How to cope with a bipolar market

'Today's dizzying and daunting market volatility is driven by astonishingly short-term investor thinking. Over the course of 2011, the S&P 500 Index fluctuated 2 per cent or more on 35 days (based on closing prices) only to end up almost exactly where it started." - Seth Klarman, recent Baupost Group investor letter.

'Today's dizzying and daunting market volatility is driven by astonishingly short-term investor thinking. Over the course of 2011, the S&P 500 Index fluctuated 2 per cent or more on 35 days (based on closing prices) only to end up almost exactly where it started." - Seth Klarman, recent Baupost Group investor letter.

Mr Market's bipolar moods have never been more obvious. On some days, the fear of the problems of excessive leverage is palpable.

Then governments and their agencies step in, usually with more liquidity, and the rally starts, only for fear to resume on the next round of bad news, of which there is plenty (and plenty more to come).

Investing legend Jeremy Grantham, in what he titles Investing Advice from Your Uncle Polonius, the first part of GMO's latest quarterly letter, has some valuable strategies to deal with and profit from such an environment.

Needless to say, they are easy to understand but difficult to practise, although don't let that detract from their value.

1. Believe in history

First, Grantham says that Santayana is right and history does repeat itself: "The market is gloriously inefficient and wanders far from fair price but eventually, after breaking your heart and your patience (and, for professionals, those of their clients, too), it will go back to fair value. Your task is to survive until that happens."

2. Neither a lender nor a borrower be

"If you borrow to invest, it will interfere with your survivability. Unleveraged portfolios cannot be stopped out, leveraged portfolios can. Leverage reduces the investor's critical asset: patience."

3. Don't put all your treasure in one boat

This one's obvious, really, although I'm continually amazed by how many so-called experienced investors have a portfolio top-heavy with speculative resource stocks. Even the big banks should not form more than about 10 per cent of the average portfolio.

4. Be patient and focus on the long term

In investing, this advice is so common as to be a cliche. What it really means is following the basic rules and "outlasting the bad news". Successful investors stay stronger for longer.

5. Recognise your advantage over the professionals

Investing probably isn't your chosen career. You don't have a job to protect, which means outlasting the bad news is easier than it is for the pros. It also means you don't have to act if you don't want to. Professionals, with their focus on short-term performance and need to act because that's what they're paid for, are handicapped.

For example, I have a relatively large position in QBE. I'm very happy with it. But as research director of Intelligent Investor, I have fellow professionals assailing me with their opinions, members selling out (and telling me I'm crazy) and media headlines proclaiming the end of capitalism.

Professionally, it's more difficult for me to stand my ground but the time to panic was when the share price was $36, not $12. Personally, it's easy. The only person I have to justify my decision to is myself.

6. Contain natural optimism

The media reported Grantham when he said: "Tell a European you think there's a housing bubble and you'll have a reasonable discussion. Tell an Australian and you'll have World War III." Optimism has served the species well but we struggle with uncomfortable truths. We must always remain open to doubt and accept the possibility of error.

7. On rare occasions, try hard to be brave

In early August last year at the height of the panic, we upgraded QBE Insurance and Macquarie Bank to strong buys. As Grantham says, "If the numbers tell you it's a real outlier of a mispriced market, grit your teeth and go for it."

8. Resist the crowd: cherish numbers only

Crowd psychology is embedded deep within us but it's vital to resist the lure of short-term news and the actions of others. Trust not intuition or emotion, only data and the well-reasoned opinions that stem from it.

Grantham concludes by saying it's quite simple, showing a table that compares his 10-year forecasts of 2001 with actual performance.

Despite the tumult of the global financial crisis, in each case real returns exceeded the forecast, which, in Grantham's view, endorses his eight points. If ever there was a how-to list for dealing with tumultuous times, this is it.

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