds sold before maturity if interest
rates rise.
Still, holding CDs and bonds to maturity ensures that the money
will be there when you need it. Sometimes, safety is more important than
growth. Don’t get greedy with money you know you will need.
Tip
Safety and a high rate of return are mutually exclusive. If you want a
high degree of safety, you must settle for lower returns.
Reaching a short-term goal (fewer than five years) is often more an exer-
cise in saving than investing. In any given short period, you face a real
danger of a bear market or major correction.
A number of sites on the Internet offer calculators to help you de-
termine the best path to reach your goal. For example, if you want to save
$6,000 in two years, a calculator at Bankrate.com shows you that at 5 per-
cent interest, you need to deposit $242.96 a month. If you can find a safe
savings instrument that pays more than 5 percent, the calculator will re-
calculate your needed deposit.
MID-TERM GOALS: NOW COMES THE

HARD PART
Mid-term goals (5 to 10 years) present a special problem. The window of
10 years is more than wide enough to let a bear in, and if that happens,
you’ll have a hard time meeting the goal. You could use the plans I de-
scribed in the previous section, but mid-term goals may be too long for
saving to be efficient. Besides, a long-term goal nearing its end becomes a
mid-term goal by definition. If you are in your 50s, you have a mid-term
goal to reach your retirement target.
In the last chapter, we talked about asset allocation in the context of
age groups. However, you don’t have to be in a particular age group to use
the asset allocation models for the later age groups. For example, if you
have an eight-year-old child and want to provide $15,000 for her college
education, you need to set a target and devise a plan to meet the goal
while protecting yourself from bears.
This problem is going to involve some work to solve. A basic in-
vestment problem has four variables:
■ Amount of time available
■ Amount of money available to invest

■ Rate of return
■ Your tolerance for risk
In our situation, we can’t alter the amount of time in the problem; in fact,
time will be working against us. The amount of money for investment
usually has some practical limits based on the priority of the problem.
The rate of return is what we can get from various instruments and is sub-
ject to change beyond our control. Your tolerance for risk and common
sense will prevent you from attempting an exotic solution.
There are three basic ways to accomplish this goal. (The following
examples ignore taxes, fees, and inflation. Obviously, in real life you can’t
ignore them, but for this exercise let’s put them aside for the sake of sim-
plicity. We will also ignore solutions such as home equity loans or other
types of borrowing.)
■ Use a savings account that pays 5 percent interest and make
monthly deposits. This method has the most chance for success.
Bear markets don’t affect it, and 5 percent is a reasonable savings

rate. Unfortunately, it is also the most expensive: To hit your goal
of $15,000 in 10 years, you need to deposit $96.60 each month.
By the time you reach the $15,000 goal, you’ve put in almost
$11,600. Your money isn’t working very hard for you
■ Use a mutual fund that pays 11 percent and make monthly
deposits. The likelihood of this strategy’s success is questionable.

Finding a mutual fund that pays 11 percent for 10 consecutive
years seems unlikely, but for discussion’s sake, let’s assume one is
available. To reach $15,000 in 10 years at 11 percent, you need to
deposit $69.13 each month for a total of almost $8,300. This is
much more efficient than the savings account.
■ Deposit a lump sum in a mutual fund that pays 11 percent. To
reach your goal of $15,000 in 10 years, you need to deposit

$5,000 in the account. At the end of the 10-year period, you
would be at your $15,000 goal. This is obviously the most effi-
cient, but it’s also the most risky.
Tip
Putting money in a savings account may run counter to all you know
about investing, but some place a higher value on the certainty of sav-
ings accounts than on the need to achieve the maximum return. There’s
nothing wrong with using a savings account when you do so as a con-
scious choice.
You have to navigate a 10-year period without a major setback to meet

your goal. Of these three plans, the first one, employing a simple savings
account, has the most chance for success. It doesn’t worry about bear mar-
kets, and a 5 percent interest rate should not be a problem.
The other two plans rely on a mutual fund (or any other invest-
ment) returning 11 percent each year for 10 years. It certainly has hap-
pened, but I wouldn’t bet my daughter’s college education on escaping a
bear market for that long.
You could look at some other possible investments such as junk
bonds, but they’re even more unpredictable than mutual funds and
stocks. There are also all types of exotic options/futures trading plans.
None of these is suitable for the average investor, and most of them lose
money anyway.
So, a savings account will get us there, but it will cost the most. In-
vesting for 10 years is the least expensive way to reach our goal, but mak-
ing it without a downturn seems improbable. Here are the parameters of
the problem:
Savings Mutual Fund Lump Sum

Cost: $11,600 $8,300 $5,000
Chance of success: Good Questionable Questionable
Chance of bear attack None Good Good
Tip
Even in bear markets, the Internet overflows with get-rich-quick
schemes. Some are complicated hedging plans that the vast majority of
investors should avoid. Others are outright frauds. Don’t let a bear mar-
ket frighten you into trying one of these quick fixes to recoup losses.
SOLUTION A: SAVINGS PLAN

The savings plan works, and only hinges on you finding a savings instru-
ment that pays five percent interest. In the event you cannot find a 5 per-
cent return, you’ll have to add more money into the monthly deposit.
The calculator on Bankrate.com lets you put in a starting balance.
If that 5 percent isn’t available, plug your current balance into the calcu-
lator, and recalculate the number of remaining months and the interest
rate you can secure. The calculator will refigure your monthly deposit
with the new information. For example, say you were able to earn the 5
percent interest for 36 months, but you could only find a 4 percent rate
after that.
Current earnings: $96.60 per month at 5 percent interest for 36
months = $3,759.17.
To reach your $15,000 goal, you will need to increase your monthly
deposit for the remaining seven years to $103.65 at 4 percent interest.
Nothing hard about this solution (if you have the money), and it still keeps
the bears off your back.
SOLUTION B: MUTUAL FUND—MONTHLY

DEPOSITS
This solution works just like the preceding one with the exception that
you face more frequent changes in the rate of return.
Assuming you can start in a normal market, what type of mutual
fund should you use? This is more a question about your investing style
than finding one correct fund to use. In normal markets, several fund
types will get your 11 percent return (and we are assuming it pays a con-
stant 11 percent for the period, which, like I said earlier, is unlikely).
One consideration is an S&P 500 index fund. These funds typi-
cally have very low costs and little in the way of tax implications. These
funds mimic the market index. The S&P 500 is a very broad look at the
market and is not subject to the wild gyrations you see in other indexes.
During market volatility, it will not normally decline as fast or go up as
fast as some of the other indexes (the Nasdaq Composite, for example).
Review the observations in Chapter 12, “Bear-Proof Assets,” on how dif-
ferent products react in different market conditions for hints on which
funds to select.
If you find yourself in a bull market, index funds do quite well. The
Vanguard 500 Index (VFINX) had a spectacular run during the late
1990s bull market before falling into negative numbers in 2000. Catch an
express train like this bull market, and you will have your $15,000 in
fewer than 10 years.
However, if you are starting in a bear market or one is looming, you
need a different strategy. You may want to avoid the market completely
until things settle down—in which case, fall back on the previous savings
plan.
Don’t try to pick the bottom of the market and jump in for the up-
turn. As we have noted earlier, bear markets are notorious for sending out
false signals about rallies. As the Nasdaq Composite began its death spi-
ral in March 2000, where would you have called the bottom? As I am
writing this one year later, the Nasdaq is below 2,000. It has lost over
3,000 points in one year. At every mark along the way, some pundit called
it the bottom. If anyone says, “It just can’t fall any lower,” you know dif-
ferently. Wait until you feel sure the market is on solid ground before
transferring out of savings and into a mutual fund.
Use the Bankrate.com calculator to recalculate your monthly de-
posits after transferring your earnings from savings. At a constant interest
rate, the calculator will give you a new monthly deposit number. Unless
there is a major change in market conditions, I would monitor the fund
weekly and make adjustments quarterly. This is a lot of work, but you
can’t leave the success of this investment to chance. Ten years from now,
you’ll have to write a tuition check, and you need to be sure the money is
there.
SOLUTION C: MUTUAL FUND—LUMP SUM

If you have a lump sum ($5,000 in this example) to invest now, you may
have an easy solution to the problem. As we have seen, this sum will get
you to your goal with an 11 percent annual return. However, if you
wanted to start this solution in March 2001, it would have been hard to
find a fund with a positive rate of return near what you need.
This solution is much like the one above. However, with a lump
sum you have some other safe options. Bonds, for example, don’t neces-
sarily lock you in until maturity, but you can’t be certain what they’ll sell
for on the open market in the future. If interest rates rise, you’ll likely
have to discount the bond to match the yield of newer bonds. Bear mar-
kets accompanied by inflation won’t be kind to bonds. On the other
hand, a bear market during a recession may raise the rate of return on
bonds, as companies have to pay more for debt in uncertain times.
Tip
Bonds can be a great spot for bear-shy investors if you are avoiding the
right kind of bear. However, understanding the bond market is not easy,
and you should consider using a professional.
Bond mutual funds are not good choices for short-term investing any
more than stock funds are. Once the market turns in your favor, you may
want to consider putting the money in over several periods, rather than
dumping it in all at once. This takes advantage of the power of dollar cost
averaging and may give you a better overall yield.
CONCLUSION
Financial goals that fall into the under-10-year range are particularly per-
ilous for investors. History suggests you can expect at least one bear mar-
ket in this period, plus several major corrections.
If you need a specific amount of money by a certain date, you have
to protect it from bear markets. As we saw in Chapter 1, bear markets can
last for months, even years. The recovery usually takes even longer.
Important financial goals demand that you focus on safety as well as
growth.
CHAPTER 15
F AT T E N U P
ON BEAR
Bear markets don’t mean that you can’t look for profits in the mar-
ket. They simply mean that you have to look in different places.
Bears are indiscriminate in their attacks—they take down
healthy stocks along with weak or obese ones, although the healthy
ones will bounce back eventually. If you’re interested in adding to
your portfolio, there just might be some bargains.
However, you need to be very clear on one thing: Just because
a stock is down 75 percent doesn’t mean it’s a bargain—or that it
isn’t going to fall another 15 percent.
IDENTIFYING BARGAIN STOCKS

If you can’t explain in concrete terms why a stock is a bargain, it
probably isn’t one. Investors who just look at the percentage decline
in the stock’s price aren’t asking the big question: What is this stock
worth—not what was it selling for in a hyper-bull market?
You answer that question by doing your homework and thor-
oughly analyzing the business behind the stock. Ultimately, the
soundness of the business creates the perception of value in the
stock.
Caution
A stock that has fallen by 75 percent is not necessarily a bargain. Some
stocks do fall to virtually zero in value. If you don’t believe this can hap-
pen, ask some of the folks holding stock in the “dot.bombs.”
LOOK FOR SIGNS

Bears sometimes attack the whole market and other times individual sec-
tors. The demise of the longest bull market in history began in April
2000, when bears began their sustained attack on Internet/technology
stocks. Like most bears, this one threw off confusing signals. Beleaguered
investors saw every brief rally on the way down as a sign that a firm bot-
tom was in place. Unfortunately, it wasn’t.
When a sector is under attack, few stocks escape. Everything suffers,
whether it was really bear food or not. The whole sector may be under at-
tack, but you are interested in one or a small group of stocks you think
are ultimately sound. Stocks in a sector can ride a bull up with the same
ease that they rode the bear down.
XYZ is a great company with innovative products and a potential
market leader in its sector at some time in the future. Right now, its stock
is enjoying a dizzying ride upon the back of a bull. Watch XYZ’s funda-
mentals on the way down. Are analysts cutting back on earnings projec-
tions? Has the company missed any earnings estimates? After you do your
research, you believe XYZ is worth about $20 per share, even though it
currently trades at $50 per share.
Caution
You can be your own worst advisor. You convince yourself a stock is
going nowhere but up, so you buy at any price. When it starts to fall,
you tell yourself it will surely rebound. When it doesn’t rebound, you
sell at the bottom. Don’t feel bad—professionals do the same thing
sometimes.
The mistake many investors make is to buy the stock on the way up and
sell when it has lost most of its value. If you stick to your analysis, the
FA T T E N U P O N B E A R 171
stock isn’t a buy candidate until it reaches the approximate dollar figure it
is worth. Don’t be dismayed if the stock falls even past the price you set
as reasonable. There’s nothing reasonable about a bear market.
TROUBLE BY ASSOCIATION
Sometimes the only thing wrong with a stock is the company it keeps.
This is especially true when bears are ravaging a market sector. If it even
smells like the sector, the stock may come under attack.
A sound company that has its stock beaten up because it is in the
wrong sector is an excellent candidate for bargain hunters. When the mar-
ket begins its upturn, this company is likely to draw much attention from
investors looking for a solid buy.
DON’T GIVE YOUR HEART AWAY

Bears love lovers of particular stocks. They know if you fall in love with a
stock, you will pay an outrageous price and then hold on until the stock
has betrayed you a dozen times and trades at 10 percent of what you paid.
You will sell in disgust, and the bear wins again.
Always make the stock come to your price. If it doesn’t, move on to
something else. There are well over 8,000 individual stocks; surely one of
them will catch your eye.
STAYING POWER
The bursting Internet/tech stock bubble taught many investors that just
because a company can raise hundreds of millions of dollars doesn’t guar-
antee it will be around in three months. However, there are many
companies—some old, some new—that dominate their markets in a way
that assures continuance for at least the immediate future.
Microsoft, whether you love it or hate it, isn’t going anywhere soon.
Microsoft software is in 95 percent of the personal computers in the
world, and it will stay there until something cataclysmic happens. Will
Microsoft stock return to its previous levels during the raging bull mar-
ket? What is a reasonable price for the stock? After the 2000–2001 melt-
down, the market may have fairly priced the stock for the first time in
years.
Make the buy decision based on the fundamentals of the business

and what you expect from the stock. A bear market can take the hype out
of a stock’s price and make it a good buy.
NOTHING LASTS FOREVER

The last section notwithstanding, just because a company has been dom-
inant in the past is no guarantee it will remain so in the future. U.S. Steel
was once a symbol of America’s industrial prowess. Montgomery Ward
was a retailing powerhouse. Apple Computer held the personal com-
puter market in its hand and let it slip away.
The list goes on and on. Once proud leaders—dissolved, bankrupt,
or buried by competitors—remind us that companies that fail to evolve
and adapt to change are fodder for the scrap heap.
Blue-chip stocks are not immune to bear attacks, and past glories
mean nothing to today’s investors. It isn’t hard to spot companies cling-
ing to outdated business models and pre-Internet strategies. The business
press does a good job of pointing out these companies to the public.
A ROSE BY ANY OTHER NAME

In addition to studying a company’s fundamentals and market position,
you need to anticipate how other investors will view the stock during a
rising market. A stock’s price is driven up or down by investor demand. If
there are more sellers than buyers, the stock’s price will fall no matter what
the fundamentals look like.
Fundamentals may influence investor demand, but emotions can be
even more powerful. The truth of that statement is borne out by the
recently burst Internet/tech stock bubble, where fundamentals were
nonexistent or ignored. The same emotions that inflated the bubble
punctured it. Will other investors see the same rose among the thorns you
see? If not, the stock isn’t going anywhere.
WHAT DO THE ANALYSTS SAY?

Stock analysts for major investment companies follow stocks and report
on them. One of their key tools is estimating future earnings.
Much of this information is available free on the Internet at such

sites as Morningstar.com and MSN MoneyCentral.com. Major compa-
nies may have a significant number of analysts studying the company and
making projections. Projections are very subjective because they call for
an interpretation of future events. It’s common for two analysts to have
very different views on the same company.
One way you can tell if a stock could drop further is to look at the
earnings projections from different analysts. If you see a big gap in the es-
timates, it’s a sure sign the stock has not finished its drop in a bear mar-
ket. Analysts also issue recommendations about whether investors should
buy, hold, or sell a stock. There are variations, but the idea is that a stock
that analysts move from “buy” to “hold” is going to drop.
Tip
The Internet has done wonders to level the playing field for small indi-
vidual investors, but it’s just a matter of following the money to realize
that big institutional investors and wealthy individual investors still get
the best information first.
If more analysts are rating a stock a “buy” than one month ago, you can
also expect a price increase. Likewise, if more analysts are downgrading
from a “buy” to a “hold,” expect further price drops.
DEAD-CAT BOUNCE
A “dead-cat bounce” is one of the false signals bears leave. (Please, no
angry letters from cat lovers—I don’t write the news, I just report it.) This
indelicately phrased phenomenon occurs when a stock has fallen from a
dizzying height, hits bottom, and briefly rallies.
True believers in the stock will see this as a sign of a return to new
heights. Unfortunately, what happens next is not a rally but a continued
slide into the dumps. “Dead-cat” stock doesn’t rebound or stage a sus-
tained rally. If you’re in love with one of these unfortunate stocks, your
hopes for a life together are shattered.
A COMPANY IS NOT ITS STOCK

One company’s stock sells for $125 per share, while another company’s
stock sells for $15 per share. If you asked a group of nonprofessional in-
vestors which company was better, many would pick the $125 per share
company. As consumers from birth, we learn that an item’s quality relates
directly to its price. High-priced items are high-quality items.
But the Internet/tech stock collapse in the spring of 2000 proved
that the quality of a company doesn’t directly drive the stock’s price. A
company’s fundamentals certainly influence investors, but the price of a
stock is ultimately set in the market where many other forces come to bear
(there’s that pun again).
Tip
A company’s stock price may or may not be an accurate reflection of the
company’s value. Stock prices move based on expectations of future
events and whether more investors are positive or negative in those ex-
pectations.
Bulls are as indiscriminate as bears. When the market is super-heated, as

it was in the late 1990s, you find stocks trading in triple digits that weren’t
worth a single-digit price. Internet/tech companies believed they had to
grow very fast to survive and burned through cash like there was no
tomorrow—and for many, there wasn’t.
Don’t confuse a company with its stock price. Bad companies can
have very high-priced stock, and good companies can have lower-priced
stock. When the bubble bursts and the market clears its collective head,
companies with good fundamentals will be popular again. Investors still
smarting from high-priced failure will look for solid investments when
the market begins a recovery.
PROTECTING YOURSELF
As noted earlier, bears are notorious for sending out false signals. Stocks
may rally in what appears to be the end of a bear market, only to fall back
even further.
If you think you’ve found a real bargain, keep the bears from turn-
ing around and biting you by using limit sell orders. These orders become
market orders if the stock’s price falls back to a certain price.
This way of protecting yourself from a stock retreating after a rally
works best for stocks you’re not interested in holding for a long time,
since a volatile stock may drop back far enough to trip the limit sell order.
SHORT-TERM PROFITS
While this borders on speculation, there’s no reason not to take advantage
of a relatively quick profit when you see one.
The stock market is self-correcting which is why there are bull
markets and bear markets. Bears often overcorrect the market, espe-
cially for stocks not particularly overpriced in the beginning. These are
times for profits.
Just because the market has underpriced a stock doesn’t mean you
should buy and hold it in your portfolio. As I emphasized in our previous
discussions on asset allocation, any asset you buy should fulfill a purpose
in your portfolio.
Reaching for quick profits can be risky, so don’t use your retire-
ment money for this purpose. You should also be aware of the tax con-
sequences of quick profits. However, when framed the right way, a
quick profit is a way to raise more cash for those securities you want to
hold.
DON’T LOOK FOR THE BOTTOM

