Foolish summer

How do you “stay the course”—in Vanguard founder Jack Bogle’s oft-used phrase—when those around you are losing their heads?

That can be exceedingly difficult, as the late July-early August market swoon demonstrated.

I like the old aphorism from legendary financier and advisor to U.S. presidents Bernard Baruch: “The main purpose of the stock market is to make fools of as many men as possible.”

You can easily appreciate that sentiment when the market seems to be gunning directly for you, which is how I felt when the Japanese market tanked and U.S. small caps had a few scary days.

The only way to avoid being made a fool is to behave unlike other market players, and that usually means standing pat or buying when others are selling. Of course, there are times to sell a losing investment or to sell a winner that is well off its highs, but that is a whole other discussion—and one you don’t face when you only invest in broad market index funds.

But I have a tendency to overweight certain parts of the market. My biggest bias is toward value, especially small-cap value. That’s arguably reasonable and defensible—but has been a money loser for value-oriented investors for about 17 years.

On a smaller scale, I make side bets on specific sectors and sometimes even countries. (I’ve written often about my refusal to invest much in China, so that constitutes a bet against a country, mainly for moral reasons.)

But I’ve been betting on Japan, as I wrote three years ago. I got the country right, but didn’t fully participate because I bet on small caps over large caps and didn’t hedge currency exposure.

Finally, this year I switched to Japan funds that hedge against declines in the yen.

You can guess what happened several months later: The yen rose, and Japanese stocks cratered. It’s easy to believe in hindsight, with the Nikkei bouncing back, that the sell off was an overreaction. It seems to have been partly the result of a massive deleveraging of the so-called “yen carry trade,” as traders who borrowed money in the steadily falling yen and invested in up-trending assets like the Japanese market and U.S. mega-cap tech were forced to liquidate as the yen reversed course.

So, the market made fools of some big-money hedge funds. It almost made a fool out of me.

Because two of my bets bore the brunt of the selling, I nearly lost my nerve. But I did some journaling. (Even in good times I write down and track the results of my investment decisions.) For two or three days, I wrote out my worries and sketched out plans for what to do next. Sell my losing Japan funds? Sell a winning defense stock and buy more of the losing funds? Bail on my high yield fund because of growing recession fears? Bail out of a large growth fund (which I bought as part of the barbell strategy I wrote about recently).

Almost all the options I considered would have quickly lost money as markets reversed course. But because I waited, and because I kept writing down my thoughts, I eventually cooled down and realized there was one simple move to make first, while reserving other decisions for later: It involved taking a short-term tax loss but immediately investing the proceeds in a very similar fund.

The move didn’t materially change my portfolio positioning. Over the past few days, the market and my psyche have begun to heal, and the realized tax loss is icing on the cake.

I have long intended to wind down my value bet as I got closer to retirement and to do more market-cap indexing. The cycles of underperformance for any investment “factor”—whether it be growth, value, size or momentum—are just too long for an older person to risk. (I’m just determined to wait until small value has its day in the sun.)

I’m not sure I can ever rise above the temptation to make the smaller side bets. But if I limit them to about 10% of a portfolio that otherwise is invested in broad index funds, I should be OK.