The Big One

By Bob Wood, MMNS

These are very trying times for investors as the bear market punishes individuals and professionals alike. What amazes me most is the apparent lack of loss controls put in place by so many professional fund managers. Obviously, the lessons learned during the last bear cycle were quickly forgotten.

What surprises me most is how many well-paid and highly respected fund managers are flunking the most basic math when it comes to avoiding losses. Surely they all know that deficits accumulate faster than gains, as markets tend to fall much faster than they rise. Losses that, at first, look manageable quickly require miraculous gains to recover.

We all should know that an investor who loses 10% in the value of his savings needs only an 11% gain to get back to even. But the investor with a 20% drop needs a gain of 25% to get back to the starting point. Even in good times with a bull market, that achievement can take a couple of years.

Yet currently, many professional fund managers have taken some of the biggest hits, suffering losses of 40 to 50%. Losses like that will require managers to earn returns of 80 to 100% to replenish these losses. How long might that take under the best circumstances? And how long might it take while mired in a secular bear market like the one we are enduring now?

Some of the today’s better-known fund managers, including several who can claim wonderful, long-term track records, have put those long-term gains in jeopardy by failing to use controls to limit their losses. In many cases, those losses are so severe that recouping capital becomes all but impossible. Leading this pack is Bill Miller of the Legg Mason Value Trust Fund, who is noted for beating the S&P 500 for more years in a row than any other manager has done.

But, as of the end of October, his losses are making supporters cringe in fear. His fund has lost over 50% in the first 10 months of the year, putting him in the unenviable position of having to perform a minor miracle to regain his client’s money. Breaking even won’t happen any time soon, given Miller’s devotion to investing in domestic markets.

What makes matters worse for Miller is that the total of his current, year-to-date losses have wiped out all gains generated by his fund since the start of the bull cycle running from 2003 through October 2007. The fund is now on pace to end the six-year period ending December 31, 2008 with a cumulative loss of about 20%, which is not a good return for a six-year run. And that number does not reflect the effects of higher inflation.

This is a pretty dismal performance, to say the least! Investors in Miller’s fund have not only lost 20% of their capital, they have also lost six years of gains in other funds invested in foreign markets, energy and gold, to name the most obvious winners. But Miller is not alone, of course. According to the Lipper tables of fund performance, losses of 40 to 50% are common now, especially in the formerly hot foreign market funds. Unfortunately, loss controls are missing from many funds today.

Joining Miller in the loser’s corner is another candidate for “best fund manager” of our time, Ken Heebner of the CGM Focus Fund. Since his fund managed a stellar 80% gain in 2007, it, no doubt, attracted large numbers of new customer money, which so often chases past performance. His fund is also down about 50% this year, meaning the investor who joined the fund at the start of that big year 2007 is now nursing a cumulative 10% loss. That wonderful 80% gain has been wiped out — and then some.

Really, I thought we had all learned this lesson during the last bear market cycle, which ended in early 2003: we always need to mitigate losses so as to avoid ‘’the big one,’’ since that loss will almost certainly never be recovered. Think back to those hot technology stock funds of the late 1990s and how those stunning losses put many companies either out of business or holding and managing dramatically smaller sums of investor money.

For investors in domestic markets, the big loss is already a reality, a painful one that many wish they had avoided. Of course, none of us can know with any certainty what the markets will do going forward. But we can know when limits should be set and obeyed.

For me, a loss of 20% means that I have been dead wrong in allocating funds in an account and, therefore, must make changes. Living to fight another day is more important than trying to salvage the last traces of my pride. Stubbornly insisting that I am right in the face of mounting losses is a sure sign of forgetting my most basic role.

The first and only goal for any fund manager is to help clients achieve their financial goals with the highest degree of certainty. And in times like these, that means having a plan in place for managing losses. If that credo results in gaining a little less during the “up years,” then so be it.

Once that big loss has been taken, the investor has lost valuable capital and, even more, valuable time. The investor who has stubbornly stayed with the domestic stock market for the duration of this decade is now nursing a loss of about 40% in nominal terms, using the S&P 500 as a proxy. Surely some have fared even worse, given the tendency to chase recent performance, as seen in Heebner’s fund.

Imagine that your savings are 40% smaller today than they were almost eight full years ago. And that would be before calculating the effects of inflation, which has reduced the purchasing power of the dollar by about 30%! That investor must come to grips with the reality that he may never again be as rich as he was eight years ago.

Doesn’t he wish now that he and his fund manager had loss controls in place, controls that strictly limited losses in any one year to 20% — or even less? Let’s face it, a loss of even 10% is but a marker on the way to bigger losses. That much lost money is difficult to make up, but that much lost time for incremental growth will never be regained. It is gone forever.

If you are investing your own money in risky assets like the stock market, put a loss limit in place now, before you need it. Making efforts to limit your losses while your account is falling is nearly impossible to do, considering the emotional challenges that we all face during stressful times.

Or if your fund manager does not have loss controls in place, make that a requirement for him. And any fund, or any stock for that matter, should be dropped when it exceeds that limit. And let me say again that, though you might be able to afford the loss of capital, you can never regain the time lost while your account suffers.

Avoid “the big one.” Live to fight another day, and find better markets to invest in. The home market will be a challenging place to earn decent returns for years to come.

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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