It doesn’t make any sense to wait for the bottom of the market, because
you won’t see it until it has passed. Focus instead on a reasonable price for
the stock: Where do you expect the stock to go?
Bottom feeders seldom find the bottom. They’re just like the folks
who want to sell at the absolute peak. Buy when the stock hits a price sup-
ported by the fundamentals of the business. Sell when you have made
your profit target, or not at all if that is your strategy.
IDENTIFYING BARGAIN MUTUAL FUNDS

Finding bargains among mutual funds is different from “K-Marting”
stocks. When you buy a stock, you should know what you’re buying.
That’s not always the case with mutual funds. Funds may have a name
that suggests one investment model, when they may actually invest in a
whole different class of assets.
Fund managers may have wide latitude in where they place the
fund’s money. They may also use sophisticated investment tools such as
options and futures contracts. This all makes it difficult to understand
when a fund is performing well or poorly. Morningstar.com has a great
deal of information on individual funds, and most of it is free. The Web
site classifies funds by what they actually do with investors’ money rather
than what the fund’s name suggests. This is very helpful in comparing one
fund to other similar funds. They also include an appropriate index com-
parison.
In general terms, stock mutual funds experience net outflows dur-
ing bear markets. This means they are redeeming more shares than in-
vestors are buying new shares. In other words, investors are pulling out of
stock funds. This forces the managers to sell stock shares to cover the re-
demptions. In better times, new money coming in to the fund more than
offsets the redemptions.
Right now, a good question might be: Who is still investing in stock
mutual funds in the middle of a bear market? It’s hard to know exactly,
but a good deal of the money is probably coming from 401(k) and other
retirement plans that automatically invest participants’ contributions. A
bear market may also leave some sectors of the economy relatively un-
touched. Funds that invest in these sectors, such as consumer staples, util-
ities, and so on, may do all right in a bear market.
If money is flowing out of stock funds, what happens to it? Fre-
quently, you can track the money to bond or cash funds and some hybrid
(bonds and stock) funds.
Unfortunately, the same situation with individual stocks afflicts mu-
tual fund investors. They watch the fund drop well below what they paid
before they bail out. When the market comes back, they watch the fund
climb above where they sold and find themselves in the unfortunate posi-
tion of selling low and buying high, which compounds their loss. Unless
you get your money out before the carnage, you may be better off doing
nothing, assuming your time horizon permits a wait for the market’s
return.
WHERE TO FIND BARGAINS

Mutual funds can produce bargains in a bear market, and there are sev-
eral ways to take advantage of them. Use the same caution with mutual
funds that we employed with stocks: Don’t assume that because the fund
has had a huge drop in share price that it is a bargain. The health of the
underlying stocks is more important than other factors we considered for
individual stocks.
For example, investor sentiment has less of an influence on mutual
fund pricing than it does on individual stocks. Individual stocks trade a
fixed number of shares. More buyers than sellers means the price per share
rises; if a stock is hot, buyers drive up the price. If a mutual fund is hot,
new money coming in doesn’t change the share price. The reason is that
mutual funds expand to accommodate as many investors as possible.
There are some limits to how much new money a fund can handle, and
some funds limit the amount of new money.
Caution
Finding bargains in the mutual fund area can be difficult. Other factors
(fees, expenses, taxes, and so on) besides the underlying value of the
fund’s holdings can affect the price per share.
NO PLACE LIKE HOME

If you already own a stock mutual fund, you may not have to look any
further than your own portfolio. Assuming you don’t need the money
immediately, you may want to do nothing.
Research will tell you how the fund did in a normal market (not a
bear or a bull) if the fund is old enough. If you are satisfied that you want
to own the fund under that scenario, you might consider adding more to
the fund on a monthly basis. This puts you in a dollar cost averaging
mode of investing and can be particularly effective in unstable markets.

You don’t worry about where the bottom is because you’re going to keep
investing right through it and into the upturn.
A note of caution: If the fund is tech-laden, don’t expect a big re-
bound when the market turns, and certainly don’t expect it to return to
the glory days of the late 1990s. Stock funds that invested in a broad
cross-section of industries and index funds may be your best bets.
VALUE FUNDS
Value funds are just what the name implies: funds that look for under-
valued stocks. The strategy is to buy cheap and sell expensive as the stocks
move up to a more realistic value.
Value funds do what I suggested investors do with individual stocks.
They will undoubtedly be more efficient, but you always give up some
gain due to mutual fund fees and so on.
Value funds may not perform all that well in the depths of a bear
market, but when the market begins its upturn, expect some handsome
gains.
Tip
If you just can’t decide what to do, you are probably better off doing
nothing. If you can’t stand to watch your funds fall, sell your losers and
put the money in a money-market fund, bond, or other cash instru-
ment.
SECTOR FUNDS
Sector funds invest heavily in particular industries. They should never be
a solo investment, but used in connection with a well-balanced portfolio.
However, during a bear market, sector funds that focus on indus-
tries that aren’t at the top of the bear’s menu may be an appealing buy for
a small portion of your portfolio.
THE BEST DEFENSE IS A GOOD OFFENSE

As I mentioned earlier, a bear market may be a good time to put money
into the market, as opposed to taking it out. By the spring of 2001, in-
vestors considered surviving Internet/tech stocks as values. Intel, Cisco,
and Microsoft had all taken big hits in the bear sell-off, yet these compa-
nies represent the cream of tech stocks. Funds that focus on large cap tech
stocks might be good buys.
It is doubtful these stocks will quickly recover all the ground they
lost, but you don’t care. If the fund buys at depressed prices, the stocks
don’t have to move back to their old highs for a good profit.
Dollar cost averaging into these funds may be a good long-term
strategy for picking up a large number of fund shares at low prices before
the market comes back.
CONCLUSION
Bear markets can be times of great concern for investors. However, there
are always opportunities for profits in any market. Investors need to adjust
their thinking and expectations to deal with bear markets. Most folks
would be happy to come out of a bear market close to even. If you can pick
up some bargains and convert them into profits, you may offset losses in
other areas.
PA R T 5
BEAR DEN
The period beginning when you realize that retirement is not very
far away and continuing into retirement is a dangerous time for in-
vestors. Just when the thought of retreating from the front lines of
employment starts sounding better every day, a bear jumps out of
the woods and takes a bite out of your future income.
Bear markets can strike at any time, and the closer you are to
needing money from your investments, the more your portfolio is
at risk.
As we discussed earlier, pulling out of the market too soon can
also be costly. In this part of the book, we will be looking at spe-
cific strategies for pre-retirement and post-retirement. We will also
discuss some of the “safe” places you can sock away some money.
CHAPTER 16
PRE-RETIREMENT
S T R AT E G I E S
Our parents called retirement the “golden years,” but now we know
them as the “anxiety years.” The reason is that so many retirement
plans tie ultimate benefits to investing decisions made by individual
workers.
As you approach retirement, be aware that you probably need
to make some fundamental changes in your portfolio. With any
luck, you will be able to make these changes in normal market sit-
uations.
DANGEROUS TIMES
Earlier in this book, we talked about the length and recovery of bear
markets reaching back 70-plus years. Those numbers should chill
you to the bone if you are beginning your pre-retirement planning.
A major reversal at the wrong time (assuming there ever is a right
time) can mean the difference between a retirement of fun and re-
laxation and one spent worrying about outliving your money.
Caution
If you have a 20-plus year retirement, it’s almost a certainty that
one or more bear markets will attack your portfolio.
Bear markets do happen, and there’s no way to predict whether they will
be close together or spread out with periods of bull markets in between.
Preparation is your best defense, especially if you start during a normal
market.
PRE-RETIREMENT CHECKLIST
When you start your preparations for retirement is a personal choice, but
I would start within 7 to 10 years of retirement, depending on the cur-
rent market and what the future looks like. This gives you time to slowly
rebalance your portfolio to more accurately reflect your retirement pos-
ture and fill in any holes that may exist.
Here are some points to consider during pre-retirement:
■ If you have an investment portfolio and a retirement portfolio
(and I hope you do), consider them together but with different
roles.
■ Make sure you understand your retirement plan and its with-
drawal rules. Generally, the IRS requires you to begin withdrawals
at a certain age. Since this age is subject to change, your tax pro-
fessional can tell you the rules that apply in your situation. You
also need to understand the distribution options, especially for
pension plans.
■ You may have more than one retirement plan. If you had a 401(k)
or other qualified plan from a previous employer, you probably

rolled it into an IRA when you left. This plan becomes part of the
mix, too.
■ Check with the Social Security Administration for an estimate of
your benefits and any rules that may apply to working after retire-
ment.
■ Consider hiring a financial professional if you don’t already have
professional help.
These are some of the major investment and planning steps you need to
consider. Of course, there are other concerns, such as paying off all or a
substantial portion of any debt, preparing or updating your will, polish-
ing your golf clubs, and so on. Let’s expand on some of those points.
P R E - R E T I R E M E N T S T R AT E G I E S 185
INVESTMENT AND RETIREMENT PORTFOLIOS

If you planned well, you have both an investment portfolio and a retire-
ment portfolio. When it comes to facing a bear market, you may want to
treat these portfolios differently. Bear markets aren’t the only considera-
tion, however. Taxes, both capital gains and income; inflation; and gen-
eral economic instability are forces to contend with also.
Your investment portfolio presents you with some serious tax con-
cerns. If you sell large pieces at a profit for living expenses during a bear
market, you will generate tax bills. Withdrawals from a qualified retire-
ment account generate taxes as ordinary income. You avoid all the capital
gains associated with nonqualified accounts. As I write this, the capital-
gains tax is 20 percent on securities if held for at least one year. If you an-
ticipate a higher income tax bracket than 20 percent after retirement, you
may be better off paying the capital-gains tax. (Of course, if you invested
in a Roth IRA, your withdrawals are tax-free.)
When you do your pre-retirement planning, think about which ac-
counts you withdraw from first. Consult a tax professional before making
any decisions.
Tip
Roth IRAs are a special type of retirement account that lets you put
after-tax dollars in an account that builds tax-free. When you begin
withdrawals, they are also tax-free.
You should also consider the composition of your investment account. If

it contains a significant percentage of growth stocks, a bear market could
inflict heavy damage. The asset-allocation models we looked at in Chap-
ter 13, “Age-Appropriate Strategies,” suggested a move toward more pre-
dictable returns as you approach retirement. However, inflation and the
possibility of another 20-plus years of living expenses after retirement
make a complete retreat from the market unwise.
UNDERSTAND YOUR RETIREMENT PLAN

A cliché I often hear is “Your house is your biggest asset.” That is absolutely
wrong. Your biggest and most important asset is what you’ve put away for
retirement. This asset has to last you for the rest of your life, which, pre-
sumably, you hope is a long time. How you manage it before your actual
retirement will determine how well you will enjoy your “golden years.”
(Manage it poorly and you may find yourself saying, “You want fries with
that burger?”)
Your first step is getting a firm handle on what your particular plan
offers in terms of a payout. Can you roll it into an IRA? What about
dumping a lump sum into an annuity?
Tip
Estimating your income and expenses during retirement is complicated.
Bear markets can throw your estimates off on the income side. Inflation
can play havoc with expense estimates.
The worst thing that can happen is you have to make an uninformed de-
cision at retirement and it costs you a chunk of your nest egg. You should
have an estimated payout a few years before retirement and a well-
designed plan to deal with the proceeds. Your decision should consider all
your assets and how “bear exposed” you are.
There are rules regarding withdrawals that could come into play in
the middle of a bear market if you’re not careful. Tax laws change fre-
quently, so please consult a professional before making any decisions on
your own.
MULTIPLE RETIREMENT PLANS

If you’ve changed jobs a few times in your career, you may have rolled as-
sets from retirement plans into an IRA(s). These need to be a part of your
total retirement plan, with special attention paid to the type of assets you
are holding in the IRA.
Many folks take an aggressive stance with their retirement accounts
because they can avoid the capital-gains tax issues while the assets are in
the account. Remember that bears love growth stocks and funds. Take a
hard look at how much damage you are willing to risk in order to stay in-
vested in the market as an inflation hedge.
CHECK WITH SOCIAL SECURITY

ADMINISTRATION
Before retirement gets too close, check with Social Security on the status
of your account. They can provide you with a statement including an es-
timate of benefits when you retire.
It’s also important to check the accuracy of your report in time to
get something done before you start drawing monthly payments.
HIRE A PROFESSIONAL TO HELP YOU PLAN

Your pre-retirement planning sets up your standard of living for the rest
of your life. When you consider all your assets, even people with modest
incomes may have amassed many hundreds of thousands of dollars in net
worth.
Although this may seem like a large sum of money, it has to last the
rest of your life. Now is not the time to “do it yourself.” Retirement plan-
ning under the best of circumstances is a complicated process. When you
add in the almost certainty of one or more bear markets, it may seem
overwhelming. I feel strongly that you should hire a professional to help
draw up a plan for financing your retirement, someone to look at the
whole picture—not just your investments but other considerations such
as insurance and so on.
Caution
A retirement-planning professional can help you put together a plan
that considers all the variables and outlines a course of action to achieve
your retirement goals.
Ideally, this plan will be in place before you retire so there are no decisions
about pension plan payouts and rollovers. This professional should spe-
cialize in retirement planning and work on a fee-only basis. Many com-
panies that provide investment products will help you with retirement
planning, but I’m not convinced their recommendations always have your
best interests in mind.
A CPA or other financial professional can put together a compre-

hensive plan for your retirement that considers the whole picture. You will
pay several thousand dollars or more depending on how complicated your
situation is, but it will be the best money you ever spent. Express your
concern about bear markets, and the professional will factor it into the
plan.
Don’t cheat yourself out of a hard-earned retirement by guessing
how to organize your assets or letting a bear market take a big percentage
away from you.
DANGEROUS TIMING
You can use your pre-retirement years to get your financial life organized,
so by the time you’re ready for a well-earned permanent vacation, you
won’t have to spend extra time worrying about how to pay for it.
No one plans for a stock market disaster just before retirement, but
it happens. My experience is that planning is very important if you hope
to accomplish a goal, but you need to be flexible enough to adapt to sud-
den and unexpected changes.
Bear markets can play havoc with your pre-retirement planning,
and they almost always come at the worst time. In Chapter 13, we dis-
cussed the process of gradually moving your portfolio from a growth pos-
ture to a more secure posture. This helps you move out of volatile assets
over time and can eliminate some of the concern that you may need to
cash in a mutual fund at the bottom of a bear market.
Think of it as dollar cost averaging in reverse. Dollar cost averaging
directs you to invest a fixed amount every month or so into the market.
You invest regardless of the market’s behavior. You buy more when it is
down and less when it is up. I’m not suggesting you take out a fixed
amount each month and move the proceeds to a more appropriate pre-
retirement asset. I’m suggesting that realigning your portfolio and its pri-
orities should be a gradual process.
On a practical note, cashing out all at once also generates some sig-
nificant tax considerations. Spreading out the redemptions over several
tax years can ease the load.
LOCK IN RETURNS
One benefit of realigning your portfolio in your pre-retirement years is to
lock in returns on part of your assets. These fixed returns will give you a
solid base. Bonds, CDs, money market accounts, and money market
funds can help you do this. Money market accounts and funds are highly
liquid, but their interest rates do fluctuate. Bonds and CDs are not as liq-
uid, but you can lock in a return and feel confident about the security of
your principal.
Bankrate.com is an excellent source for information on interest rates
for various cash instruments. Your CD is as safe in an insured bank across
the country as it is in the bank across town.
BONDS COME IN DIFFERENT FLAVORS

The two main attributes of bonds, fixed return and security of principal,
are important antidotes to bear markets. One reason you use bonds to
protect against a bear market is that they are not subject to market
changes if you don’t plan to trade them.
Trading bonds in the open market subjects them to interest-rate
changes and market-demand influences. If you’re concerned about lock-
ing in a return, stick with individual bonds you plan to hold to maturity.
You can buy bonds in many different denominations and with a variety
of maturities. In the previous section, I talked about realigning your port-
folio gradually. Bonds are ideal candidates for this situation.
For example, say you have $20,000 in a growth mutual fund and
you are 55 years old. You want to take some of the fluctuations out of
your portfolio common to this type of fund, but you want to stay in the
market as long as possible, so the fund can work for you. If you take
$2,000 out of the fund every year and buy a bond with a five- to seven-
year maturity, you have shifted part of your assets out of the bear’s reach
and into an asset that normally has a reasonable return.
Of course, if you see the bear coming, you can accelerate the
process.
THE DOWNSIDE OF INDIVIDUAL BONDS

Buying individual bonds isn’t difficult, but it’s not quite as painless as
buying stocks or mutual funds. You need a broker with experience and
connections in the bond market. Many consumers balk at the often com-
plex pricing and commission schedules of bonds. However, do a little
homework and you should be set.
You don’t have to buy a newly issued bond to meet your maturity
requirements. Your broker will explain how the secondary market prices.
If you want to sell your bond before maturity, you may or may not get a
good price for it depending on interest rates and market demand. Trad-
ing bonds eliminates the stability you need to counteract a bear market.
Caution
Trading bonds removes the stabilizing influence they can have on your
portfolio and puts them in the same category as stocks, subject to mar-
ket variances.
BOND MUTUAL FUNDS

Many investors prefer bond mutual funds to individual bonds. They are
just like stock mutual funds in that they buy and sell bonds looking for a
certain return. The attributes of bonds dictate the structure of the fund.
For example, you can find short-, medium-, and long-maturity bond
funds as well as tax-exempt bond funds.
A large number of bond funds offer a variety of goals and benefits. In
general, bond funds offer more liquidity than individual bonds. However,
bond funds don’t assure you of a rate of return or that your principal will
be intact when you need it (if the bond market sours, bond funds share
price falls). If you want to be sure that a precise sum of money is available
on a certain date, individual bonds held to maturity are the answer.
This is why you use bonds as a hedge against bear markets. Indi-
vidual stocks and mutual funds (stock, bond, or both) can’t make that as-
surance. Bonds give you a firm basis to defend yourself from bear attacks.
Full disclosure: Yes, bonds do default. However, if you use a rep-
utable broker, that risk is almost zero.
THE IMPORTANCE OF CASH

The title of this section may seem a little silly. Of course, cash is impor-
tant. The point goes beyond the obvious to a more practical defense
against bear markets.
Your pre-retirement planning must include an estimate of your
living expenses. What do you need each month to pay for utilities, the
phone, groceries, and the other basics? How much beyond that do you
want to spend on recreational activities?
These two numbers make up your cash needs for retirement. As you
shift assets in the pre-retirement years, make sure you can easily cover the
basics without dipping into your principal if possible. This may help you
weather a bear market without selling assets at a loss after retirement. It is
possible to curtail your recreational activities to avoid selling in a down
market, but it may not be possible to curtail your basic needs.
Tip
Don’t go overboard and put everything in cash. Inflation reduces the
value of cash by raising prices.
Cash gives you the option of avoiding selling assets in a bear market un-
less you absolutely have to cover an unexpected expense.
CONCLUSION
The planning and preparation you do in your pre-retirement years will
determine the quality of your retirement. If you take only one thing away
from this chapter, I hope it is that hiring a retirement-planning profes-
sional is the smartest, and ultimately cheapest, move you can make.
CHAPTER 17
RETIREMENT
PROTECTION
I live where bears (real bears, not market ones) can be a problem.
Most of the incidents occur farther north, but bear sightings and
problems can happen anywhere. I’ve never had a problem with the
bears, but every year, bears ravage campsites, destroy trashcans, and,
occasionally, chew up hikers and hunters. This has given me a
healthy respect for what bears can do.
This is a roundabout way of warning you that investors must
also respect bears—market bears and real ones. Market bears de-
mand the most respect just before and during retirement. The pre-
vious chapter detailed some of the precautions and planning
necessary to prepare your bear defense.
I don’t mean to be an alarmist or to frighten you about bear
markets during your retirement. I do want to help you prepare for
the bear market(s) that will surely come sometime during your re-
tirement. There is no guaranteed bear repellent, and some bears and
accompanying recessions can be so bad that no one will escape un-
harmed. With proper planning, however, you can hope to prevent
serious damage. This section and the rest of the book will help you
formulate your plan.
NO MARGIN FOR ERROR

