Six Lessons from the Bear Market

In their latest Kiplinger’s column, Whitney Tilson and John Heins — who were well ahead of the curve on the housing and financial meltdown last year — use their own experience and those of other noted investors to offer six lessons to take from the recent bear market.

Their lessons:

Beware of over-concentration: This one comes from top manager Mohnish Pabrai, who believed his previous allocation of 10% on 10 different investments was too concentrated and led to his poor 2008. Pabrai has since changed his approach to aim for 5% positions for his favorite ideas, or 2% positions for riskier plays or plays that are very similar to his biggest holdings.

The big picture matters: “We learned the hard way that financial crises don’t tend to be self-contained, that very few companies’ earnings are immune to a terrible economy, and that even if profits hold up, investors are likely to reduce the amount they’re willing to pay for each dollar of earnings,” Tilson and Heins write.

Expect the unexpected: For this one, Tilson and Heins turn to hedge fund manager Tom Brown, who wrote of his 2007-08 performance, “I made the mistake of assuming that prior events always provide a good guide to what’s in store for the future. Wrong … The scale of the disruption might have been highly unlikely — but it wasn’t impossible.”

Book profits: “It’s easy to be mesmerized as stocks you hold appreciate,” Tilson and Heins say. “Each uptick provides further confirmation of your wisdom and your assessment of a company’s bright future. The result can often be that you build too big a position in a market darling that is likely to fall hard at any inkling of bad news or a more general market shock.”

Don’t outsmart yourself. As an example of this, Tilson and Heins turn to Timothy Mullen of VNBTrust, the money-management arm of Virginia National Bank. Mullen bought shares of Lehman Brothers and Wachovia on rumors of their demise, thinking he’d sell when the rumors turned out to be false. They didn’t. “I’ve purposefully started exercising much more in the past 12 months,” Mullen said, “and one big reason has been to help avoid making stupid mistakes because I get all caught up in staring at the screen and overthinking.”

Stay humble: “The markets never seem to tire of imparting the wisdom of humility,” Tilson and Heins say. They quote Brown again on this: “If the period from January 2007 to July 2008 taught me nothing else, it’s taught me that disciplined self-doubt is a vital part of the investment process,” Brown said.

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