Investment Principles for Tough Times

"Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."

These words -- from Sir John Templeton, the great investor who passed away in July -- are easy to understand but hard to put into practice. Or, as said by another investment great, Warren Buffett, investing is simple but not easy.

The problem is that we are not as rational as we think. We tend to extrapolate negative trends into the future without recognizing that these trends will change, or that the economy is cyclical. We want to sell at the bottom when the outlook is bleak, and we want to buy at the top when things couldn't look rosier. We know that stocks outperform fixed income and money markets over very long periods of time, yet we suddenly become unwilling to hold onto our stocks when things go bad. The logical long-term strategy that worked just fine during good times suddenly becomes easy to throw away when things turn grim.

Research shows that when we feel safe we take more risks, and when we feel scared we shy away from taking any risk. We know that drivers take more risks when they wear seatbelts. They slow down considerably when they pass bicyclists without helmets, yet they zoom by cyclists that wear helmets or look like they are in "professional" gear.

We can be similarly irrational as investors. These days, it is easy to act scared and to shun stock investment. But we should remember that there are opportunities for long-term investors even in times of great uncertainty. As an example, we continue to look at many U.S. companies operating very successfully in fast-growing foreign countries. In addition, companies domiciled in China, India, and other emerging economies which cater to their own rising middle classes still are turning out strong earnings results. And there always are two sides to a coin. While high oil prices are fueling fears about inflation and the consumer's dwindling purchasing power, they also are benefitting companies working on alternative energy and energy efficiency and conservation solutions. The idea, of course, is to spot these opportunities and buy them when they are inexpensive.

It may not be a bad time to remind ourselves of a few other long-term investment principles as well. It becomes so easy to abandon one's game plan in the midst of duress, but long-term return is primarily driven by finding an appropriate asset allocation based on one's objectives and risk tolerance - and then sticking with the plan. Trying to jump in and out of stocks by picking tops and bottoms through periods of extreme optimism and pessimism simply doesn't work. Staying diversified and minimizing fees always remains important. Sufficient diversification reduces overall portfolio volatility and enhances return.

Finally, the key principle is to keep a keen focus on valuation. We know that over the long term, stock prices are determined by the fundamentals of a business. Emotions can push stocks deep into overvalued or undervalued territory, but prices eventually return to a level that reflects a business' earnings power. The trick is to look for those quality companies that have been pushed deep into undervalued territory.

And this, of course, brings us right back to where we started - with Sir John Templeton's advice to look for opportunity at the point of maximum pessimism. Smart long-term investment is built on finding companies that have temporarily gone out of favor and identifying bargains that others may shun. When individual businesses or sometimes entire markets go "on sale," times of pessimism become times of opportunity. It is worth remembering that Sir Templeton had the fortitude to go against the extreme pessimism by buying stock during the Great Depression. That turned out to be the start of a long, prosperous investment career built on contrarian thinking.