There I go again, being an alarmist. However, I don’t think I’m overstat-
ing the seriousness of the situation by stressing that a major error during
retirement can change the rest of your life. Do you remember our lady
friend from the first chapter? She didn’t pay attention to her portfolio,
and a bear market took half of it just before her retirement. Would it be
fair to say that event changed her life?
Retirement should be a time when you have options about how you
spend your time and live your life. In the last chapter, I encouraged you
to use a professional planner to help you prepare for retirement. This may
be the most important decision you make in regards to securing a solid
retirement. This book and others like it can only provide general guidance
and information.
Every person’s particular retirement situation is different. A profes-
sional planner can translate the principles discussed here into a real plan
that specifically addresses your needs and concerns. I recommend a fee-
only professional to avoid any undue influence product commissions
might have on a proposed plan.
TWO OPPOSITE PROBLEMS

Ironically, retirees face two opposite choices: being too conservative and
being too aggressive. Either one can cause big problems for your retire-
ment. If you’re too conservative with your investments during retirement,
you risk outliving your money. If you’re too aggressive with your invest-
ments, a bear market may rob you of a substantial portion of your port-
folio. Add to this the problem of having enough but not too much cash,
and it’s easy to understand why professional planners earn their fees.
Tip
The proper balance between a portfolio that is too conservative and one
that is too aggressive is the heart of a retirement plan that takes advan-
tage of continued appreciation with sufficient safeguards.
RETIREMENT PROTECTION 195
TOO CONSERVATIVE
In the previous chapter, I talked about the importance of moving some of
your assets into bonds and/or cash instruments to cover living expenses
during a bear market so you wouldn’t have to sell off assets at depressed
prices. You might be tempted to convert everything to bonds and cash, so
you don’t have to worry about bear markets.
Tempting as this sounds, it has problems of its own. Even if infla-
tion stays at its recent low of about 3 percent a year, that’s enough to erode
your cash stash much quicker than you think. For example, say you con-
vert your assets to cash and invest $500,000 in a fixed-return instrument
like a CD or bond that pays 6 percent per year. You estimate the $30,000
of income each year will be enough to cover expenses.
This seems like a simple plan—except inflation will rob you of 3
percent each year. Instead of $30,000 per year for expenses, you have less
each year in purchasing power. After 10 years, your $30,000 per year will
now only buy just over $22,000 per year in goods and services. Subtract
income taxes and the figure would even be lower.
I chose to use a 6 percent return in this simple example on purpose.
It’s twice the 3 percent inflation rate of the recent past, and it illustrates
that earning even twice the inflation rate isn’t enough to hold off the drain
on your retirement cash.
This is why the Fed and everyone else fears inflation. People on
fixed incomes suffer the most during inflation, and adopting a too-
conservative posture can be devastating. Inflation will eat away at your
earnings, and the only way you can compensate is to reduce spending.
Caution
Inflation, even at a modest rate, can destroy a fixed-income budget over
time. Protection against its effect means leaving at least part of your
portfolio invested as a hedge.
The point is that to stay even, your investments must earn the rate of in-
flation and then some—but protecting yourself from inflation can leave
you open to other problems, not the least of which are bear attacks. In the
past, large cap stocks have proven that they can grow faster than the rate
of inflation. They are also targets of bear markets. During a few days of
wild bear trading in March 2001, the Dow (all large cap stocks) lost over
1,000 points.
AN UNLIKELY FRIEND
Although unlikely, deflation can be your friend in retirement. You’ll re-
member from earlier discussions that deflation occurs when too many
goods are chasing too few dollars. Cash becomes more valuable than
goods and prices fall. People on fixed incomes can do very well in defla-
tion because their fixed income increases in value over time.
Deflation is probably the least likely reason we will have a bear mar-
ket, but events in Japan for the 10 years leading up to early 2001 indicate
it is possible. As I write this, their equivalent of the U.S. Fed is providing
Japan’s banks with zero-interest loans to keep the entire system from col-
lapsing.
Could that happen here? Probably not, but as the world’s economies
grow more entwined through globalization, the possibility exists for mas-
sive economic disruptions.
NO PAIN, NO GAIN
The asset-allocation models we looked at earlier in Chapter 13, “Age-
Appropriate Strategies,” provided for some participation in the stock mar-
ket even after retirement except in the most conservative models.
Unless you have a very large retirement nest egg and very modest
plans after retirement, most of you will still need the growth stocks pro-
vide to see you through. That extra post-retirement growth may make a
big difference in how long your money lasts and how you can spend it.
Without that growth, you may need to work some after retirement
whether you planned to or not.
Those folks with a high aversion to risk might find this necessity
painful. That’s perfectly understandable, but you need to find a way that
is as comfortable as possible to accomplish the goal of continued growth
after retirement.
Tip
Many investors find mutual funds a convenient and safe way to invest
in stocks. Professional managers take on the burden of evaluating indi-
vidual companies as investments.
Mutual funds are the safest way to stay invested in equities. They offer
professional management and most provide a level of diversification indi-
vidual investors can’t achieve. Mutual fund managers should also be bet-
ter prepared in the event of a bear market. Hybrid funds that invest in
stocks and bonds may be a good choice for low-risk investors.
TOO AGGRESSIVE
Investors who are too aggressive after retirement expose themselves to
more risk than is prudent by most standards. These folks often fall into
two groups:
■ Those like our lady friend in Chapter 1, “Bear Markets,” who just
didn’t pay any attention to her portfolio before retirement and lost
a big piece of it in a bear market.
■ Those investors who believe they can jump out of the way (just in
time) of a charging bear.
Their portfolios suffer the same result: They rob themselves of a better life
in retirement.
START PAYING ATTENTION

Investors who don’t pay attention and lose part of their retirement port-
folio to a bear market have no one but themselves to blame. Many re-
sources are available to help you understand the basics of investing,
including books (such as Alpha Teach Yourself Investing in 24 Hours),
Internet sites, and educational programs offered locally in many commu-
nities.
If you have neither the time nor the patience to handle these deci-
sions on your own, consider using the services of a professional. Fee-based
financial planners will help you devise a strategy that you can follow on
your own with periodic updates.
Tip
Financial planners usually carry a professional designation such as CFP
(Certified Financial Planner) or ChFC (Chartered Financial Consul-
tant). These designations mean the planner has fulfilled specialized ed-
ucation requirements and met ethical and professional standards. The
designations don’t necessarily mean they are fee-only.
Some brokerage houses still offer investment services. Check to see if any
of them have offices nearby; they’ll be glad to put together an investment
program that meets your needs and is appropriate for your age group.
You’ll pay fees and/or commissions for these services, but you may sleep
better with someone else making the decisions and keeping an eye on the
progress of the plan.
Investors who don’t pay attention to the market or economy are too
aggressive by default because they set up an investment pattern years ago
and never changed it. Asset allocation and diversification are foreign
terms to these investors. They sail into retirement with their assets in one
or two instruments and with a big “Bite Me” sign on their back. Guess
whom the bear is going after first?
The bear market that ate the Nasdaq in 2000 and 2001 feasted on
investors who put all they had into tech stocks during the late 1990s. For
a while, they looked like market geniuses, until the bear ate them for
lunch. Don’t let your portfolio suffer from lack of attention.
THE MARKET TIMER

The investor who believes he can quickly jump from in front of a charg-
ing bear is practicing market timing. In previous chapters, I made a strong
case for avoiding the practice of market timing—just because you may
have more time in retirement to spend watching every tic of the market
doesn’t mean you will be any more successful than before you retired.
Professionals, who spend their whole life watching the market, can’t
do market timing with consistent success. You can’t either. In fact, spend-
ing your days watching the market’s every gesture may be worse than not
watching it at all. There is too much information coming in at one time
to be meaningful. The microanalysis of the stock market on a minute-by-
minute basis, like you find on cable television and Internet sites, fed the
hysteria that created the Internet/tech bubble in the late 1990s. This same
microanalysis helped fan the panic selling, which began with the tech-rich
Nasdaq in April of 2000 and spread to the rest of the market in early
2001.
Tip
Changing technology and information sources may have long-term in-
fluences on the stock market we haven’t even begun to understand.
Micromanaging your portfolio is no guarantee of success. People who
actively trade run up commission charges and tax bills, often for little
gain.
My grandfather had a saying about spending too much time worrying

about a decision: “You study long, you study wrong.” (I usually heard this
while trying to figure my next move in a game of dominoes with him.) In
the best of worlds, you have a plan in place before the bear attacks, and
you already know the next move. When it comes time to make decisions,
having goals and objectives identified will keep you focused on those areas
of highest priority.
BEND IN THE WIND

I’m sure you’ve heard the old cliché that trees that bend in a windstorm
are more likely to survive than trees that stand rigid. Being flexible in the
face of adversity is important. Have a plan for your retirement nest egg,
because even the best plans can’t allow for every circumstance.
Technology has given us the opportunity to retrieve, analyze, and
act on information almost instantly. Half of all households in America
have a stake in the stock market through direct investing or retirement
plans. This unprecedented set of circumstances may change the way mar-
kets react to major economic events, and we don’t know what those
changes will mean. How will bear markets be different in the future?
What challenges will we face because of this new set of circumstances?
Retirees should be prepared to adjust their plans if a new type of
bear rears its ugly head. Safe havens for investors, which we will discuss
more in the next chapter, may no longer be safe. For example, real estate
is a traditional haven from market woes, yet if deflation becomes a seri-

ous problem, it will be a terrible safety net in a bear market.
What you thought was a fairly conservative investment when you
bought it may have turned into a much more aggressive stock or mutual
fund. Individual stocks are the most likely to change as companies evolve
in the market and take on new directions or drop old product lines. Mu-
tual funds can also change their focus and move from one level of risk to
another.
A helpful tool is the Portfolio Manager on Morningstar.com. You
can create a portfolio of the holdings you question, and the Portfolio
Manager will give you detailed information, including how conservative
or aggressive your holdings are. This is very helpful if you are planning to
rebalance your portfolio and build a bear defense.
OUTLIVE THE BEAR

“The best revenge is a long life.” This proverb could describe a perfect
strategy for dealing with a bear market. One of the ways you can get past
a bear market is to simply outlive it. Of course, you don’t know how long
it will last, so this strategy is not without flaws.
In the previous chapter, I talked about cash and how important it
is in allowing you to avoid drawing down on your principal. This is
where that strategy can work to defeat a bear market. You should have a
“Plan B” that addresses ways to reduce expenses or even increase income
during a bear market. The longer you can avoid cashing in investments
at depressed prices, the longer your investments can continue to work
for you.
Tip
Plan for the possibility that a bear market can be defeated or at least se-
verely wounded by cutting back on expenses to put off cashing in in-
vestments at depressed prices.
With some careful planning and a little luck, you might be able to get
through all but the lengthiest bear markets without cashing in depressed
investments. Even if you eventually have to cash in some investments, a

prudent cash plan can postpone that necessity. The longer you can keep
your investments in the market, the better chance you have that the bear
will die and the market will turn up. You can then sell fewer shares and
raise more cash.
CONCLUSION
You are most vulnerable to bear markets during your retirement years
when you are relying on investment income to pay the bills. Retirees often
live 20-plus years past retirement, which means they will almost cer-
tainly face one or more bear markets. A well-planned retirement that
takes special care to provide adequate cash is your best defense against a
bear market.
CHAPTER 18
S A F E H AV E N S
A friend once explained to me a reaction to Chaos Theory that he

learned in the army:
When in danger,
When in doubt;
Run in circles,
Scream and shout!
The chaos of the stock market can certainly encourage one to fol-
low my friend’s reaction. However, most of us look for more con-
structive ways to deal with the uncertainty of market turmoil.
As I’ve said repeatedly: The most important way you can pro-
tect your assets from bear markets and other nasty surprises is to
have a well-diversified portfolio. Correctly allocating assets relative
to your goals, risk tolerance, and time horizon prepares you for
most of the bad things that happen in the market.
There are times when you need a “safe haven” to ride out a
market storm or take an extra measure of protection for your port-
folio. The term “safe haven” implies someplace you can put assets
with no fear of harm. Unfortunately, “safe” in this case is somewhat
relative. Most truly safe places to put your money always involve
giving up a substantial amount of return in exchange.
Tip
Safety always has a price in the market. Lower returns and growth are
the usual outcome when your primary motivation is safety. There is
nothing wrong with this since the market rewards (and punishes) risk.
This chapter looks at some of the “safe havens” available to investors. You
can use them for a variety of reasons. The most common reason is to
avoid the clutches of a bear market.
BONDS
Bonds are a traditional part of virtually every asset-allocation model. A
bond is simply an I.O.U. or debt from an organization. Various govern-
mental units and corporations issue bonds. They are as safe as the organ-
ization issuing the bond. They provide a measure of stability for your
portfolio’s equities.
One of the safest moves you can make is increasing the bond com-
ponent of your portfolio. We have discussed this in the asset-allocation
discussions. Bonds provide a fixed rate of return and an assurance of prin-
cipal if you hold them to maturity. Along with cash, bonds add a stabi-
lizing influence to your stock portfolio.
Several independent services rate bonds against the possibility of de-
fault. The greater the possibility of default, the higher interest rate the is-
suer must pay.
U.S. TREASURY ISSUES

U.S. Treasury bonds are a great place to park cash until the need to use it
arises. They offer absolute safety and a fixed rate of return and are exempt
from state and local taxes.
However, the low rate of return that accompanies this safety means
you may be essentially parking the money for no return by the time you
factor in taxes and inflation. Bear markets can’t hurt these bonds. The risk
they present is lost opportunity costs associated with not having your as-
sets invested in the market when it returns.
S A F E H AV E N S 205
Lost opportunity costs are the profits you miss because your money
is tied up in a safe but low-return investment. Quality investments will
score significant increases when the market leaves bear country, but you
will miss those gains if your money is tied up elsewhere. That is the “cost”
you pay for safety.
Tip
Treasury bonds are absolutely safe if held to maturity. You will get your
principal back plus interest. This feature is often more important than
high rates of return.
There is some upside to Treasury bonds. If interest rates fall while you are
holding a bond, you may be able to sell it at a premium. This comes in
handy when the danger has passed and you’re ready to move the money
back into the equity market. Of course, the opposite is also true. If inter-
est rates rise while you’re holding the bond, you may have to discount it
on the open market. As you can see, the minute you trade Treasury bonds,
the absolute guarantee disappears. Market conditions may dictate that
you discount the bond to sell it.
If you only need a holding place for a short time, consider one of
the very short (one year and under) maturity Treasury issues. These pay
the lowest interest rate, but you only have to hold them a short time until
maturity to get your full principal back.
U.S. AGENCY BONDS

A number of U.S. government agencies issue bonds to finance a variety of
services, including mortgages and student loans. These bonds usually pay
more than U.S. Treasury issues, but they do not carry the “full faith and
credit” of the U.S. Government. They are only slightly more risky than
Treasury issues. Specific assets like houses back the bonds.
Some of the more familiar U.S. agency bonds include Ginnie Mae
(GNMAs), Fannie Mae (FNMAs), and Freddie Mac (FHLs). These
bonds range in maturity from 1 month to 20 years. You are fairly secure
in using agency bonds as a safe place for hiding from bears. They are ex-
empt from state and local taxes.
Tip
There are special municipal bonds that are tax-free including federal,
state, and local taxes. There are mutual funds that specialize in these
issues.
MUNI’S
State, county, city, and other local agencies issue municipal bonds or
muni’s. Independent services rate the issuers for creditworthiness. Tax rev-
enues and other income sources back these bonds. Municipalities issue
the bonds in large denominations ($5,000 and up).
They are less secure than U.S. Treasury or agency issues, but highly
rated muni’s seldom default. They are exempt from federal income tax.
CORPORATE BONDS
Companies issue bonds to finance business growth, especially new plants
and equipment. Companies sometimes use bonds to finance acquisitions.
Companies may prefer bonds to commercial loans because the company
can structure longer pay-offs and better interest rates.
Independent services rank corporate bond issues also, and the inter-
est rate is determined from the credit rating. Corporate bonds are more
risky than U.S. Treasury bonds because bad economic times can affect the
company’s ability to repay.
If you’re using bonds to cushion your portfolio during bear markets,
corporate bonds may not be the answer. Bear markets in connection with
a recession could put a strain on the company to repay the bonds.
Caution
Corporate bonds that are poorly rated by independent services are not
appropriate when safety is a primary concern.
Safety is a prime concern when investing in bonds, and corporate bonds

are not necessarily the safest haven of all bonds.
BOND MUTUAL FUNDS

There are a number of mutual funds that invest in bonds. You can find
just about any combination of yield and maturity you want in bond
funds, which are easier and usually less expensive to buy than individual
bonds. Professional managers make the decisions for you and follow the
market more closely than you ever could.
You can get started in bond funds for a small initial deposit. Indi-
vidual bonds often require significant sums to buy. You can also con-
tribute small monthly amounts like stock funds, which makes getting into
bonds very convenient.
Bond funds as part of your asset-allocation model make a lot of
sense for all the reasons I just cited. However, if you are very conservative
or absolutely need a certain sum of money at a future date, bond funds
may not be for you. Bond funds trade bonds constantly. When they do,
it opens the fund to the possibility of losses, just like equity funds.
If you buy a one-year, $10,000 U.S. Treasury bond, at the end of
the year you will get your $10,000 back for sure. If you put $10,000
in a bond fund, in one year you may not get $10,000 back when you
need it. Of course, you may get more than $10,000 back if the fund
does well.
That’s the difference between buying and holding a bond to matu-
rity and trading bonds on the open market. Holding a bond to maturity
is a reasonable guarantee that you will get your entire principal. Trading
bonds, whether individually or within a mutual fund, exposes you to the
possibility of loss or gain.
Bond funds work well in your asset-allocation model; however, if
you absolutely need the principal intact, then individual bonds held to
maturity are the answer.
Bonds are an important part of any well-diversified portfolio. You
can accomplish this part of diversification using individual bonds or a
bond mutual fund. When you must protect the principal at all costs, U.S.
Treasury bonds held to maturity are the answer.
REAL ESTATE
Real estate is one of those “hard” assets investors flock to when inflation
threatens. In an inflationary environment, real estate will usually keep
pace.
Investing in real estate is complicated and requires huge amounts of
capital and time. Once you own real estate, it’s hard to get rid of. In the
words of a banker, real estate is an “illiquid” asset, meaning you can’t eas-
ily convert it to cash.
Fortunately, you don’t have to go through all this to own the bene-
fits of real estate. Real estate investment trusts (REITs) and real estate mu-
tual funds are the answer to all the difficulties of owning real estate.
REITS
REITs are a special breed of investment. They are more closely related to
closed-end mutual funds, but they trade like equities on the stock ex-
change.
REITs invest in income-producing properties, such as shopping
centers, apartments, and other commercial real estate. They receive in-
come in the form of rent. Despite their specialized nature, REITs trade on
major stock exchanges. This gives their shares liquidity or the ability of
the owner to convert them to cash easily. Not all REITs trade as freely as
others do. Some may be “thinly traded,” meaning there isn’t much of a
market for the shares. If you want to sell these shares, you might find it
difficult to get a good price—or any price.
REITs are popular during unstable markets when investors are look-
ing for something of value. They did very well in 2000 when every major
index closed down for the year: Periods of uncertainty in the stock mar-
ket drive investors to look for alternative investments, and investors div-
ing for cover from the Internet/tech sector found not only a safe place but
a profitable one. However, real estate is not immune from the problems
of recession and will drop in value like everything else.
REITs often act differently than equities during a turbulent market
and may move in opposite directions. Their income derives from rents
paid by tenants in the properties they own. Regular companies, on the
other hand, sell products and services for their income. REITs must pay
out 90 percent of their income, which means a steady flow of income to

shareholders.
Tip
REITs that specialize in particular types of investments give you the op-
portunity to pick the type of property that seems poised for the greatest
growth.
Deflation will be bad news for REITs, as will a rapidly rising market. De-
flation causes prices to drop as money becomes scarce. A rapidly rising
market presents too many other good opportunities, so investors dump
REITs in favor of growth stocks.
REAL ESTATE MUTUAL FUNDS

