The World’s Best Investors: Three Ways to Avoid the Next Crisis

For starters, keep in mind that your most recent mistake may be one of omission: If you haven’t been invested in the stock market since early March, you’ve missed the sharpest stock rally since 1938. There’s no guarantee, of course, that the upswing will continue, but it makes sense to come up with a strategy that will allow you to participate if it does, and not get hammered too hard if it doesn’t.

Renowned investor Jeremy Grantham

Jeremy Grantham, the chairman of GMO money managers in Boston who was accorded near rock-star status at the conference thanks to his prescient warnings before the crash, says the key now if you missed the rally is “regret minimizing.” Start trickling into the market with the aim of being fully invested by 2011, thereby taking advantage of any further pullbacks. Grantham acknowledged, though, that it is hard to find the stomach to buy into a falling market, and admitted that while he’d had the discipline to buy for client accounts as the market hit its recent lows in March, he’d been less aggressive in his own and his children’s accounts. “I found excuses for not being as brave as I should be,” he said.

It’s worth noting, however, that Grantham is very price-sensitive. He said that if the current rally takes the S&P 500 past 1,000 (it recently traded in the mid-900s), he would probably sell some stocks. Grantham’s worst-case scenario would take the index down to 550, at which point he’d go all-in.

Fund manager Chris Davis, of Davis New York Venture, also spoke of the virtues of regular buying, known as dollar-cost averaging, though he looked back to an even worse crisis for proof of the benefits. Using the example of an investor who started buying stocks in 1929 on the eve of the Great Depression, he went through the numbers: The market did not return to its 1929 peak until 1954. But if an investor with bad timing and good discipline had put $10,000 a year in the market over next quarter-century, his $260,000 outlay would have grown to $1.7 million, thanks to compounded dividends and the appreciation of shares bought cheap. And whatever the future holds, Davis pointed out, we’re certainly well off the market’s peak today.

Another Grantham strategy is hard to execute, but potentially so rewarding that it’s worth at least considering. While most financial advisers recommend that investors set a target asset allocation of diverse investments and stick to it in good times and bad, Grantham recommends trying to determine which asset classes are undervalued and investing more heavily in those. To make his point, he showed the difference in returns between emerging market stocks and U.S. stocks over the past 10 years. While the S&P 500 is actually lower than it was 10 years ago, investors in an emerging market index have reaped average annual returns of nearly 13 percent over the past decade.

“Big asset classes are very inefficiently priced,” he said. Rather than struggling to decide, say, which small-cap value fund to buy, when the difference in return is likely to be just a few percentage points, make the big bets on asset classes. To be sure, he didn’t mention that if you bet wrong, the pain can be disproportionately large. Right now, Grantham said, the asset classes poised to outperform over the next seven years are high-quality domestic stocks (investors can get access to “quality” stocks through a mutual fund such as The Jensen Portfolio, whose managers have a strict return-on-equity screen) and, once again, emerging markets.

Part of the reason this market collapse was so brutal was that all risky assets got clobbered, whereas in the previous bear market, to take one example, small-cap stocks performed adequately. And even this time around, diversifying more broadly was not a complete failure: If you held Treasury bonds, for example, that portion of your portfolio did well, and cash eked out a positive return.

In a panel on asset allocation, Vineer Bhansali, a managing director at PIMCO, also offered a new way to think about diversification. Bhansali suggested that investors look at their portfolio as they look at their house, and buy a little insurance. First, consider the risk you want to protect against, then find a hedge. So, for example, if you are concerned about inflation, add some commodities to your portfolio, as well as TIPS, or Treasury Inflation Protected Securities, which are bonds that increase in value as inflation climbs.

Fellow analyst Tom Idzorek, chief investment officer of Ibbotson Associates, noted that a young person’s future earning power is a natural form of inflation insurance, while a retiree on a fixed income would need to invest more heavily in TIPS. Sure, you’re likely to get a lower return than you would on stocks, but that difference is the equivalent of the annual premium you pay for your homeowner’s policy.

And just as you don’t wait until the hurricane is just off the coast to buy flood insurance, don’t wait for inflation to buy TIPS. Do it now, while the insurance is cheaper. Worried about a market crash? Then increase cash in your portfolio. Just remember that that hurricane has already hit. As a result, bear market insurance is quite expensive (cash yields are low and it’s a painful time to sell stocks considering how far down most of them still are from their highs). Maybe it’s less urgent to buy that insurance immediately.

While dollar-cost averaging, seeking out undervalued sectors, and diversifying your portfolio are not brand-new concepts, they are effective. Of course, the holy grail would be an ability to spot the next bubble. While there’s no surefire method, fund manager Ron Muhlenkamp of the Muhlenkamp Fund had a suggestion. Muhlenkamp studied market statistics from Goldman Sachs and concluded that much of the recent stock market crash was caused by forced selling, as hedge funds and other big players had to reduce leverage, or the amount they’d borrowed. Clearly, the real estate market is suffering from forced selling, too.

So in future years, Muhlenkamp suggests people use common sense as they look out beyond their own picket fence: If you find yourself wondering how the neighbors are possibly affording that new BMW, if you get the sense that a colleague at work would lose his house if he lost his job, that’s a red flag that if something goes wrong, they’ll be forced to sell. “Ask yourself, how much cushion do they have?” he said. And if the answer is not much, it’s probably time to make sure you have plenty.