This answer was written 22 October 2006.
We are in the fourth year of a bull market which has just gone through a difficult correction and has now roared up again to test the old all-time high. This may or may not be the end of the bull market – only time will tell. However, all bull markets end sooner or later. We should be thinking through what we plan to do when it finishes well before the event. We should have mentally rehearsed our plan so that it has become instinctive and we can act on it without hesitation. If you are not already in this situation, start thinking. You may not have as much time as you think. It is too late to start thinking it through in the heat of battle. That is how you get to join in the panic. The winners will know what they intend to do and calmly execute their plan.
Since March 2003 it has been easy to make double digit returns. Ask whether you are mistaking the bull market for brains. The hard bit is keeping what you have made when the bust comes along.
All markets go through bull and bear cycles, even though there are many who swear that property only ever goes up. I have lived through many property cycles and I can tell you the carnage when the bubble bursts is not pretty unless you derive pleasure from watching the misfortune of others. This weekend's Australian Financial Review contained an article headed A Sceptic's View of the Property Boom, by Mathew Dunckley, which every investor should read. It is about Bill Bowness, one of Australia's most successful property investors. He has just sold out ahead of the next bust. Some of his advice for managing a bust is instructive and can be equally applied to the stockmarket.
His first golden rule is to look for warning signals. I know no better way to do that in the stockmarket than by using Dow phase analysis and basic charting. This is all explained in detail in my book Building Wealth in the Stock Market.
His second golden rule, which he has just invoked in the property market is not to get caught with stock when the music stops and to have plenty of capital in cash. The strategy I set out for market exposure in The Aggressive Investor is how I do the same thing in the stockmarket. It saved me in October 1987 and at several other important market tops.
His third golden rule is what breaks you is not bad stock selection, but holding costs. If you are using margin lending, you will have holding costs in the stockmarket too, but the big destroyer is losses. The golden rule is to cut losses quickly and let winners run. Most people do the reverse. The best investors worry most about the losers. If you have a good plan and cut the failed choices quickly, that is the main game in a market bust.
Another of his golden rules is diversification. I agree in principle. However, if you want to beat the market you need to avoid wide diversification or you may earn a mediocre return. I am a stock-picker. I am frequently pestered for how I pick the stocks I buy. I am happy to talk about that and have outlined it in detail in Building Wealth in the Stock Market. The smart students read what comes after that in the book – how I manage my investments. That is where the money is really made. Nobody ever asks for a seminar on that topic.
Finally, Bill Bowness says that cash is king in a recovering market. I learned this lesson decades ago by studying Howard Hughes. He had cash at the bottom of the great crash of 1929-32. He bought great assets cheaply when nobody else had cash. I have always sought to get out of the market – entirely if necessary – around the top and be in cash when the bottom approaches. The easy money is often made at the start of the bull market, not the end of it. If you want to know my rules, read Building Wealth in the Stock Market. It is all there.