Another way to get into real estate is through mutual funds that invest in
REITs. The main advantage to investing through a fund rather than di-
rectly into the REIT is liquidity.
With mutual funds, liquidity is not the problem it can be with
thinly traded REITs. In addition, you get all the other benefits of mu-
tual funds: professional managers and diversification.
Before you add REITs or real estate mutual funds to your portfolio,
take a close look at any value funds you own. Value funds sometimes pick
up REITs in their investments. You may already have coverage of real es-
tate in your existing funds. You will probably have to ask for the fund’s
holdings, since funds report real estate investments in the “finance” sec-
tion on most services. Contact the fund for more information.
Caution
Many financial advisors suggest you put a small portion of your port-
folio in foreign stocks, since they may not follow U.S. markets into the
teeth of a bear. Buying individual foreign stocks is getting easier, but I
recommend beginning investors stick with mutual funds that invest in
foreign economies.
INTERNATIONAL FUNDS
Although it may strike some as odd that investors would look overseas for
protection against a bear market in the U.S., that is exactly what some ad-
visors do recommend.
Globalization is blurring the economic lines between national
economies. However, overseas markets are rapidly developing markets
with much room for future growth. You may be better off with a fund
that targets medium to small foreign firms. Large multinational compa-
nies tend to move together.
International funds may provide some relief during turbulent do-
mestic markets. I would not classify them as “safe havens” per se, just
alternatives during down U.S. markets. Even then, I would not let inter-
national funds exceed 5 to 10 percent of your portfolio. While individu-
als can buy shares of stock in foreign companies, I believe most investors
are better off turning those decisions over to professional managers of mu-
tual funds.
INVESTING IN SECTORS
As we saw earlier, some sectors do better than others in a bear market.
These sectors may not have the glamour of the Internet/tech arena, but
they turn in steady performances in almost any market or economic con-
ditions.
The following sectors offer some protection from bears in certain
circumstances. You should consider mutual funds that follow these sectors
volatile and probably not long-term investments but rather brief retreats.
Individual stocks in these sectors require careful analysis to make sure they
will follow sector trends.
Caution
Investing in economic sectors can be risky since you are not taking ad-
vantage of diversification. However, for a small part of your portfolio,
they can provide a hedge against losses in the broad market for a lim-
ited time.
FINANCE
Falling interest rates usually help the finance sector by stimulating activ-
ity in home building and other credit-intensive activities.
Banks and other institutions that lend money do better in an envi-
ronment of lowering interest rates, which might occur when the Fed tries
to head off a recession. However, the financial sector may not benefit
from falling interest rates if consumers are concerned about an economic
slowdown.
UTILITIES
Utilities are favorite hiding places for many investors. They are tradition-
ally very conservative investments that find their way into many retire-
ment portfolios. Investors like them for their higher than average
dividends, which have more value in a falling market with falling interest
rates.
Not all utilities are equal—or managed well, for that matter. Dereg-
ulation and heavy debts from replacing aging facilities have strained some
utilities. Utilities in California suffered disastrous consequences of a mis-
guided deregulation that they themselves pushed for in early 2001.
The lesson is to pick wisely. A mutual fund that specializes in utili-
ties may be a good bet, although the dividend issue is a problem.
CONSUMER STAPLES
Consumer staples include items like food and basic necessities. This sec-
tor is one of the most unglamorous, yet it keeps moving forward even in
the midst of a bear market. Economic downturns have little effect on this
sector since people still need to eat and wear clothes. Earnings may not
grow at a fast rate, but this sector is a favorite safe haven for many bear-
market veterans.
Tip
Consumer staples are the bread and butter (pardon the pun) of many
conservative asset-allocation models. Companies in this sector don’t
show rapid growth or super increases in earnings.
This is not a sector to stay with for the long term. When the economy
picks up, these stocks are not going to grow much faster than during a re-
cession. (People probably don’t eat a lot more in an expanding economy).
Investors often dump these funds in favor of growth-oriented invest-
ments.
HEALTHCARE
Healthcare is another favorite of investors during bear markets and reces-
sion. HMOs and drug companies are among the companies represented
in this sector. Even in a down economy, people still get sick and buy drugs
or go to the hospital.
This sector has a little more upside than consumer staples, thanks to
increases in elective procedures (laser eye surgery and hair transplants, for
example).
PRECIOUS METALS
Precious metals are a traditional hiding place from inflation. Along with
real estate, precious metals were the weapon of choice in the 1970s and
1980s when inflation was high.
These stocks and funds have long been out of favor, thanks to an ef-
fective lid on inflation. You can be sure, however, that if inflation mounts
a serious threat, investors will run to gold.
Caution
Some bear market funds use shorting as their primary investment
model. When the market is sliding into a bottomless pit, these funds do
very well. However, when the market turns they may find themselves
scrambling to stay alive. Approach with caution.
BEAR MARKET FUNDS

The most direct response to a bear market is to invest in mutual funds de-
signed to profit from it. These funds come in several forms; however, they
basically bet against the market by shorting growth stocks and stock in-
dexes that will probably decline in a bear market.
Most of these funds are only a few years old and have no real track
record to analyze. Most did well in 2000 and the beginning of 2001. You
don’t want to hold these funds when the market turns. They suffered mas-
sive losses during the bull market of the late 1990s.
These funds, especially those that try to achieve an inverse return of
major indexes, are for short-term buys at best. When the market turns up,
you’ll want out of these funds fast. Unfortunately, you won’t know when
the market is truly turning up or just blipping before falling some more.
MARKET NEUTRAL FUNDS

The idea sounds great: Create a fund balanced in such a way that it prof-
its regardless of whether the market is rising or falling. The fund invests in
undervalued stocks and short overvalued stocks, and, no matter which way
the market moves, the fund should achieve a target growth rate.
Unfortunately, practice and theory often produce different results.
Few of the market neutral funds have performed up to expectations.
They require accurate and timely predictions of which stocks may
go up and which stocks may go down. This is not foolproof by any
means: Any fund that consistently requires managers to know which
stocks are going up and down will have a hard time succeeding.
BALANCED FUNDS
Balanced or hybrid funds help you address the ratio of stocks to bonds in
a single fund. These funds vary the ratio of stocks to bonds, so you can
find one that is more conservative than another one.
One way to judge balanced funds is to look at some of the older
ones and see how they fared in unstable markets of the past.
CONCLUSION
You can look at a number of alternatives when faced with a bear market
that might help you weather the downturn. If you’re young and have a
long time horizon, you may be better off just riding it out. On the other
hand, you may not want to sit passively when there are investment vehi-
cles that might ease the pain.
Whatever measures you decide on, don’t get completely out of the
market. When the market turns up, you won’t know it right away and will
miss the early gains, which can be substantial.
PA R T 6
BEARSKIN RUG
Bears are dangerous because they are cunning and can move quickly.
Your best defense against a bear market is preparing your portfolio in
advance. This means you diversify your assets across stocks, bonds,
and cash. This multi-pronged defense works on the theory that dif-
ferent assets move in opposite directions in certain market condi-
tions.
Asset allocation addresses the proportions of each asset rela-
tive to your risk tolerance, time horizon, and financial goal.
Dollar cost averaging is a way to counterattack the bear market.
It’s the most effective tool the average investor can use.
CHAPTER 19
YOUR BEST BEAR

S T R AT E G I E S
Is a “buy-and-hold” strategy always the best answer in a bear mar-

ket? Can dollar cost averaging really let you invest your way through
a bear market? What other strategies can you use to survive a bear
market?
I wish there were a better answer than “it depends.” Of course,
if the answer were simple, you wouldn’t need this book! No pat an-
swers will fit every investor in every down market. The number of
variables is dramatic, and some of them are subjective and don’t eas-
ily lend themselves to obvious answers.
In this chapter, I am going to look at some of the strategies I
have mentioned in previous chapters. The idea is to help you come
up with a strategy that fits your particular situation. You’re more
likely to follow a strategy consistently if you worked it out yourself
than if you simply follow directions you don’t really understand or
believe.
BUY-AND-HOLD
The buy-and-hold strategy is almost carved in stone by some in-
vestors. It certainly has its strengths, but it has some flaws that you
need to know about.
A long-term strategy works best when followed as your base invest-

ing philosophy. This means you don’t deviate from buy-and-hold without
a very good reason. The strength of this strategy is that it keeps you in the
market through the good times and the bad. Overall, you are better off
invested than not.
On the other hand, buy-and-hold can be a disaster if you’re in the
wrong investment. Your money is not working for you if it is sitting in
some stock or mutual fund that is going nowhere.
Here’s a look at some of the positive and negative aspects of the buy-
and-hold strategy.
BUY-AND-HOLD: PRO
The buy-and-hold strategy is one that many, if not most, investment pro-
fessionals believe best suits the average investor. Some Wall Street tycoons
have built their fortunes on this strategy.
The underlying reasoning of buy-and-hold is that over time you are
better off invested in the stock market than not. This means you will do
better if you put your money in and leave it because, over time, the stock
market has been the most consistent investment you could make.
Two key elements make buy-and-hold work for you: a long-term
view and quality investments. Actually, there is a third key element: the
resolve to stick with the strategy when the market heads south. These el-
ements work with the market’s strengths to make your money work hard
for you. Let’s look at each one.
LONG-TERM VIEW
Although it went out of style during the 1990’s bull market, the stock
market has always been about long-term investing. The market works the
most consistently over the long term.
Plenty of statistics reflect this positive aspect. One of my favorites is
the fact that you can pick any 20-year period in the market’s history, in-
cluding the Great Depression, and “the market” has never lost a dime.
(This statistic is through 1998.) It didn’t matter where you got into the
market as long as you stayed for 20 years. This points out the great
Y O U R B E S T B E A R S T R AT E G I E S 219
strength the market has as a long-term investment. (I’m sure you can see
some holes in this argument; however, I’ll discuss those when I look at the
weaknesses of buy-and-hold.)
Investors almost worship Warren Buffett as an investing guru.
He identifies hidden jewels and buys them before the market discovers
the stock and bids up the price. An interviewer asked the legendary in-
vestor how long was the proper holding period for an investment. Mr.
Buffett answered, “Forever.” Mr. Buffett made his fortune buying dia-
monds in the rough: companies that showed signs of future greatness
and that the market undervalued. They became industry leaders and
made Mr. Buffett a very wealthy man. (Of course, Mr. Buffett didn’t
hold every stock he bought forever, and this points out the other weak-
ness of the buy-and-hold strategy. I’ll talk about that more later, too.)
When you buy and hold a good stock for an extended period, you
allow the company to grow at a natural pace. If you pick industry leaders
as Mr. Buffett did, the effect of compounding growth is what makes buy
and hold so potent. Great companies re-invest all or a substantial part of
their earnings back into the company in the early years to finance growth.
The market favors large companies. Over time, the large companies dom-
inate their markets. This domination allows the company to make even
more profits. A long period allows companies to grow and acquire mar-
ket share. It lets them open new markets. Coca-Cola, one of Mr. Buffett’s
early successes, has huge operations outside the United States. According
to Morningstar.com, 62 percent of the company’s revenues come from
operations outside North America.
GREAT COMPANIES
Investing in great companies is a key part of the buy-and-hold strategy.
Great companies may stumble, but they do not fall. They lead markets
out of bear territory. They continue to grow and innovate. They take ad-
vantage of market opportunities for new revenue sources. They forge
alliances with strategic partners and swallow up competitors. Great com-
panies open new markets overseas and domestically. They discontinue or
sell off unprofitable ventures.
Tip
Great companies are not as easy to spot as you might think. Sometimes
they are in very unglamorous industries and are overlooked by active in-
vestors.
If you buy and hold great companies, you will profit from their continu-
ing success. Even when they fall on hard times, they eventually work their
way out of trouble.
BRANDING
Another benefit time buys companies is branding. Branding is the process
of establishing a company’s presence in the market. Branding makes Mc-
Donald’s, IBM, and Coca-Cola household words not just in the United
States, but around the world.
The dot.coms of the 1990s spent billions of dollars trying to build
“brands.” Some of them, like Amazon.com and Yahoo!, were successful,
but the vast majority were not. Many of the New Economy order dis-
missed old brand identities as passé and not of great value. After the
Internet/tech market flamed out, companies with a pre-Internet brand
have done much better than the pure dot.coms.
What is a brand worth during a bear market? There’s no easy an-
swer, but we do know that investors are likely to stick close to companies
they know.
MARKET TIMING
I have discussed in some detail the dangers of trying to time the market,
which is impossible to repeat with any consistency. Another way to “time
the market” is by staying invested. This keeps you in the market and
means you will catch the first up-ticks of recovery.
Many recoveries make their biggest moves in the first 5 to 10 days.
If you miss these days, you will miss the first burst of moves upward and
reduce your overall gain. Investors who try to catch the first part of a re-
covery often miss it completely or mistake a “dead-cat bounce” for the
recovery.
BUY-AND-HOLD: CON
The buy-and-hold strategy is widely accepted and praised as the best tool
for individuals to accumulate wealth in the stock market. Investing in
great companies for the long term is a sound strategy. However, there are
some potentially dangerous flaws in the buy-and-hold strategy:
■ The first and foremost potential flaw is the notion that individu-
als will consistently pick “great” companies.

■ The second flaw is the notion of committing to the long-term
hold. A commitment to a long-term hold can blind you to changes
in the investment, market, and/or economy.
■ Finally, the strategy relies on the investor remaining calm during a
bear market and not selling in a panic to save something from the
investment.
THE “GREAT” COMPANY FLAW

Every investor wants to invest in great companies. However, Mr. Buffett
and other value investors didn’t invest in companies that appeared “great”
to the market.
Value investors look for companies undervalued by the market for
reasons that have nothing to do with the fundamental soundness of the
business. Many investors today associate high P/E ratios with greatness in
a company. (Actually, all the P/E ratio shows is how expensive a stock is
relative to the company’s earnings.) I am very sure Coca-Cola didn’t have
a P/E ratio of 100 when Mr. Buffett began buying shares. Whatever it was
selling for at the time, Mr. Buffett saw a bargain and the potential of
something much greater.
Caution
It is difficult to make a profit buying a stock at or near its historic high,
even if you hold it for a long time.
One of the “great” companies of the 1990s bull market had a P/E of over
100 for several years and over 180 for one year. If you invested in this
company at that level, you faced a rude awakening when the stock fell
from a high of 82 to a low of 18. Even then, it still had a P/E of 46. How
long is it going to take this “great” company to recover what it lost for in-
vestors? Is this stock a good buy now with a P/E of only 46?
There are only two ways a P/E can go down: The price of the stock
has to fall, and/or the earnings have to increase. If this stock continues to
fall and it manages to get earnings up, what is a good P/E to trigger a buy
signal?
These are not fair questions because you need to know so much
more about the company before you consider buying. Value investors
never buy on just low P/E alone. Sometimes, a low P/E means the mar-
ket is fairly valuing the stock.
THE “GREAT” COMPANY MYTH

The other problem with buying and holding “great” companies is they
may not always be great companies. As I noted earlier, “great” companies
that lost that mantle litter our history.
Caution
Don’t assume that a “great” company today will be a “great” company
tomorrow. Things change and companies that don’t change with the
times are lost.
U.S. Steel still dominates the domestic steel industry, but there’s not
much left to dominate. Foreign competitors with significantly lower costs
have eaten into the steel industry. It could barely muster $6 billion in sales
in the 2000–2001 trailing 12-month period, compared to almost $24 bil-
lion for Microsoft in the same period.
Montgomery Ward, once a powerful retailer, filed for bankruptcy in
2000. The list goes on and on of once mighty companies reduced to sec-
ondary roles at best.
Things change and companies that can’t change and profit from the
change won’t remain “great” companies for long.
THE LONG-TERM FLAW

The strong buy-and-hold followers suggest that once you buy that great
stock, you should put the certificates in a deposit box and forget about
them for 20 years or more. The problem is, just because you buy a truly
great company at a great price and it remains a great company, that
doesn’t mean it’s the best you could do with the money.
Great companies (and even not so great companies) can be down for
15 years and still turn a positive return to the 20-year holder. The prob-
lem is the lost opportunity costs of having your money in a nonproduc-
ing asset for many years when you could put it somewhere it will make
money now.
Plain English
Opportunity costs are those profits you lost because your money was
in a nonproductive asset instead of one making you money.
This doesn’t mean you have to become a day trader or a speculator. You
can set price targets for your investments that they may reach in a short
period or over a longer time span.
I discussed this strategy earlier. Some professionals suggest you have
a price you want to sell at when you buy the stock. This strategy also has
its flaws; for example, hitting your target may mean selling just as the
stock was preparing to rise sharply.
COURAGE TO HANG ON
The buy-and-hold strategy requires a lot of courage: to sit tight through
a tough bear market and watch your stock drop like a rock.
This may be the weakest link in the strategy. Investors without the
necessary resolve often hold on as long as they can, then give up just when
the investment has hit the bottom.
The unfortunate consequence is the investor has sold low and will
probably have to pay more to get back in the market later.
THE BUY-AND-HOLD BOTTOM LINE

Despite its flaws, the buy-and-hold strategy offers individual investors the
opportunity to achieve significant earnings over time. It does not guaran-
tee you will make a profit or not lose money.
Buying wisely and having the courage to hang on through tough
times is important to make the strategy work. Buy-and-hold will not turn
a turkey into an eagle.
One danger of the strategy is a strict adherence no matter what.
That doesn’t make sense. Hold on if the stock drops but nothing has fun-
damentally changed about the company, but if the “great” company loses
its greatness, move on to some other stock.
PRICE FOLLOWERS
A strategy that might be called the opposite, although not an exact oppo-
site, of the buy-and-hold adherents is focused on hitting certain stock
prices to drive buy and sell actions.
Caution
Don’t fall into the trap of buying on price alone. Just because a stock is
down significantly doesn’t mean it’s a bargain.
These folks study a stock and arrive at a price they believe is a fair market
value for the stock. They don’t buy until they get that price. At the same
time, they set a selling goal. Once the stock hits this mark, they either sell
or put in escalating sell limit orders to protect the price.
This strategy has two premises: The first is that the way to build
a portfolio is to never take a big loss. The second is that once a stock
reaches a certain price, the market has overvalued it and you should sell
before the market corrects the price (the price falls).
There is no arbitrary hold time on the stock. You act when the stock
hits the appropriate price. This tends to take some of the emotion out of
the process.
PRICE - SETTING: PROS

