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This chapter is from the book

Expect the Unexpected

The first principle that investors have to adhere to is quite simple: Be prepared. Investors must be psychologically prepared for any surprise the market can deliver. Part of preparedness is assuming the market can tumble sharply at any time. Corollary to that: Always assume the market can mount a sudden big rally.

After you drill that into your head, that these surprises can besiege the market without warning, you are ready to take on panic.

First of all, assuming that you are already invested in the stock market and you want to take advantage of the bursts of market activity, you need to have a cash reserve. Cash reserves should be from 10 to 20 percent of your portfolio.

That brings us to the next step: Prepare two lists of stocks. The first list to keep handy is of stocks you want to own for the long haul. If you already have them in your portfolio, mark them as the stocks you should buy more of. These are the stocks that, when they tumble in price, you would want to snap up to add to your holdings. The second list should consist of stocks you own but that have already produced handsome gains, and that you would be willing to sell when the market goes on a buying rampage. The reason to sell them is so you can augment your cash fund.

Armed with these two lists of stocks, an investor will have a clear mind as to what to do when a panic situation hits the market. He or she will be free of fear about any trouble in the marketplace. The Buy Panic commandment will, in truth, free you of the jitters that normally afflict investors in times of market volatility.

This is not to suggest that you will engage in short-term trading. On the contrary, this maxim encourages building a long-term portfolio and, with an ample cash reserve, fortifying it whenever panic times hit the equity market. It suggests for you to build a stronger long-term portfolio, by increasing the number of the good stuff you have in your portfolio when opportunities come knocking.

There are a couple of ways of taking advantage of the market’s dysfunction in times of panic. When the market starts selling off, watch which of your favorites are getting a whacking. Because you have owned these stocks for a while, you have an idea whether they are being unjustifiably pounded, based on their fundamentals. Any drop of 5 to 10 percent or more should be enough to inspire you to buy more shares. If the stocks drop to anywhere near their 52-week lows, that should also alert you to buy. Also, consider your cost at the time you first bought them. If their prices are lower than your original buying prices—or even if they’re just about even—consider them a bargain.

Let us look at the flip side. When the market is rapidly pumping up, as it was on September 18, 2007 when Federal Reserve Board Chairman Ben Bernanke cut the federal-funds rate by a half a percentage point, you should sell the stocks you listed as disposables or potential profit sources. Remember: You have to sell stocks that have given you sufficient profits so you can build up your cash reserves with which to buy more of your favored stocks.

When you embrace the Buy Panic commandment, you will—strange as this might sound—look forward to the market’s periodic bouts of panic. You will finally see the stock market as nothing more than a bastion of opportunities.

Now, how do you know that you are holding stocks that are solid enough to keep and buy more of? One important basic requirement is homework/research. A big part of homework is reading up on the market and stocks. Be an earnest reader of anything that has to do with investing and the markets. Newspapers and magazines are a good start. After you develop the habit of reading the business and investment sections of periodicals, you will become more informed about stocks, their prices and trading patterns, their high and low points, and price-earnings ratios. Make it a habit to read books on equity investing and the markets. You will be familiarizing yourself with a big part of the stock market. These books are not trivial; they are essential information about a part of the business world where you can make money.

The Internet is a big arsenal of information about companies, their backgrounds, and every aspect of their businesses. Yahoo.com, Google.com, and AOL.com quickly come to mind, in addition to Web sites of newspapers like The New York Times, The Financial Times, The Wall Street Journal, and Investors Business Daily. BusinessWeek Magazine provides more than 350,000 companies worldwide in its Company Insight Center, as a free resource on the Web, at http://investing.businessweek.com/research/company/overview/overview.asp.

Of course, there is always the direct approach. Most corporations are willing to send out information directly to future and present investors. The majority have Investor Relations Offices that handle these matters of interest for investors. Contact the companies directly by phone, letter, or through their Web sites.

Searching for information might already be part of your routine if you are invested in the market. If you aren’t yet comfortable or experienced enough to know what to buy or sell to practice the Buy Panic rule, there is one simple and easy way to do it. You will rarely fail if you start concentrating on the major big cap stocks. These are the blue chips. Start with the 30 components of the Dow Jones Industrial Average, or the most widely held stocks, including General Electric Co., Boeing Co., AT&T Inc., Citigroup Inc., Coca-Cola Co., and ExxonMobil Corp., to name just a few.

The main reason I suggest them is because it is easier for investors to understand these companies because most of them have widely known brands or franchises.

During market meltdowns, these companies get hit as much as the small-cap stocks, and sometimes even harder. Although they have vast resources and are triple-rated companies by the credit rating agencies, they are as vulnerable to the panicky swings of the market as the small fries are. The large-cap and widely followed stocks are definitely the logical candidates to start with in practicing the Buy Panic commandment.

For investors who work for or are associated with publicly traded companies, the most convenient way to start applying the Buy Panic maxim is to buy employer stock. With your knowledge of the company, you likely feel comfortable and confident about buying your company’s shares—assuming that it is a relatively well-managed company. Closely follow the stock through the company Web site or internal sources of information. After you get a handle on its stock, watch how it trades. When one of those market crashes takes place, make sure you are on the ready to grab any opportunity and buy more should the stock drop sharply.

Playing the market with your employer’s stock is a practical way of testing your patience and nerves in practicing the Buy Panic commandment. Ownership of stock in your company familiarizes you with the challenges that confront investors day to day. You will find yourself keeping tabs of the company’s growth, outlook, and quarterly earnings guidance. Investors in effect are students of companies, and exam time is when the market starts jerking around to test nerves—and decision-making prowess.

A good example of a stock that challenged investors is Goldman Sachs, the premier U.S. investment bank. Even the Wall Street giant took a beating when the credit squeeze troubles grabbed the headlines. If you played the panic game with its stock, you easily could have piled up significant profits. Let’s see how that worked.

Shares of Goldman Sachs, one of the most profitable and rapidly growing Wall Street houses, traded as high as $233 a share in June 2007. Its stock was knocked when the subprime mortgage troubles erupted. The height of panic selling caused by the credit problems started on August 13, 2007, and Goldman’s stock tumbled to $177.50 a share that very day. In just a couple of days, the stock got pounded even harder, pulling the stock down to $164. For the Buy Panic investor, that would have been a perfect buying point. Knowing Goldman Sachs background and resources, would you have thought that the company was in danger of getting into serious trouble because of the subprime mortgage mess? The stock behaved like it was in serious trouble, and many investors, including some of the institutional investors, did sell the stock in their usual panicky way.

At $164 a share, the Goldman Sachs stock was a pure bargain, selling at just 6.8 times projected 2008 earnings of $23.90 a share, compared with a price-earnings ratio of 10 in June. A month later, on September 18, the market mounted an unexpected giant rally, driven by the Fed’s federal-funds rate cut. Goldman Sachs stock was among the market’s giant winners. The stock closed that day at $205.50. Just about a week later, the stock continued to fly, to $210—and rising. That was a 46-point jump in just over a month, had you practiced panic buying. On October 31, 2007, Goldman Sachs’ stock hit a 52-week high of $250.70.

Now that you are fully prepared for panic, the complex stock market becomes a bit simpler. In sum, opportunities abound if you are alert enough during times of panic. True, you can lose money under certain and unusual circumstances. But by obeying the Buy Panic commandment, your chances of winning are almost clear and nearly predictable. And when you become proficient at it, panic won’t even enter your mind. You will be sufficiently mentally prepared, so sudden market jerking won’t confound you anymore. In fact, you will welcome panic on Wall Street because you now know how to profit from it.

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