The Little Book of Bull's Eye Investing: Finding Value, Generating Absolute Returns, and Controlling Risk in Turbulent Markets

Chapter Two

Rules of Engagement

Adjusting Your Expectations to the New Reality

INVESTORS HAVE BEEN TAUGHT an approach to investing called modern portfolio theory (MPT), which seemed to work quite well for decades. It is confidence in this theory that prompts investment gurus to tell us to take a deep breath and remain calm when our portfolios are down 40 percent. It is this theory, or what is really a twisted version of it, that allows brokers to tell you to buy and hold large-cap stocks with high price-earnings (P/E) ratios (or whatever investment they are pushing), even as the stocks tumble. There is much to be learned from modern portfolio theory, but I think it is at the root of much of the pain individual investors have been feeling these past few years.

The rules of engagement for warfare have changed. The end of the Cold War and the beginning of the War on Terrorism marked a change in the nature of conflict. War is still a grisly business, but fighting today’s battles with the old tactics would be a recipe for defeat.

The rules of engagement for investing, as it were, have changed as well. What worked for the 1980s up through 2000 won’t work now. If you don’t adjust to the change, you won’t be happy with your investment returns over most of the rest of this decade.

Jumping Ahead

Stock market returns for the next five to eight years or so (from the vantage point of early 2012) are likely to be far below those of the 1980s and 1990s and below the expectations of most investors. ...