This strategy has an almost mechanical quality about it, since you oper-
ate with an established plan from the beginning. There is no emotion in
the decision to buy or to sell.
If you cut your losses before they get too big, you preserve capital
for other investments. Allowing your profits to rise until a certain retreat
(say a 10 percent drop in price) puts no limits on your potential return.
This conservative strategy is happy with small losses and slightly
larger gains.
PRICE - SETTING: CONS

Like all strategies, this one has some flaws. Moving in and out of stocks
on minor price changes may knock you off a stock before you are ready.
This strategy is even more dependent on careful analysis than the
buy-and-hold plan. You need the ability to determine a fair market price
for the stock and a reasonable level to take profits. You are more likely to
get big swings in price in the short run. These swings might cause you to
sell too early or buy too high.
For example, if you won’t accept a drop of more than 10 percent of
the stock’s price, you may sell prematurely. Volatile stocks may move that
much and more in a single trading session.
Tip
Be sure you know how to use stops, stop limit orders, and other price-
sensitive controls on your trading account before you make a mistake.
You could take a 10 percent loss on a stock, only to watch it turn around
to take off without you. Practitioners of this strategy point out that it is
also possible that 10 percent dip may turn into a 25 percent or more drop,
which could take years to recover.
Another significant negative is the taxes and commissions you
might incur with active trading. Any stock sold for a profit in less than
one year faces ordinary income tax rates for your tax bracket.
DOLLAR COST AVERAGING

Should you dollar-cost-average your way through a bear market? It’s ar-
guable, but for the average investor (as opposed to the professional) it’s
still one of the best tools for building wealth in the stock market.
A key to this strategy is picking the right vehicle and, for most in-
vestors, dollar cost averaging is more convenient to use with mutual
funds, which can automatically deduct a certain amount out of your
checking account each month.
Tip
Many mutual funds will dramatically lower the initial deposit if you
agree to let them debit your bank account by a fixed amount each
month.
Many independent Web sites rank mutual funds (I believe Morningstar.

com is the best). It is easy to see how the fund is doing compared to an
appropriate index or peer group with Morningstar.com tools. As long as
the fund doesn’t fundamentally change, stick with it through the down
times when you are buying more shares with your fixed monthly deposit.
When the fund begins to rise, you are still there to participate in the
growth. Trying to jump in and out of markets is too risky for most people.
TIME STRATEGY
Time is your investment’s best friend. Time is why buy-and-hold works.
Time will cover many investing mistakes.
The best thing you can do for yourself is start now, today, if you’re
not already an investor. If you start early enough (and there’s no such
thing as too early), you can make several mistakes along the way and still
end up with a sizable nest egg at retirement.
Time defeats bear markets, too. Even though in the middle of one
it may not seem like it, bear markets will pass. You want to be there when
it happens and enjoy the upturn.
CONCLUSION
No single strategy is perfect or works for everyone. As you gain experience
as an investor, adopt a strategy or devise one of your own. Whatever you
decide, it needs to make sense to you and meet some basic investing
guidelines. This strategy will carry you through bear markets with much
less anxiety.
CHAPTER 20
DIVERSIFY OR DIE
Diversification is the process of spreading your assets over a num-

ber of different asset classes and different maturities to prevent a
portfolio overloaded in one area from dragging down all of your
holdings.
Unfortunately, diversification is not nearly as sexy as investing
in Internet/tech stocks. You won’t hear many people standing
around the water cooler bragging about fine-tuning their portfolio
by adding an international stock fund. I haven’t seen any reports on
how many people took money out of other investments to dump it
into the Internet/tech craze of the late 1990s, but I’ll bet there were
a lot of them.
If you had a well-diversified portfolio going into the hottest
part of the bull market, you didn’t do as well as those folks who
rolled the dice on Internet/tech stocks. It would have been difficult
to not make money during that feeding frenzy.
Caution
Many investors who made money early in the 1990s bull market
confuse luck with success. When the market began to unravel,
luck was not enough to keep their heads above water.
What a difference a year makes in your perspective. The Nasdaq is down

over 60 percent, and the Dow and S&P 500 have suffered significant
blows. All of this happened in a year beginning in April 2000. The person
with the well-diversified portfolio probably had a good run during the bull
market, but their return looked anemic compared to the Internet/tech
investor.
In previous chapters, we discussed diversification and asset alloca-
tion as ways to defend against a bear market. In this chapter, we are going
to spend additional time on diversification. Specifically, we’ll look at how
you can classify a number of different assets and suggest how they may or
may not fit into your portfolio. Think of them as pieces of a puzzle that
has no single solution. You can put them together in many different ways
to achieve your goal.
In the next chapter, we will look at using these pieces in defining the
asset-allocation model that is right for you.
PUZZLE PIECES: STOCKS

Diversification is the process of spreading your assets over different types
and maturities of investments. Asset allocation is precisely defining what
proportion each asset represents in your portfolio.
Another way to think of diversification is like the ingredients in a
recipe: eggs, milk, sugar, flour, and so on. Asset allocation is the recipe it-
self: two eggs, one cup of milk, a cup of flour, and so on.
Some folks treat diversification and asset allocation as two terms
with the same meaning. Even though I draw a distinction, it’s just for clar-
ification. You may read information on diversification that sounds just
like what I call asset allocation. Don’t be put off by the semantics. It’s the
process that’s important, not what I call it.
Tip
Classifying stocks by a single system makes it easier to compare similar
issues when looking for an investment.
DIVERSIFY OR DIE 231
When we looked at asset allocation in earlier chapters, it was in the con-

text of stocks, bonds, and cash (either individual instruments or mutual
funds). We talked about them in some broad terms, like large cap,
growth, value, and so on.
Stocks don’t lend themselves to easy classification, but a number of
Web sites do this for you. Using their system, you can discover whether
a stock fits a growth or aggressive model. My favorite system is from
Morningstar.com. It classifies stocks into eight types based on financial
measures of growth, profitability, and so on. You can use their system to
help identify components of your asset-allocation model. If you’re look-
ing for an aggressive growth stock, Morningstar will help you identify
those stocks that fit that type, then you can choose the stock that best
fits your needs from a much smaller subset than the whole market.
If you don’t have Internet access at home, try your public library.
Most libraries offer free access to the Internet and may have personnel to
help you get started. For those readers without access to the Internet, here
are some definitions that will roughly track with some of Morningstar’s
stock types. My definitions are helpful, but Morningstar’s are much more
precise and worth the effort to research potential stock buys.
Tip
If you haven’t taken the plunge into the Internet, I strongly encourage
you to. It’s not as expensive or complicated as you might think. You
don’t have to trade online, and the access to free information is un-
believable. I can’t imagine today’s investor buying and selling without
access to Internet research.
AGGRESSIVE GROWTH STOCKS

These companies exhibit rapid growth in sales and—hopefully—earnings
over an extended period. Many people considered the new Internet/tech
stocks aggressive growth, but most of these wonders failed the earnings
test. Without earnings, you’re still dealing with a company in the startup
mode.
Many aggressive growth stocks don’t pay dividends; instead, they

push profits back into the company to finance more growth. These com-
panies can put up big growth numbers and impressive increases in stock
prices, but they are also very sensitive to economic slowdowns.
If an aggressive growth company issues a warning that they won’t hit
revenue or earning projections, investors are likely to dump them. Con-
sequently, aggressive growth stocks tend to be volatile. Often these stocks
lead the market into a bear and lead the market out. Look for growth rates
in excess of 20 percent in revenues and a strong quarter-to-quarter in-
crease in earnings. Be very careful that these stocks don’t dominate your
portfolio after a big run-up in the market.
GROWTH STOCKS
Much lower numbers in revenue growth distinguish growth stocks from
aggressive growth. However, growth stocks can be cash machines with
earnings that are rising at a good clip. These companies are established
and confident in their place in the economy. They pay out more of their
earnings in the form of dividends (or stock buy-backs) than aggressive
growth firms do.
Tip
You can’t afford to not have some part of your portfolio in growth as-
sets. You have little opportunity to participate in an upward movement
in the market without growth stocks or mutual funds.
Growth stocks are a key part of any diversification strategy with the ex-
ception of the radically conservative. They still have growth potential, but
are less likely to exhibit wild swings in price.
As growth firms mature, they show slower and slower growth, but
they may pay out increasingly high dividends. Folks who can use current
income (retirees, for example) and some stability of price favor these
stocks. Their steady dividends help offset a decline in price during a bear
market. The company isn’t likely to grow significantly, but it’s steadiness
is ideal for investors who want some security of principal and income.
HARD ASSET STOCKS

This type corresponds directly to the Morningstar stock type. These com-
panies are involved in such enterprises as the following:
■ Mining, especially precious metals
■ Real estate
■ Timber
Stock in these companies typically represents a hedge against inflation

since they tend to move differently from the market. You might consider
a hard asset stock as a temporary hedge; however, they are not exempt
from the effects of recession.
VALUE STOCKS
Value stocks represent potential bargains in the market. They represent
companies that are, for some reason, out of favor with the market.
The companies may be distressed or just in industries that don’t have
the growth potential of other sectors. Distressed companies may be
turnaround possibilities or just poorly run firms that are going nowhere
fast.
Caution
Some stocks are values because the company is a loser. Buying cheap
doesn’t mean the stock will automatically rise at some point. More cheap
stocks stay that way than rise to new highs.
The market undervalues value stocks. A low P/E relative to the rest of the
market or industry peers is one sign of a value stock. Value stocks can oc-
cupy a small part of the aggressive side of your asset-allocation model.
They are aggressive because there is a chance the stock will not move up
during a bull market, and you will lose the opportunity for growth.
Value stocks don’t do much for your diversification goal. You want
components of your portfolio to move when other parts are not. Value
stocks seldom react strongly to the market.
THE BOTTOM LINE ON STOCKS

Using a consistent system for identifying stock types is a good way to fill
in your asset-allocation model with the proper asset. Morningstar.com’s
stock types are comprehensive tools that can help you compare stocks
using the same criteria.
Tip
In the interest of complete disclosure, I have no financial interest in
Morningstar.com, and they in no way compensate me for my opinions.
PUZZLE PIECES: MUTUAL FUNDS

Mutual funds are even harder to classify for the do-it-yourself investor un-
less you have access to the Internet. The major problem with mutual
funds is that their name may or may not say something about how and
where they invest your funds. When you are filling in an asset-allocation
model and need an aggressive growth fund, it doesn’t help to find out the
fund you picked routinely keeps 30 percent of its investments in cash. Al-
though you may find the reading difficult, it is always a good idea to read
a fund’s prospectus regarding investment strategies and goals. Ultimately,
you define a mutual fund by where it invests your money, regardless of
what the fund names itself.
Morningstar.com has an extremely helpful system for classifying
mutual funds. They classify every individual stock by a number of finan-
cial ratios such as growth, value, and so on; look at which stocks the mu-
tual fund buys; and, from this mix, determine where the fund belongs in
its classification system. Morningstar also ranks funds by growth types,
risk, and a number of other categories. The site also allows you to look at
the individual stocks in each fund to make sure you are not buying two
funds with essentially the same companies.
Many mutual-fund holders found themselves in this fix when the
Nasdaq took its 2000–2001 dive. Investors discovered that they owned
several funds that were each heavy in the same Internet/tech stocks. This
defeats the whole purpose of diversification.
Tip
Mutual funds offer many investors the best way to participate in the
market because they can turn most of the decision-making over to pro-
fessionals.
Another great piece of information on mutual funds is how much they have
invested in various economic sectors and a rating on how well they might
hold up in a bear market. If you don’t have access to Morningstar.com or
some other free Internet-based service that classifies mutual funds, I would
suggest you use a broker that can get this information for you. Without this
information, you may or may not accomplish the goal of diversification—
you won’t know for sure until it is too late and the market punishes you.
PUZZLE PIECES: BONDS

You cannot consider your portfolio diversified without some bonds in the
mix. You can use individual bonds or a bond mutual fund to meet this
goal. Bonds add stability to your portfolio by fixing a return (for individ-
ual bonds) and often moving in different directions from the equities
markets.
Investors use bonds in diversification to offset some of the instabil-
ity in stocks. Bonds react to economic changes (interest-rate changes, in
particular), but there seldom are the massive sell-offs that mark the stock
market during a bear attack.
Investors caught in the frenzy of a charging bull market may be
tempted to pull money out of bonds and put it where the growth poten-
tial is much higher. This defeats the purpose of diversification and, if a
bear market catches you with your diversification pants down, could cost
you dearly for the opportunity.
Tip
If you feel yourself being caught up in the buying frenzy of a bear mar-
ket, cut yourself off from the media hype for 48 hours. Don’t watch tel-
evision or listen to radio reports about the market. Stay off the Internet
and avoid magazines with raging bulls on the cover. Out of the hype-
storm, you may feel differently about that stock you just couldn’t live
without two days ago.
STICK WITH YOUR PLAN

The purpose of diversification is to achieve reasonable gains in the current
market, while protecting your portfolio during a bear attack. Had a bear
attacked one asset in the original model shown above, the investor would
not have suffered near the loss chasing the fast dollars of runaway tech
stocks. Taking cash out of other assets and putting it in the tech stocks
compounded the mistake. That action alone caused the notion of diver-
sification to vanish. The higher the tech stocks went, the worse the model
became out of balance.
It’s hard to resist the temptation to jump on the express train to
wealth that a red-hot sector looks to be. How embarrassing is the water
cooler talk when your associates find out you aren’t dumping everything
you own into the “sure-thing du jour”?
Maintaining diversification and fine-tuning it with asset allocation
requires discipline and a commitment to long-term success. If you must
speculate, do so outside your normal investment and retirement accounts.
However, consider this: The $10,000 you lose speculating would
have grown to over $89,000 in 20 years if your portfolio earns 11 percent
(not counting taxes). Of course, you aren’t going to lose are you?
Caution
Built into the collective consciousness of our society is a fascination with
getting something for nothing or making a financial killing with no ef-
fort. That’s not investing—that’s the lottery.
Those investors who watched the Internet/tech skyrocket in the late

1990s understand how hard it was to not jump into that market with
both feet. There were investors who did just that and sold off enough to
get their money back and then some before the bubble burst. Yet, these
folks were in the minority. With stocks going from nothing to triple dig-
its almost overnight, it was difficult to convince yourself to stay diversi-
fied, especially when other sectors were flat or down.
Bear markets have voracious appetites. They enjoy nothing better
than a good feeding of wealth. As we discussed earlier, the bear market in
the Nasdaq of 2000–2001 (and counting) ate well over $2 trillion in
wealth. That wealth is gone, and it won’t come back. The surviving com-
panies may rebuild some of that wealth, but it will take much longer than
in the bull market preceding the fall. A well-diversified portfolio main-
tained a significantly higher value than the Internet/tech stock domi-
nated accounts.
Of course, the story of the bear that ate the Nasdaq isn’t just about
out-of-whack portfolios. It’s a larger tragedy of investors who only in-
vested in the Internet/tech-stock boom. While the media (both Internet
and traditional) have to take some blame for the superhype surrounding
the market, no one pointed a gun at investors and made them buy tech.
WHY SLOW AND STEADY WINS THE RACE

I could make a lot more money writing books with titles like Become a Mil-
lionaire in 30 Days Trading Penny Stocks with Borrowed Money. Of course,
if I could actually do that, why would I want to write a book about it?
Tip
Focusing on a diversified portfolio is the best way to keep common
sense in your investing. You will thank yourself in 20 years when your
portfolio has continued to grow year after year.
Investing is not a get-rich-quick scheme, but that’s just what it became at

the height of the Internet/tech-stock boom. The daytraders and IPO
hawks filled the media with stories of easy money that was lying around
waiting for you to grab.
Quick profits are a powerful narcotic. Even after the massive sell-off
in Internet/tech stocks, investors are still looking for the good old days of
triple digit Nasdaq gains. One mutual-fund official told me that even
though their tech fund was down 70 percent and still falling in March
2001, people were putting new money into the fund. His sense was that
at least some of these investors expected the sector to shoot back up any
time and resume its climb to 10,000.
That may or may not happen. While the die-hard tech investor is
still waiting for the market to come back, the slow-and-steady investor
with a well-diversified portfolio continues to make money month after
month.
IT TAKES COURAGE TO STAY DIVERSIFIED

The hardest thing an investor can face is a charging bear. The second
hardest thing is a bull charging away from you. Both situations require
courage to stay diversified. Unfortunately, the common reaction to either
situation is to jettison the diversified portfolio in favor of a pure defensive
strategy or an offensive charge to catch up with the bull.
Even if investors don’t lose complete control, there is a tendency to
overreact to rapidly changing market conditions. You may want to dump
anything aggressive in your portfolio in favor of bonds or cash. If you
have a diversified portfolio, you won’t have a huge position in aggressive
assets, with the possible exception of very young investors.
When a bear market heads your way, reexamine your portfolio to
make sure you know all your aggressive positions (no unknown aggressive
asset buried in mutual funds). Unless you have a high aversion to risk,
keep your portfolio balanced with some aggressive assets (growth stocks,
mutual funds, and so on).
When the market turns around, it will almost certainly be the
growth stocks that lead you out of the bear’s mouth. If you’re completely
defensive, there won’t be anything in your portfolio to catch the bull mar-
ket on the way up. This puts you in the unfortunate position of trying to
catch the train after it has left the station. Since we already established
that you can’t call the market bottom, you will miss the upturn until it’s
well on its way.
Remain in your diversified portfolio and you have a better chance
at weathering the bear market and catching the upturn quickly.
CONCLUSION
Diversification means you may not profit to the fullest in certain bull
markets. It also means you may not lose to the fullest in bear markets.
Maintaining a well-diversified market takes some effort, since major
market moves can unbalance your portfolio. It takes courage to stay di-
versified when jumping into a hot sector seems like such easy money.
However, in the end, you’ll come out ahead with a steady return.
CHAPTER 21
YOUR WEAPON
OF CHOICE
I hope by now I have convinced you that there are only two real
weapons you can use to defend your portfolio from a bear attack:
diversification and asset allocation.
Asset allocation is a way to target the precise defense you need.
However, no matter how hard we try, some bears are just too pow-
erful. Bears reinforced by recession, deflation, or inflation can be
formidable enemies. When faced with this much strength, the best
we can hope for is to keep damage to a minimum. It may not be
much consolation to know that your portfolio is only down 20 per-
cent while the market is off 40 percent. However, you have cut your
potential loss in half, and that’s worth celebrating.
Using diversification, you spread your assets over the market
spectrum of conservative to aggressive. Asset allocation defines the
specific amount of each asset as percentage of your total portfolio.
MONITORING ALLOCATION
It doesn’t do much good to set up your asset-allocation model to
protect your portfolio from bears if it becomes out of balance
thanks to a large movement in the market.
Tip
It is important to stay on top of your asset-allocation model. If it be-
comes unbalanced, you have defeated the purpose.
Many folks during the bull market of the late 1990s may have had 10 per-
cent of their portfolio in Internet/tech stocks before the explosion. When
the dust settled, the tech sector of their asset-allocation model had in-
creased to 30-plus percent. The huge run-up in tech stocks increased the
total portfolio. However, when combined with taking money out of some
other assets and putting more into tech, those stocks dominated the port-
folio.
Here is what the model looked like originally, during the bull mar-
ket, and after the crash.
Bull Market After the

Assets Original Model Run-Up Bear Bites
Tech stocks $10,000 10% $43,000 34% $5,000 6%
Other asset $20,000 20% $18,000 14% $17,000 21%
Other asset $20,000 20% $18,000 14% $15,000 19%
Other asset $20,000 20% $18,000 14% $13,000 16%
Other asset $20,000 20% $18,000 14% $17,000 21%
Other asset $10,000 10% $10,000 8% $8,000 10%
Total: $100,000 100% $125,000 100% $81,000 100%
As you can see, the choice to take money out of other assets proved
to be very unwise. When the bottom fell out of tech stocks, the port-
folio was devastated. What should the investor have done to prevent this
disaster?
The choices weren’t popular during the middle of the tech-stock
boom. To bring the asset-allocation model back into balance, the investor
must sell off tech stocks and redistribute the cash to other assets or add
more money to other assets so the percentages got back in line. This
would undoubtedly create some significant tax bills, and you may not
have extra cash lying around to add funds to the other assets.
YOUR WEAPON OF CHOICE 241
Tip
You should always be mindful of the tax consequences in selling invest-
ments. However, don’t let tax concerns stop you from taking actions to
protect your portfolio.
Some investors who knew they were violating their asset-allocation model
told themselves they would ride the Internet/tech stock boom until it re-
versed itself. They would sell for a fat profit, then wait until the tech
stocks bottomed out and use some of the profits to pick up bargains
among the devastated tech stocks.
A nice plan, however, investors in the middle of a boom might not
give up so easily. They might convince themselves that every dip was
merely a correction, and the stock would soon begin soaring to previous
heights and more.
HARD CHOICES
Rebalancing your portfolio can be painful when one part is on a hot
streak. Our natural tendency is to let profits run, but if you’re truly con-
cerned about protecting your portfolio, you will make the hard decisions.
Another solution for our hypothetical portfolio above is to follow a sim-
ple rule: Never reduce a position in one asset to increase a position in an-
other asset just to take advantage of a hot market.
Caution
Selling assets to put the proceeds in a hot sector is gambling at best and
dangerous at worst. Should a bear attack that sector, you will likely suf-
fer major losses.
Obviously, as your goals and time horizon change, you will change as-
sets and percentages of other assets. Just don’t engage in this activity to
put more money in a hot sector. These have a tendency to cool off—
sometimes quite rapidly. Let’s look at the portfolio after the bull market
run-up.
Assets Bull Market Run-Up

Tech stocks $43,000 34%
Other asset $18,000 14%
Total: $125,000 100%
This is a disaster waiting to happen. Our investor’s first mistake was to

pull money out of the other assets to add to the tech-stock sector.
The first thing he needs to do is cash in enough tech stock to get the
other assets back up to their original levels ($2,000 from four assets for
$8,000). Now the portfolio looks like this:
Assets Bull Market Run-Up

Tech stocks $35,000 28%
Total: $125,000 100%
This looks better, but the tech stocks are still dominating the portfolio. In
an almost perfect world, the investor would continue making the hard
choices, reduce his tech stocks back to 10 percent of the portfolio, and re-
distribute the proceeds to the other assets.
Assets Original Model Bull Market Run-Up

Tech stocks $10,000 10% $12,500 10%
Other asset $20,000 20% $25,000 20%
Other asset $20,000 20% $25,000 20%
Other asset $20,000 20% $25,000 20%
Other asset $20,000 20% $25,000 20%
Other asset $10,000 10% $12,500 10%
Total: $100,000 100% $125,000 100%
Now, when the bear attacks (and note that all assets are hit by the bear)
the results are not nearly so bad.
Bull Market After the

Assets Original Model Run-Up Bear Bites
Tech stocks $10,000 10% $12,500 10% $1,786 2%
Other asset $20,000 20% $25,000 20% $21,250 24%
Other asset $20,000 20% $25,000 20% $18,750 21%
Other asset $20,000 20% $25,000 20% $16,250 18%
Other asset $20,000 20% $25,000 20% $21,250 24%
Other asset $10,000 10% $12,500 10% $10,000 11%
Total: $100,000 100% $125,000 100% $89,286 100%
The portfolio is still out of balance, but no single asset dominates it.
When I applied the same percentage reductions in all assets, the loss in
tech stocks did not have the dollar impact as when it dominated the port-
folio. This maneuver saved the investor over $9,000 in losses, and all the
assets except tech stocks are close to their original allocations.
Obviously, this is just an example of one strategy you could em-
ploy. Unfortunately, it requires the courage to sell off the tech stocks just
when they’re booming. This proved the correct strategy, but if the bull
had continued for another six months, the investor would have missed
even higher gains.
This bear launched an across-the-board attack and the portfolio
didn’t have a cash component, which would have offered another strategy.
Tip
It is not wise to hide all your assets in cash accounts, because there will
be nothing to take advantage of the market when it begins to rise out of
a bear.
The investor could have sold off the tech stock like before, but instead of
putting the money back into the other assets, he could have kept it in
cash. In this bear market, that would have been the best solution. Every-
one is a great investor when looking backward. The trick is to protect
yourself going forward.
ANOTHER SOLUTION
If you simply can’t stand to cash in a winning investment like the tech
stocks in the previous section, there is another alternative. It also requires
discipline and some attention to the market.
The first task is to sell off some tech stocks and return the other as-
sets to their full funding. The next step is one you take in your head. Take
all the gains out of the tech-stock sector of your asset-allocation plan.
Mentally, you have rebalanced your portfolio, and you have a sum of
money tied up in tech stocks that sits outside your portfolio.
If these are individual stocks, consider trading tools to protect your
profit. You can use a “stop limit order” to set a price below the current
price. If the stock falls to this point, the order becomes a market order,
and the system automatically sells the stock.
Tip
Protecting profits is not the same as market timing when done with a
commitment to sell upon a specific retreat in price. This is letting the
market time itself.
Should the stock(s) keep rising, you can raise your stop limit order ac-
cordingly. One way to visualize this process is to think of a ladder with
rungs going up and down. As the stocks rise, you follow up the ladder
with new stop limit orders.
That ladder might look like this:
ORIGINAL COST OF STOCK: $10 PER SHARE—1,000 SHARES

Price of Stock Stop Limit Order
$20 $16
$24 $18
$30 $25
$35 $28
$42 $32
In this example, you will notice that there is an increasing spread between
the stop limit order and the price of the stock. There are two reasons for
this:
■ First, at the lower price, the stock doesn’t have to move much to
take away your profit.

■ Second, as the stock gets more expensive, it will likely become
more volatile on daily trading. A lower stop limit order keeps you
in the stock through corrections and still protects your profit.
This system requires you to keep a close eye on the market and move your
stop limit orders up as necessary. However, you should never lower the
stop limit order. When you do this, you are trying to time the market and
could easily watch your profit disappear. Some investors use a percentage
to figure their stop limit order. Either way, you are using logic and reason
to set the price as opposed to hope and emotion.
Using stop limit orders is a way to let the market time itself. You are
not attempting to call a market turn. You are setting a price and letting
the market come to that price or move away from it. When the market
backs up and you’re cashed out of the tech stocks, take the cash and ei-
ther reinvest per your asset-allocation model or put it in a cash instrument
if you believe a bear market is lurking.
WHAT ABOUT MUTUAL FUNDS?

If all or a major part of your portfolio is in mutual funds, you face a dif-
ferent set of challenges. Regular mutual funds don’t post intra-day prices
like individual stocks. Mutual funds are “marked to the market” after
trading on the stock exchanges has closed.
The share price, also known as net asset value (NAV), is a reflection
of the performance of the fund’s individual investments. After the market
is closed, the fund readjusts the NAV to reflect the new individual values
of its holdings. If you want to use the strategy of protecting your profits,
you will need to watch the fund’s NAV every day. Unlike stocks, there are
no stop limit orders for mutual funds.
You can only tell the fund or broker that you want to redeem X dol-
lars out of the account. Check the fund’s prospectus for rules regarding re-
demptions relative to the market’s close. This shouldn’t be a real problem,
just an inconvenience. Since mutual funds are by definition diversified

(with the exception of some sector and index funds), they will usually not
move in large increments from day to day. You need to set a share price
that will be your sell order. When the fund hits that price or is close and
moving in a downward direction, redeem your shares.
Tip
Mutual funds are slightly harder to work with because you only get fresh
pricing once a day. Usually, this is not a problem because mutual funds
don’t often move in big steps one way or the other.
Unfortunately, this system relies on your attention to the share price, un-
like the strategy for stocks that use orders that execute automatically when
the stock hits your stop limit order price. I suggest you write the price on
a piece of paper and keep it where it will remind you to check the NAV.
If you are riding a bull market up, you can change your sell price as often
as necessary.
REBALANCING SCHEDULE
How often should you rebalance your portfolio? I would check it every
month or so during a normal market and more frequently when the mar-
ket is moving strongly in one direction or the other. It’s probably not nec-
essary to rebalance if one or more assets are only a few points off target.
However, watch for bracket creep if one sector is growing faster than the
rest of the market.
If there are signs of economic slowdowns or bear markets in the
near future, reevaluate your portfolio to see if you want to take a more
conservative stance until the uncertainty is over. In Chapter 13, “Age-
Appropriate Strategies,” I discussed the components of conservative asset-
allocation models. Your two most important conservative or defensive
tools are cash and bonds. Inflation on the horizon signals interest rate in-
creases, which aren’t going to be good to bonds. Cash will be a better
choice. A looming recession means interest rates are likely to drop, which
will help bonds and not cash.
Caution
Keep an eye on the Fed through the media for hints of whether interest
rates are likely to go up, stay the same, or go down.
Avoid making major shifts in your portfolio in response to possible eco-

nomic or market problems. Your portfolio should stay balanced regardless
of bulls or bears.
USE OF CASH
I believe cash should be a part of your asset-allocation model, although
you will undoubtedly see articles on asset allocation that don’t mention
cash. There are reasons for eliminating cash from the model, one of the
most common being that cash instruments (CDs, money market ac-
counts, money market mutual funds, and so on) are savings vehicles, not
investments. Rather than quibble, I would simply point out that cash in
a money market mutual fund earning 5 percent looked pretty good in the
bear-ravaged early months of 2001.
Opponents might argue that bonds and bond mutual funds can ac-
complish many of the same tasks as cash. I would beg to differ. Bonds
may not sell at par (face) value on the open market if interest rates have
risen. Bond mutual funds can actually lose part of your principal.
Neither of these is true of cash. Cash is always quickly convertible
to other assets, while the same isn’t necessarily true.
In the previous section, we looked at what happens when a major
market move unbalances your asset-allocation model. A possible solution
was to sell off the inflated tech stock sector and put the proceeds into cash
instruments. Hiding in cash is not always the best answer. The biggest
downside is that when the market turns, you are not in a position to take
advantage of the earliest moves.
IRRATIONAL EXPECTATIONS
One of the biggest obstacles to accepting the structured approach to in-
vesting that asset allocation imposes is the irrational expectation still
smoldering after the Internet/tech-stock bull market. The frenzy built up
around the Nasdaq was just short of a riot. Unbelievable gains became be-
lievable and even expected. If the Nasdaq Composite didn’t post a triple
digit gain, pundits considered it a down market.
These expectations have long lives, even after the bull became ham-
burger. Investors are always looking to the unknown future. Could we see
a return of the wild bull market in tech stocks? No one knows for sure,
but that won’t stop the true believers from loading up on downtrodden
tech stocks in anticipation of a renewed buying frenzy.
Biotech stocks were once the objects of these same irrational
expectations. Investors bid the stocks up, then when products and prof-
its appeared to be years away, the market cooled and the sector col-
lapsed. I am sure there are some folks who loaded up on these stocks
hoping for a return to the center ring. One day, the market may prove
them right.
Tip
Investors should not write off the Internet/tech stocks because of the
2000–2001 bear market. Survivors may be good buys now that the bear
has punctured the hype.
The Internet/tech companies that survived the shakeout are not going
away. They will continue to play a major role in our economy for years to
come. Will they ever return to the boom days of the 1990s? No one
knows for sure. However, I wouldn’t dismiss the industry leaders. They
will likely lead the way out of bear markets for several years to come.
ASSET-ALLOCATION TOOLS
As I noted earlier, I find the information and tools on Morningstar.com
to be top rate for free services. In this final section, I want to introduce
you to two tools that can be extremely helpful in guarding your portfo-
lio from a bear attack, help you decide which mutual funds fit your asset-
allocation model, and help you judge the likelihood of a portfolio’s
success.
PORTFOLIO ALLOCATOR
Morningstar’s Portfolio Allocator is a tool that helps you decide which
stocks and funds should go into your asset-allocation model. You set up
the criteria for your model and the Portfolio Allocator suggest different
mutual funds that might fit your model. These are funds selected from
small groups of funds that Morningstar’s analysts have studied in detail.
If you want the Portfolio Allocator to include individual stocks, you
must manually enter them yourself. The Allocator looks at all the possi-
bilities and reports the best combinations. The Allocator isn’t giving ad-
vice, it is simply recommending a mix based on your input. The ultimate
responsibility is yours.
Tip
The Internet has many good tools to help you with your investing ques-
tions and problems; however, always consider the source of the infor-
mation before acting on it.
This tool is a very helpful starting place if you are a beginner in asset al-
location. Don’t use it as a recommendation service. It works by giving you
a starting place, which is sometimes the hardest part.
THE GOAL PLANNER

Morningstar’s Goal Planner is a helpful tool that estimates the chances of
success in reaching a financial goal. You can enter your portfolio and the
parameters of the goal (time to goal, amount, and so on). The Goal Plan-
ner shows you a graphic that plots the chances of your portfolio’s success.
The Goal Planner will also take a financial goal and let you adjust the per-
centages of cash, bonds, large cap stock, small cap stock, and foreign
stock.
The tool uses a sliding graphic that allows you to adjust the per-
centages, and you can see the results (chance of success) on a chart. This
is very helpful in understanding how the mix of assets changes the
chances of success. Obviously, this tool can’t predict the future, but it does
give you a very educated guess at what results your portfolio might
achieve in the future.
CONCLUSION
Asset allocation is your weapon of choice in defending your portfolio
against bear attacks. Monitoring your allocation can force you into some
hard choices when your portfolio needs rebalancing. Selling winners is
often painful; however, leaving your portfolio out of balance is extremely
dangerous. Bears love to attack undefended portfolios.
Rebalancing your portfolio after a strong market movement is nec-
essary for it own protection. Check your portfolio once a month or more
if the market is unstable. There are numerous tools on the Internet to help
you establish an asset-allocation model and maintain its balance.
CONCLUSION
Now that you’ve worked your way through this book, I’m sure
you’re feeling supremely confident about handling any market
emergency. Right?
Of course you’re not. Wrestling with bear markets and a tum-
bling economy is unnerving at best and terrifying at worse.
However, there are steps—and now you know them—you can
take to prevent the market from washing your portfolio wherever
the bear wants to take it. The two words to keep repeating are: asset
allocation.
This strategy prepares your portfolio to deal with the curve
balls bear markets can throw. Will it guarantee you won’t lose
money? No, but it will give you a fighting chance to ride out a bear
market with much less damage than a randomly constructed basket
of investments. Ask anyone who had 40 percent of their portfolio
in Internet/tech stocks what a bear market can do in a short period.
(Maybe you were one of the victims.)
Asset allocation aims for the best return in today’s market with
reasonable protection against bear attacks. The key features you
need to remember about bear-proofing your investments are …
■ You must diversify your portfolio across stocks, bonds, and
cash.
■ How you determine the proportions for each asset depends
on your time horizon, risk tolerance, and financial goal.
■ In most cases, it doesn’t make much difference if you use
individual instruments or mutual funds to fill your asset-
allocation model.
■ There are signals that warn of upcoming economic and market

turmoil.
■ Investing always involves an element of risk. This is the question
you must ask: “Is the potential reward worth the amount of risk
involved?”
■ Market timing is a dangerous and, ultimately, a losing game. Pro-
fessionals can’t do it and neither can you.

■ A lot gets written about when to buy which stocks and mutual
funds, but knowing when to sell is equally important.

■ The underlying economic conditions (recession, inflation, or de-
flation) change the characteristics of bear markets and how you

handle them.
■ Bear markets can dramatically change retirement plans. Extra care
is required when you approach or enter retirement to guard against
bear attacks.
■ There are definite signs that can tell you the difference between a
bargain and a turkey investment in a bear market.
■ Dollar cost averaging is the most effective investment tool most in-
vestors can use. It works in bear and bull markets.
■ Rebalance your portfolio after major market moves.
These points will help you face bear markets with a greater confidence in
your ability to make good decisions. You may not avoid a loss, but when
the dust clears, your portfolio will look a lot healthier than if you acted
like the good times would last forever.
APPENDIX A
GLOSSARY
This glossary contains definitions of common investment terms used in

this book, plus a few more for good luck.
401(k) plan A qualified, defined contribution plan offered by employ-

ers. It allows employees to have a certain percentage of their salary de-
ducted and invested in the plan. The deduction is pre-tax, which reduces
current income tax. The plan usually offers five to seven mutual funds
among which the employee can distribute his deduction. In some cases,
the employer may match a portion of the employee’s contribution. The
deposits and earnings are tax-deferred until withdrawn in retirement.
403(b) plan Similar to the 401(k) plan, the 403(b) is for religious,
educational, and other nonprofit groups. This plan uses tax-deferred
annuities as investment vehicles.
actively managed mutual fund Actively managed mutual funds meet
their investment objectives by actively buying and selling securities. These
funds may have high expense ratios and create tax liabilities passed
through to the investor.
administrative fees Fees charged by the mutual fund company to
maintain and administer the fund.
annual report A required document all publicly traded companies, in-
cluding mutual funds, have to produce. It presents the financial results for
the past fiscal year, audited by an accredited accounting firm.
asset allocation The process of distributing your investment assets
across stocks, bonds, and cash. This allocation will change as your life cir-
cumstances change.
bear market A market where there are significant and long-term de-
clines in market value as shown by falling market indexes—usually 20
percent or more.
blue-chip stocks The most prestigious and solid companies on the

market. The term came from the fact that blue chips in poker are the
most expensive ones.
bond mutual funds These invest in bonds and may target long or short
maturities and different issuers. Triple tax-exempt bond funds are sold in
specific states where residents may enjoy tax-free income from the bond
fund.
bonds Debt instruments that represent an obligation on the part of the
issuer to repay the debt. Governments and private corporations may issue
bonds.
bull market A market characterized by significant and long-term
growth in value in the stock market as shown by rising market indexes.
buy-and-hold investment strategy A strategy that suggests that buying
and holding quality investments for long terms results in superior returns.
capital gain The profit from the sale of an asset; realized when you sell
a stock or bond for a profit and when a mutual fund does the same. Mu-
tual funds pass capital gains to shareholders. Any asset sold for a profit
and held less than one year is subject to ordinary income tax by the owner.
An asset held for more than one year and sold for a profit is a long-term
capital gain, and the tax is 20 percent.
cash equivalents Financial instruments that represent a deposit of cash.
They include certificates of deposits, money market accounts, and savings
accounts. They are highly liquid.
certified financial planner A professional designation for someone
who has extensive training in financial planning. Many certified financial
planners charge a fee only for their services, while others may take a com-
mission on products they recommend you buy.
closed-end mutual fund A hybrid type of investment that offers shares
for sale only once. After that, there are no new shares sold. The remaining
shares trade like stocks and can be bought and sold on the open market.
commissions Fees brokers charge to buy or sell securities for you.
common stock The primary unit of ownership in a corporation. Hold-
ers of common stock are owners of the corporation with certain rights, in-
cluding voting on major issues concerning the corporation. Shareholders,
as they are known, have liability limited to the value of stock they own.
GLOSSARY 255
compounding The mathematical means by which interest is earned on

the principal during one period, and then the next period the account
earns interest on the resulting principal plus interest in the first period.
correction A polite term for a full-scale retreat by a market sector or the
whole market. It usually only lasts for a short time before reversing.
day trader Someone who engages in aggressive trading using an Inter-
net connection to a broker or a terminal in the broker’s office. Day traders
may make dozens of trades each day with the hope of making numerous
small profits.
depression A long-term (multiple years) decline in the national stan-
dard of living.
diversification The calculated spreading of your investments over a
number of different asset classes. This cushions your portfolio if one part
is down, since different asset classes (stocks, bonds, cash, etc.) seldom
move in the same direction. In mutual funds, you achieve diversification
by the fund owning 50 stocks instead of a few.
dividend reinvestment plans (DRIPS) These allow stock and mutual
fund owners to reinvest dividends back into the investment program. You
can also set up a DRIP and make periodic payments as a way of buying
stock without going through a broker.
dividend yield Calculated by dividing the current price per share into
the annual dividend per share. The resulting percentage tells how cheap
or expensive a dividend is relative to the stock price.
dividends Portions of a company’s profits paid to its owners, the stock-
holders. Not all companies pay dividends. The board of directors makes
that decision. Companies that do not pay dividends reinvest the profits
back in the company to finance additional growth.
dollar cost averaging An investing technique that makes regular de-
posits in an investment account regardless of market conditions.
Dow Jones Industrial Average Also known as the Dow, this index is
the best known and most widely quoted in the popular press. The Dow
consists of 30 companies considered leaders in their industries. Together,
they account for a significant amount of the value of the market. Al-
though not as reflective of the whole market as other indexes, the Dow is
watched earnestly.
economic indicators Key measures of the economy’s health, such as

unemployment, wages, prices, and so on, that gauge the health of the
economy.
economic risk The danger that the economy could turn against your
investment. An example would be a real estate company in a period of
high interest rates.
economics Pertains to the production, distribution, and consumption
of goods and services, and the factors such as taxes, inflation, labor, and
so on, that affect the economy.
equity What remains after paying all liabilities. Equities are another
name for stock and indicate an ownership position.
expectation bubble The value added to a market or stock by investors
who expect growth to continue on a straight line upward. They are will-
ing to pay a premium for this future benefit, even if the benefit is in their
imagination.
Federal Reserve Board Also known as “the Fed,” it controls the nation’s
interest rates by setting the key interest rates charged to banks. Alan
Greenspan has headed the board for many years. An unanticipated
change in interest rates will have a dramatic effect on the markets. Rais-
ing and lowering interest rates is analogous to turning up or down the
heat while cooking.
fiscal year The bookkeeping year for a company. It may or may not
correspond with the calendar year.
focused funds These concentrate their investments in specific, narrow
sectors of the market. The idea is to take advantage of rapid growth in the
sector. The downside is that when the sector tanks, so does the fund.
full-service brokers Brokers who offer comprehensive services to per-
sons wishing to invest, including recommendations on specific products
and proprietary research.
fundamental analysis A method for evaluating a stock on the basis of
observing key ratios and understanding the underlying business.
going public The process of taking a privately owned company and of-
fering shares of stock to the public.
growth investment strategy A strategy that identifies companies with
significant growth potential and is willing to ride out frequent market
fluctuations.
GLOSSARY 257
growth mutual funds Funds that seek investments in stock of compa-

nies with potential of rapid and sustained growth.
growth stock A stock that usually pays no dividends but puts profits
back into the company to finance new growth. Investors buy growth
stock for its potential price appreciation as the company grows.
income investment strategy A strategy that identifies sources of im-
mediate income, whether through income stocks or bonds.
income mutual funds Funds that invest in stocks and bonds that pro-
vide high levels of current income.
income stock Provides current income in the form of dividends. Utili-
ties are income stocks because of the strong dividends many pay.
index A way to measure financial activity. An index has an arbitrary be-
ginning value and as the underlying issues change, the index either rises
or falls.
index mutual fund A fund that seeks to mimic some key market index
like the S&P 500.
inflation Too much money chasing too few goods, resulting in a sharp
rise in prices without any extra value added, making money worth less.
Inflation leads to rising interest rates and a cooling of the economy. If the
economy slows down too quickly and too far, it may slip into a recession
or even a depression.
initial public offering The first time a company issues stock for sale to
the public. The company is said to be “going public” when this happens.
The offering is highly regulated and often surrounded by a lot of media
attention.
intraday Prices that occur within a single trading day for the same
stock. Speculators and day traders follow them closely.
large cap stock Any company with a market capitalization of $5 billion
or more.
limit order Instructs your broker to buy a stock when the price drops
to the level you set.
limit order to sell Instructs your broker to sell a stock when the stock
climbs to a predetermined level.
liquidity Refers to how easily a financial instrument can convert to
cash. A mutual fund is highly liquid, while an apartment building would
be highly illiquid.
loaded fund A fund that charges a sales fee or commission. The load
may be up front or deferred.
lost opportunity costs When you cannot act on an opportunity be-
cause your money is locked in another investment or you pass up a chance
for profits because fear or the lack of information holds you back.
management fee Also called the investment advisory fee, charged by
the mutual fund company and used to pay the fund’s manager, who is re-
sponsible for making sure the fund meets its objectives.
market capitalization A way of measuring the size of a company. You
calculate it by multiplying the current stock price by the number of out-
standing shares. A stock trading at $55 with 10,000,000 outstanding
shares would have a market cap of $550 million.
market cycles Periods of market ups and downs.
market indicators A collective name for a number of indexes and other
measurements of market activity.
market order An order to buy or sell placed with your broker request-
ing the best price at that moment.
market value risk The danger that your investment will fall out of
favor with the market.
mid cap stock Any company with a market capitalization of $1 to
$5 billion.
money market accounts Special savings accounts usually offered by fi-
nancial institutions that pay a higher interest rate than regular savings but
require a higher minimum balance. They are not the same as money mar-
ket mutual funds.
money market mutual funds Funds that invest in short-term money
market instruments. You can often withdraw money on short notice
without penalty. Some offer check-writing privileges.
mutual funds Funds representing a group of individuals who have
pooled their money and hired a professional management company to in-
vest it for them. Each mutual fund has specific goals and objectives that
drive its buy and sell decisions. Mutual funds may invest in stocks, bonds,
or both.
Nasdaq Also known as the over-the-counter market, it is the new kid
on the block. Many of the companies listed here are fairly young, and this
is the home of many of today’s high-tech stars and former stars.
GLOSSARY 259
Nasdaq Composite Index Covers the Nasdaq market of over 5,000

stocks.
net asset value (NAV) The mutual fund equivalent of a share price.
This is the price you pay when you buy into a mutual fund. Unlike
stocks, mutual funds have no problems with fractional shares. Funds cal-
culate the NAV subtracting the liabilities from the holdings of a mutual
fund, then dividing by the outstanding shares.
New York Stock Exchange The oldest and most prestigious of all stock
exchanges. The NYSE is home to most of the “blue-chip” companies.
New York Stock Exchange Index Covers all the stocks on the NYSE,
making it a broad measurement of larger companies.
no-load fund A fund that charges no sales fees or commissions, either
up front or deferred.
portfolio The collection of all your investment assets.
precious metals mutual funds Funds that invest in stocks and bonds
of mining and trading companies of precious metals such as gold and
silver.
preferred stock As the name implies, preferred stock is a different class
of stock with additional rights not granted to common stock owners.
Among these rights is first call on dividends.
price/earnings growth ratio (PEG) Looks into the future relationship
of earnings and growth. You calculate the PEG by dividing forward earn-
ings estimates into the P/E.
price/earnings ratio (P/E) A way to show how a company’s earnings
relate to the stock price. You calculate the P/E by dividing the current
price of the stock by the annual earnings per share. The higher the P/E,
the more earnings growth investors are expecting.
price-to-book ratio Taking the current stock price and dividing it by
the book value per share calculates the price-to-book ratio. This relation-
ship shows the value of the equity as it relates to the stock price.
prospectus A legal document potential shareholders of mutual funds
and initial public offerings of stocks must have before they can invest. It
lists complete financial details of the fund as well as the associated risks.
ratio Simply a comparison of the relationship between financial items.
For example, price/earnings ratio shows the relationship between a com-
pany’s earnings and its stock price.
real estate investment trusts (REITs) Similar to mutual funds in that

they are traded as securities, making them more liquid than other forms
of real estate investments.
real estate limited partnership Pools investors’ money and buys
income-producing properties.
recession Marked by declining standards of living and rising prices. Of-
ficially, a recession is a decline in the nation’s gross national product for
two consecutive quarters.
return Another way to say yield; a percentage.
risk Measures the possibility that an investment will not earn the an-
ticipated return.
risk tolerance A way to judge how much risk you are willing to take to
achieve an investment goal. The higher your risk tolerance, the more risk
you are willing to take.
sector mutual funds Invest in various sectors of the economy such as
technology or healthcare.
Securities and Exchange Commission (SEC) The chief regulatory
body over the stock markets and publicly traded companies.
small cap stock Any company with a market capitalization of $1 bil-
lion or less.
socially responsible mutual funds Funds that invest in carefully
screened companies that meet certain social or ethical standards.
Standard and Poor’s An investment research service that provides a
number of market indexes including the S&P 500. They also provide a
rating service for bonds.
Standard & Poor’s 500 (S&P 500) A weighted index of 500 of the
largest stocks. It is the most widely used measure of broad market activ-
ity and is often the benchmark other investments are compared to.
stock mutual funds Invest exclusively or primarily in stocks. The
stocks may be broad-based or in one sector. They may include foreign as
well as domestic stocks.
timing the market Investors who try to pick a stock’s low to buy and a
stock’s high to sell are timing the market. No one can consistently do this
with any success.
GLOSSARY 261
trade Refers to the buying or selling of stocks, bonds, mutual funds,

and other financial instruments. Depending on the usage, it can mean a
single transaction or refer to the total market (trading was heavy).
unit investment trusts Another hybrid fund that buys a fixed portfolio
of stock or bonds and never sells or buys any more.
value mutual funds These look for companies the market is under-
valuing for some reason with the hope that their fortunes will return and
the stock will experience significant growth.
value stock The market underprices a value stock for whatever reason.
Often, a stock’s only sin is not being a part of the current hot sector.
yield The percent returned to stockholders in the form of dividends.
APPENDIX B
RESOURCES
In this appendix, you will find a list of Web and published resources to
assist you in planning and implementing your investment program.
FINANCIAL PLANNING PROFESSIONALS

www.financialplan.about.com—A whole Web site devoted to financial
planning from About.com.
www.amercoll.edu/—Background information about the designation
“Chartered Financial Consultant” and other financial planning designa-
tions.
www.cfp.com—Information on choosing a certified financial planner
(CFP) from the Certified Financial Planner Board of Standards.
www.planningpaysoff.org—Search the database of the International As-
sociation for Financial Planning to find a Financial Planning professional
near you.
investmentclub.about.com/finance/investmentclub/mbody.htm—
Investment clubs are a great way to get started in investing, and this is a
site completely devoted to investment clubs.
FINANCIAL PLANNING SOFTWARE

www.zdnet.com/pcmag/features/finance—A review of Managing Your
Money personal finance software.
www.computershopper.zdnet.com—Reviews of Microsoft Money,
Managing Your Money Plus, Quicken Deluxe, and Kiplinger’s Simply
Money.
www.quicken.com—Order Quicken Deluxe, Quicken Home and Busi-
ness, Quicken Suite, Quicken Personal Financial Planner, Turbo Tax, and
other Quicken products.
INVESTMENT PUBLICATIONS
Alpha Teach Yourself Investing in 24 Hours, Ken Little—This book is a
comprehensive overview of investing techniques and strategies. It covers
all the information you need to get started or to review the basics.
The Intelligent Investor: A Book of Practical Counsel, Benjamin Graham—
Benjamin Graham is one of the best-known value investors of all time.
Graham advocates a simple portfolio and stock selection methods.
The Only Investment Guide You’ll Ever Need, Andrew Tobias—Andrew To-
bias is a well-respected financial counselor and stresses no-load mutual
funds.
The Complete Idiot’s Guide to Making Money with Mutual Funds, Alan
Lavine and Gail Liberman—This guide is a great primer for getting you
on track with mutual funds. It is easy to follow and full of information,
including definitions and tips.
Beating the Street, Peter Lynch—Peter Lynch is a name that inspires awe
on Wall Street for his successful investing strategies.
The Complete Idiot’s Guide to Managing Your Money, Robert Heady and
Christy Heady—A great consumer guide to managing your money, this
book is easy to read and full of practical tips.
Motley Fool’s You Have More Than You Think: The Foolish Guide to Investing
What You Have, David and Tom Gardener—These guys are no fools when
it comes to investing advice. This book shows you how to get started with
a small amount.
Technical Analysis of Stock Trends, Robert D. Edwards and John Magee—
The authors offer a comprehensive look at a technical analysis of stock
movement.
MARKET INDICATORS
The following is a list of key market indicators:
Dow Jones Industrial Average (www.dowjones.wsj.com)—The oldest
and best known of all market indicators, the Dow consists of 30 stocks
representing the leading companies in their industries. Here is a list of the
stocks that make up the Dow Jones Industrial Average as of April 2001:
Alcoa, Inc. Intel Corp.
American Express Co. International Business Machines Corp.
RESOURCES 265
AT&T Corp. International Paper Co.

Boeing Co. J.P. Morgan & Co.
Caterpillar, Inc. Johnson & Johnson
Citibank McDonald’s Corp.
Citigroup, Inc. Merck & Co.
Coca-Cola Co. Microsoft Corp.
DuPont Co. Minnesota Mining & Manufacturing Co.
Eastman Kodak Co. Philip Morris Cos.
Exxon Mobil Corp. Procter & Gamble Co.
General Electric Co. SBC Communications, Inc.
General Motors Corp. United Technologies Corp.
Hewlett-Packard Co. Wal-Mart Stores, Inc.
Home Depot, Inc. Walt Disney Co.
Nasdaq Composite (www.nasdaq.com)—The Nasdaq is home to many

of the high-flying, high-tech companies on the market today. This com-
posite index reflects the top 100 stocks.
New York Stock Exchange Composite Index (www.nyse.com)—This
index covers all the stocks traded on the New York Stock Exchange.
Russell 2000 Index (www.russell.com)—The Russell 2000 is a key indi-
cator for how the nation’s small companies are doing.
Standard & Poor’s 500 (www.standardpoor.com)—The S&P 500 is the
most widely used benchmark for the market by investment professionals.
ONLINE BROKERS
The authoritative source on online brokers is Gomez.com
(www.gomez.com). They use fees, ease of use, and a number of other fac-
tors to rank online brokers. Here are some of the top-rated online brokers:
1. Charles Schwab (www.schwab.com)
2. E*Trade (www.etrade.com)
3. DLJdirect (www.djdirect.com)
4. Fidelity Investments (www.fidelity.com)
5. NDB (www.ndb.com)
6. A.B. Watley (www.abwatley.com)
7. My Discount Broker (www.mydiscountbroker.com)
8. American Express Brokerage (www.americanexpress.com)

9. Suretrade (www.suretrade.com)
10. Morgan Stanley Dean Witter Online (www.online.msdw.com)
RETIREMENT CALCULATORS
www.quicken.com—The financial software giant has a great site with
plenty of aids, including this comprehensive retirement planning calcula-
tor at www.quicken.com/retirement/planner/js/.
www.retireplan.about.com—A complete site devoted to retirement
planning.
www.interest.com—This calculator helps you figure the future value of
money before and after retirement.
www.firstar.com/persfin/—FirstStar bank’s calculator includes inputs
for a second income in the household.
www.moneycentral.msn.com/articles/retire—MSN.com shows how
much you can spend after you retire.
www.principal.com/—The Principal Financial Group discusses ex-
penses after retirement.
RISK TOLERANCE
www.better-investing.org—An article discussing risk tolerance and how
yours should affect your investment decisions.
www.cigna.com/retirement—A short risk-tolerance quiz will help you
sleep better at night with your investment decisions.
www.scudder-u.working4u.com—Another quiz on risk tolerance and
the role it plays in investing.
ROTH IRA
www.university.smartmoney.com—Online SmartMoney magazine
(from The Wall Street Journal ) has complete Roth IRA information.
www.fool.com/retirement.htm—The Internet wits from Motley Fool
have sound advice for IRA shoppers.
RESOURCES 267
www.familymoney.com—Family Money is a good site with lots of in-

formation about IRAs
SEP IRA INFORMATION

www.dainrauscher.com—Find out how much you can contribute to a
SEP, SIMPLE IRA, or Keogh plan from Dainrauscher.com.
www.newyorklife.com—New York Life details the benefits of using a
SEP IRA for retirement planning made easy.
www.bankrate.com—Bankrate.com helps you calculate your eligible
SEP IRA contribution.
ww.irs.ustreas.gov/basic/forms%255Fpubs/pubs/p590toc.htm—IRS
guide on setting up and maintaining a SEP plan.
STOCK EXCHANGES
American Stock Exchange—www.amex.com
Chicago Board of Trade—www.cbot.com
Chicago Board Options Exchange—www.cboe.com
Chicago Mercantile Exchange—www.cme.com
Kansas City Board of Trade—www.kcbt.com
Nasdaq—www.nasdaq.com
New York Cotton Exchange—www.nyce.com
New York Mercantile Exchange—www.nymex.com
New York Stock Exchange—www.nyse.com
Philadelphia Stock Exchange—www.phlx.com
STOCK SCREENING
Stock screening services make finding the right stock or mutual fund
much easier. Here are three that are worth getting to know:
■ Microsoft’s site is comprehensive and easy to customize at
moneycentral.msn.com.
■ Marketguide’s StockQuest is a powerful screening tool, but it takes
a while to get used to at www.marketguide.com.

■ Morningstar.com’s stock and fund selectors are easy to use and do
not overwhelm you at Morningstar.com.

STOCK TRADING GAMES

www.smartstocks.com—Play the market without risking any money.
www.game.etrade.com—E*Trade, the online broker, offers several dif-
ferent games.
www.stocktrak.com—Offers prizes for best performance in monthly
games.
INDEX
A myths, 148 hard asset stocks,

rebalancing schedule, 233
A/D line (advance- value stocks, 233
246-247
decline line), 52-54 assets (bear-proof ),
recession bear markets,
age variables (asset- 129-130, 143
109, 113-114, 117
allocation strategies), bear attacks, 143
Defensive Strategy,
148-157 industry sectors,
115
agency bonds, 205 131-143
middle ground
Aggressive asset-allocation stocks, 130-131
approaches,
models, 152-157
115-116
aggressive investing
growth stocks
Modified Market
Timing, 114
B
portfolio diversifi- balanced funds, 213
reasonable ap-
cation, 231-232 bargains, identifying and
proaches,
retirement planning, locating
116-117
197-199 mutual funds,
strategies, 148-167
allocation. See asset alloca- 176-178
age significance,
tion stocks, 169-175
148-150
asset allocation, 97-98, bear markets, 3-5, 13
mid-term goals,
107, 158, 250 bear market funds,
162-167
achieving balance, 140, 212-213
short-term goals,
105-106 bear-proofing your
160-161, 167
cash, 247 portfolio, 10
tools, 248
changing the mix, 106 assets, 12
Goal Planner, 249
diversification, 98-99 avoiding traps,
Portfolio Allocator,
finding the right mix, 11-12
249
104-105 looking for bear
variables, 102-103
goal-setting, 101-102 signs, 11
risk tolerance, 103
inflation and deflation investment risks,
time horizon,
bear markets, 119, 10-11
103-104
124-128 safe havens, 13
asset diversification,
investing history, strategies, 12-13
229-230, 238
99-101 surviving a bear
bonds, 235
irrational expectations, market, 13
mutual funds,
247-248 deflation bear markets,
234-235
monitoring, 239-241 31
plan maintenance,
choosing to rebal- history, 6-7
236-238
ance, 241-243 inflation/interest-rate
stocks, 230-231
mutual funds, bear markets, 29-30
aggressive growth
245-246 individual applica-
stocks, 231-232
other solutions, tions, 31
bottom-line, 234
244-245 past experiences, 30
growth stocks, 232
information bear mar- small cap stocks, D

kets, 32 136
investment technol- technology, 142 “dead-cat” bounces, 173
ogy, 32-33 utilities, 142 Defensive Strategy
lessons to learn, 7-8 value stocks, 133 approach (asset alloca-
market-liquidity bear stocks, 130-131 tion), 115
markets, 28 blue-chip stocks, 49 deflation, 22-23, 121
myths, 8-10 bond funds, 139 asset allocation, 119,
political/financial- bonds, 55-56, 137-138, 124-128
instability bear 204 deflation bear markets,
markets, 26-27 bond mutual funds, 31
recession bear markets, 207 modern examples,
28-29 corporate bonds, 206 122-124
types, 25-33 diversification, 235 strategies for handling
bear ranking funds, 140 municipal bonds, 206 inflation, 126-127
bear-proof assets, types, 189 diversification, 98-99,
129-130, 143 bond mutual funds, 229-230, 238
bear attacks, 143 190 bonds, 235
industry sectors, individual, 190 mutual funds,
131-143 U.S. agency bonds, 234-235
bear funds, 140 205 plan maintenance,
bear ranking funds, U.S. Treasury bonds, 236-238
140 204-205 types of stocks,
bond funds, 139 books (investment publica- 230-234
bonds, 137-138 tions), 264 dividend-paying stocks,
consumer durable branding, 220 132
goods, 141 brokers (online), Web sites, dollar-cost-averaging strat-
dividend-paying 265-266 egy, 226
stocks, 132 buy-and-hold strategy, Dow Jones Industrial
energy, 141 217-218 Average, 49, 264-265
financial services, bottom line, 224 Durable Goods Orders
142 cons, 221-223 Report, 41-42
foreign stocks, pros, 218-220
136-137 E
growth stocks, 132
healthcare, 142
C earnings forecasts, 54-55
calculators (retirement), ECI (Employment Cost
hybrid funds, 139
Web sites, 266 Index), 37-38
industrial cyclicals,
cash, 191, 247 economic indicators,
141
Conservative asset- 35-36, 39, 45
large cap stocks,
allocation models, Durable Goods Orders
131-134
152-157 Report, 41-42
market neutral
conservative retirement Employment Report,
funds, 140
planning, 195-197 39-41
mid cap growth
consumer durable goods Gross Domestic Prod-
stocks, 134-135
sector, 141 uct (GDP), 44-45
mid cap stocks, 135
Consumer Price Index Industrial Production
mutual funds,
(CPI), 38-39 and Capacity Utiliza-
138-139
consumer staples sector, tion Report, 43
nondurable goods,
211-212 inflation indicators, 36
141
corporate bonds, 206 Consumer Price
real estate, 142
corrections (market), 4 Index (CPI),
retail sales, 142
CPI (Consumer Price 38-39
services, 141
Index), 38-39
INDEX 271
Employment Cost forecasts (earnings), market, 48-49

Index (ECI), 54-55 Dow Jones Indus-
37-38 foreign stocks, 136-137 trial Average, 49
Producer Price foreign threats, 21 Nasdaq Composite
Index (PPI), 38 forty-year-olds, asset allo- Index, 50-51
Purchasing Managers’ cation strategies, 152- New York Stock
Index (PMI), 41 155 Exchange (NYSE)
Retail Sales Report, Aggressive model, Composite Index,
43-44 153-154 49-50
economic recession, 5 Conservative model, Standard & Poor’s
economic risks, 20-21 153-154 500 (S&P 500),
fads and gimmicks, 21 Regular model, 50
falling profits, 21 153-154 Producer Price Index
foreign threats, 21 Retirement model, (PPI), 38
recession, 20 153, 155 Purchasing Managers’
Employment Cost Index Index (PMI), 41
(ECI), 37-38 indicators
Employment Report,
G economic, 35-36, 39,
39-41 games (stock trading), Web 45
energy sector, 141 sites, 268 Durable Goods
exchanges (stock), Web GDP (Gross Domestic Orders Report,
sites, 267 Product), 44-45 41-42
gimmicks, 21 Employment Re-
GNMA (Ginnie Mae) port, 39-41
F bonds, 205 Gross Domestic
fads, 21 Goal Planner tool, 249 Product (GDP),
bonds, 205 goals 44-45
FHL (Freddie Mac) bonds, mid-term investments, Industrial Produc-
205 162-167 tion and Capacity
fifty-year-olds, asset alloca- short-term investments, Utilization Re-
tion strategies, 154-156 160-161, 167 port, 43
Aggressive model, 154, Gross Domestic Product inflation indicators,
156 (GDP), 44-45 36-39
Conservative model, gross national product, 5 Purchasing Man-
154, 156 growth stock funds, 84 agers’ Index
Regular model, growth stocks, 132, 232 (PMI), 41
154-155 Retail Sales Report,
Retirement model,
155-156
H 43-44
market, 47, 56, 264
finance sector, 211 hard asset stocks, portfolio applications, 51-54
financial planners, Web diversification, 233 major market
sites, 263 healthcare sector, 142, 212 indexes, 48-51
financial planning soft- history (bear markets), Web sites,
ware, Web sites, 263 6-7 264-265
financial services sector, hybrid funds, 139 individual bonds, 190
142 industrial cyclical sector,
fixed returns (bonds), 189 I–J–K 141
bond mutual funds, Industrial Production and
190 index funds, 64
indexes, 35 Capacity Utilization Re-
individual, 190 port, 43
types, 189 Consumer Price Index
(CPI), 38-39 industry sectors, 131,
FNMA (Fannie Mae) 141-143
bonds, 205 Employment Cost
Index (ECI), 37-38 bear funds, 140
bear ranking funds, 140 investment publications, 264 risks, 16, 23

bond funds, 139 investments age variables, 17
bonds, 137-138 bargain indentification economic risks,
consumer durable tips 20-21
goods, 141 mutual funds, inflation risks,
dividend-paying stocks, 176-178 21-23
132 stocks, 169-175 market risks, 18-20
energy, 141 diversification, perceptions, 16-17
financial services, 142 229-230, 238 types, 17-18
foreign stocks, 136-137 bonds, 235 “safe havens,” 203-204,
growth stocks, 132 mutual funds, 213-214
healthcare, 142 234-235 balanced funds,
hybrid funds, 139 plan maintenance, 213
industrial cyclicals, 141 236-238 bear market funds,
large cap stocks, squelching “get- 212-213
131-134 rich-quick” bonds, 204-207
market neutral funds, thoughts, 237 international funds,
140 stocks, 230-234 210
mid cap growth stocks, mid-term goals, market neutral
134-135 162-167 funds, 213
mid cap stocks, 135 mutual funds, precious metals,
mutual funds, 138-139 163-167 212
nondurable goods, 141 savings plans, real estate, 208-209
real estate, 142 162-165 sector investments,
retail sales, 142 offensive strategies, 179 210-212
services, 141 pre-retirement strate- short-term goals,
small cap stocks, 136 gies, 183-184, 191 160-161, 167
technology, 142 cash significance, strategies, 227
utilities, 142 191 buy-and-hold,
value stocks, 133 checklist, 184 217-224
inflation, 120 fixed returns, dollar-cost-
asset allocation, 119, 189-190 averaging, 226
124-128 hiring a profes- price-setting,
indicators, 36-39 sional, 187-188 224-225
modern examples, investment and time strategy, 226
122-123 retirement port- IPOs (initial public offer-
risks, 21-22 folios, 185 ings), 16
deflation, 22-23 multiple retirement IRAs, 266-267
protection meth- plans, 186
ods, 22 Social Security Ad-
strategies for handling ministration, 187
L–M
inflation, 124-126 timing, 188 large cap funds, 84,
inflation/interest-rate bear understanding your 131-134
markets, 29-30 retirement plan,
individual applications, 185-186 market capitalization, 131
31 retirement protection, market corrections, 4
past experiences, 30 194, 201 market indicators, 47, 56,
information bear markets, conservative versus 264-265
32-33 aggressive strate- applications, 51
initial public offerings gies, 194-199 advance-decline
(IPOs), 16 outliving the bear, line, 52-54
intentional market timing, 200-201 technical analysis,
60-61 plan flexibility, 54
international funds, 210 199-200 volume signs, 52
INDEX 273
major market indexes, recession bear markets, offensive investment strate-

48-49 28-29 gies, 179
Web sites, 264-265 types, 25-33 online brokers, Web sites,
market neutral funds, 140, mid cap stocks, 135 265-266
213 mid-term goals (invest- opportunity costs, 223
market risks, 18-20 ment strategies),
market timing, 59, 68, 220 162-164, 167
avoiding snap deci- mutual funds, 163-167
P–Q
sions, 66-67 savings plans, 162-165 P/E (price/earnings) ratios,
intentional, 60 models, asset allocation 72-73
market timers, Aggressive, 152-157 PMI (Purchasing Man-
60-61 Conservative, agers’ Index), 41
opportunity, 68 152-157 political/financial-
simple truths, 62-65 Regular, 152-155, 157 instability bear markets,
unintentional, 61-62 Retirement, 152-157 26-27
value timing, 67-68 Modified Market Timing Portfolio Allocator tool,
market-liquidity bear mar- approach (asset alloca- 249
kets, 28 tion), 114 portfolios, 12
markets (bear), 3-5, 13 money supply, 20 PPI (Producer Price
risks, 16 municipal bonds, 206 Index), 38
bear-proofing your mutual funds, 138-139 precious metals, 212
portfolio, 10 bargains price setting strategy,
assets, 12 identifying, 224-225
avoiding traps, 176-177 price/earnings (P/E) ratios,
11-12 locating, 177-178 72-73
looking for bear bear market funds, Producer Price Index
signs, 11 212-213 (PPI), 38
risk and investing, bonds, 207 professional financial plan-
10-11 diversification, ners, Web sites, 263
safe havens, 13 234-235 professional retirement
strategies, 12-13 mid-term investment planners, 187-188
surviving a bear goals profits, falling, 21
market, 13 lump sum deposit, Purchasing Managers’
deflation bear markets, 163, 166-167 Index (PMI), 41
31 monthly deposits,
history, 6-7 163-166
monitoring allocation,
R
inflation/interest-rate
bear markets, 29-30 245-246 real estate, 208
individual applica- real estate, 209 mutual funds, 209
tions, 31 selling strategies, 85-94 REITs, 208-209
past experiences, 30 real estate sector, 142
information bear mar- rebalancing schedule,
kets, 32
N–O 246-247
investment technol- Nasdaq Composite Index, recession, 5, 20, 109-110
ogy, 32-33 50-51, 265 asset allocation, 109,
lessons to learn, 7-8 New York Stock Exchange 113-114, 117
market-liquidity bear (NYSE) Composite ramifications, 110-113
markets, 28 Index, 49-50, 265 recession bear markets,
myths, 8-10 nondurable goods sector, 28-29
political/financial- 141 Regular asset-allocation
instability bear mar- models, 152-157
kets, 26-27 REITs, 208-209
resources Roth IRAs, Web sites, nondurable goods, 141

investment publica- 266-267 real estate, 142
tions, 264 Russell 2000 Index, Web retail sales, 142
market indicators, site, 265 services, 141
264-265 technology, 142
Web sites, 263-268 utilities, 142
Retail Sales Report,
S SEP IRAs, Web sites, 267
43-44 S&P 500 (Standard & services sector, 141
retail sales sector, 142 Poor’s 500) Index, 8, seventy-year-olds, asset-
retirement 50, 265 allocation strategies,
pre-retirement plan- “safe havens,” 203-204, 156-158
ning, 183-184, 191 213-214 Aggressive model, 157
cash significance, balanced funds, 213 Conservative model,
191 bear market funds, 157
checklist, 184 212-213 Regular model, 157
fixed returns, bonds, 204-207 Retirement model, 157
189-190 international funds, short-term goals (invest-
hiring a profes- 210 ment strategies),
sional, 187-188 market neutral funds, 160-161, 167
investment and 213 sixty-year-olds, asset-
retirement port- precious metals, 212 allocation strategies,
folios, 185 real estate, 208 155-157
multiple retirement mutual funds, 209 small cap funds, 84, 136
plans, 186 REITs, 208-209 Social Security Administra-
Social Security Ad- sector investments, 210 tion, 187
ministration, 187 consumer staples soft landings, 27
timing, 188 sector, 211-212 software (financial plan-
understanding your finance sector, 211 ning), Web sites, 263
retirement plan, healthcare sector, Standard & Poor’s 500
185-186 212 (S&P 500) Index, 8, 50,
protection strategies, utilities sector, 211 265
194, 201 savings plans, mid-term in- stock exchanges, Web sites,
conservative versus vestment goals, 267
aggressive strate- 162-165 stocks
gies, 194-199 screening services sector bear market stocks,
outliving the bear, funds, 178 130-131
200-201 sectors, 141-143 blue-chip, 49
plan flexibility, consumer durable diversification,
199-200 goods, 141 230-234
Retirement asset-allocation energy, 141 dividend-paying, 132
model, 152-157 financial services, 142 foreign, 136-137
retirement calculators, Web healthcare, 142 growth, 132
sites, 266 industrial cyclicals, 141 indentifying bargains,
risk tolerance, 103, 266 investment “safe 169-170
risks (investment), 16, 23 havens,” 210 bottom feeding,
age variables, 17 consumer staples 175
economic risks, 20-21 sector, 211-212 companies past
inflation risks, 21-23 finance sector, 211 their prime, 172
market risks, 18-20 healthcare sector, “dead-cat” bounces,
perceptions, 16-17 212 173
types, 17-18 utilities sector, 211 investor demand
variables, 172
INDEX 275
looking for signs, hiring a profes- tolerance (risk), Web sites,

170-171 sional, 187-188 266
price relativity, 174 investment and tools, asset-allocation, 248
protecting yourself, retirement portfo- Goal Planner, 249
174-175 lios, 185 Portfolio Allocator, 249
refraining from fa- multiple retirement Treasury bonds, 204-205
voritism, 171 plans, 186 twenty-year-olds, asset-
sector association, Social Security Ad- allocation strategies,
171 ministration, 187 150-152
short-term profits, timing, 188 Aggressive model, 152
175 understanding your Conservative model,
staying power, retirement plan, 152
171-172 185-186 Regular model, 152
stock analyst rat- price setting, 224 Retirement model, 152
ings, 172-173 cons, 225
large cap, 131, pros, 225 U.S. agency bonds, 205
133-134 retirement protection, U.S. Treasury bonds,
mid cap, 135 194, 201 204-205
mid cap growth, conservative versus unintentional market tim-
134-135 aggressive strate- ing, 61-62
screening services gies, 194-199 utilities sector, 142, 211
Web sites, 267 outliving the bear,
selling strategies, 200-201
71-82 plan flexibility,
V–W–X–Y–Z
small cap, 136 199-200 value funds, 133, 178, 233
trading games selling mutual funds, value timing, 67-68
Web sites, 268 84-94 “very conservative retiree”
value, 133 selling stocks, 71-82 investment myth, 148
stop-loss orders, 73 short-term goals, volume signs, 52
strategies, 227 160-161, 167
asset-allocation time strategy, 226 Web sites, 263-268
age variables,
148-158
buy-and-hold, 217-218
T–U
cons, 221-224 technical analysis, 54
pros, 218-220 technology (investment),
dollar-cost-averaging, 32-33
226 technology sector, 142
mid-term goals, thirty-year-olds, asset
162-164, 167 allocation strategies,
mutual funds, 150-153
163-167 time horizon, 103-104
savings plans, time strategy, 226
162-165 timing, market, 59, 68, 220
offensive investing, 179 avoiding snap deci-
pre-retirement, sions, 66-67
183-184, 191 intentional, 60-61
cash significance, opportunity, 68
191 simple truths, 62-66
checklist, 184 unintentional, 61-62
fixed returns, value timing, 67-68
189-190
ABOUT THE AUTHOR
Ken Little is a writer and an editor specializing in investing and personal
finance subjects. He is the author of four other books on investing and
the Internet including Alpha Teach Yourself Investing in 24 Hours (Alpha
Books), The Complete Idiot’s Guide  to Investing in Internet Stocks (Alpha
Books), 10 Minute Guide to Employee Stock Options (Alpha Books), and
How to Integrate E-Commerce into Your Existing Business (written under
contract for MightyWords.com). He also served as technical editor for
The Complete Idiot’s Guide  to Online Personal Finance (Alpha Books).
Until recently, he was the “Investing for Beginners” guide for
About.com, where, among other duties, he produced a weekly newsletter.
He has been the business editor of a major daily newspaper, the senior
marketing officer for a major financial services organization, and the pub-
lisher of several magazines.

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Bear-Proof

A Pearson Education Company

International Standard Book Number: 0-02864204-X

Printed in the United States of America

Publisher: Marie Butler-Knight

The Deflation Bear Market 31

Part 2: Bear Traps 57

Timing the Market Takes Time 65

Part 3: Bear Assets 95

Chapter 12: Bear-Proof Assets 129

Part 4: Bear Tracking 145

Chapter 15: Fatten Up on Bear 169

Part 5: Bear Den 181

An Unlikely Friend 196

Part 6: Bearskin Rug 215

Bear-Proof Investing is your edge in an unstable market. It gives you the

■ What if I had sold XYZ at $50 instead of $5?

■ What if the CEO of XYZ weren’t in prison now?

The dreaded Y2K disaster failed to materialize at midnight on Jan-

A declining stock market may strike younger investors as something

DEFINING A BEAR MARKET

THE PSYCHOLOGY OF BEARS

THE RECEDING BEAR

This is not to suggest there is no connection between recessions and bear

Percent Length Recovery

Source: Standard & Poor’s Corp.

This overconfidence, combined with little experience with bear

SLAYING BEAR MYTHS

including most of the market leaders, such as the bellwether S&P

earlier example of 1987, investors faced a sharp market decline.

control the stock market. If we could control the stock market,

BEAR-PROOFING YOUR PORTFOLIO

RISK AND INVESTING

In Chapter 2, we’ll look at the risks associated with investing and

LOOKING FOR BEAR SIGNS

■ When to sell a stock

BEAR YOUR ASSETS

Investors are, by definition, optimists. After all, you’re betting the

RISK AND REWARD

are more comfortable in mutual funds where there is professional man-

AGE AND RISK

These aren’t mutually exclusive—it is possible to experience all three at

Meanwhile, many companies such as Bank of America and Gen-

The Nasdaq Composite Index dropped by 50 percent in one year as even

fest themselves during a recession, which usually leads to a bear

■ Fads and gimmicks. Beware of companies built around fads and

industry leaders. There are usually a handful of leaders in every in-

Unfortunately, rising interest rates can have a chilling effect on the

There is a delicate balance between stopping inflation and undoing a re-

INFLATION’S EVIL TWIN

Deflation hasn’t happened on an economy-wide basis since the

Knowing your enemy is half the battle. In a television commercial,

BEAR MARKET TYPES

One chilling prospect is that we may be on the verge of seeing an

■ Market-liquidity bear markets

energy costs have a devastating effect on our economy; we could not

MARKET-LIQUIDITY BEAR MARKETS

RECESSION BEAR MARKETS

WHAT DOES THIS MEAN TO YOU?