ARCHIVE:: FEBRUARY 2002 :: YOUR MONEY

Street Smarts
Four Investing Lessons From the Market's Darkest Days

SmartMoney University

The Wall Street Journal headline said it all on Oct. 20, 1987: "Stocks Plunge 508.32 Amid Panicky Selling."

The crash on Black Monday sent a wave of dread through a nation drunk on its own prosperity. Fueled by Reaganomics and an easy-money culture, stocks had soared more than 225% between January of 1980 and late summer of 1987. When they plunged 30% in a matter of weeks -- most of it on that ugly 508-point day -- the nation stood still in a collective state of shock. Not since 1929 had Wall Street looked so instantly vulnerable.

Illustration: John Kerschbaum

A market free-fall is about the scariest thing imaginable for anyone who has put faith in stocks. But that has more to do with fear of the unknown than actual financial damage. It's true that if you had invested all your money near the market's peak in 1987 and held on through the crash, you wouldn't have recovered your losses until August 1989. But the fact is, most people don't invest that way. They tend to put money to work a little at a time, laying aside a part of their paycheck at regular intervals.

Suppose, for instance, that you had invested $10,000 in equal monthly increments of $385 from July 1987 until August 1989. Although you would have lost what you had accumulated by September 1987, your $385 a month would be buying stock that was dirt cheap in late October. As stocks began to rally, you'd be getting the full benefit of the recovery. And when all was said and done, you'd be sitting on almost $12,400.

Investing a little at a time is a strategy known commonly as dollar-cost averaging. It doesn't shield what you already have invested from a crash, but it does let you take advantage of the fact that stocks become cheaper as the market declines. Because the amount you invest remains constant, you are able to buy more shares of a stock or mutual fund when the price is low and fewer shares as the price rises.

Investing on dips -- or crashes -- is the hallmark of the experienced investor. It may take nerves of steel at first, but experience will teach you that the market rewards those who buy low and sell high.

Patience, Patience

Larry Ellison, the brash, billionaire chairman of Oracle, had two overriding passions: Asian culture and beating Microsoft. The one led him to establish vast Pacific Rim markets for his fast-growing database software company. The other drove him to establish Oracle as the company to beat in the business of providing big companies with software to manage their business processes.

In August 1997, however, Mr. Ellison's twin passions caught up with him.

From 1990 through the spring of 1996, Oracle stock soared a remarkable 750%. Had you jumped into the company's shares when they dipped that April to around $13 (adjusted for splits), your investment would have more than doubled over the next 16 months to $27 a share.

But then the bottom fell out. In late August of that year, a currency crisis in Thailand sparked a regional financial meltdown that eventually spread to markets throughout the world. As Oracle's Asian market weakened, competitor Microsoft was attacking the domestic database business with its NT operating system.

The next four months were pure hell for Oracle investors. The stock plunged 54% to a low of $12.50 in early January. For most of 1998, Asia's economies continued to struggle and countless Oracle investors jumped ship. You might have been tempted to sell, too -- all of your gains from that April 1996 investment would have evaporated.

But if you had sold, you would have lived to regret it. By the time the summer of 1998 rolled around, Asia began to stabilize and sales data were proving that Oracle's database customers weren't defecting to Microsoft's NT product in any large numbers. It turned out NT software wasn't powerful or reliable enough for really big database users. Oracle began to post solid earnings numbers, which lit a new fire under investors. From late August until February of 1999, the stock rocketed 200% to more than $37 a share.

Sometimes patience is your best defense against market volatility. If you've done your homework and believe in your company's management, you should have faith that they can work through the inevitable rough patches that any business encounters. If something had changed fundamentally for Oracle -- if Microsoft's NT really was gaining, for instance -- it might have been time to bail. But in this case, Wall Street simply over-reacted and those with a short-term perspective lost plenty of money.

All That Glitters

Stocks aren't always what they seem. When you set out to analyze one, much of the information -- for better or worse -- comes from the company itself. Sure, the financial statements are audited. And there are plenty of laws against fraud. But that's scant protection against a management team bent on lying to you outright.

A few years ago, the Canadian mining company Bre-X became the hottest stock on the market after company assayers salted a mining property in Indonesia with gold. The excitement over what looked to be a major new gold deposit drove Bre-X shares up to nearly 18 times their initial price. Investors who got in early saw $10,000 turn into almost $190,000 over the space of about a year. But when the fraud was discovered, the run on the stock was immediate and brutal. Bre-X shares quickly became worthless and the company eventually filed for bankruptcy.

If Bre-X had been the only stock you'd owned then, you'd be thinking of jumping down a mineshaft yourself right now. But savvy investors never put all their money in a single investment. Instead, they diversify their holdings, investing in at least 10, usually 20, different stocks. Mutual funds typically invest in anywhere from 15 to several hundred companies at once.

So if you'd limited your initial investment in Bre-X to 5% or less of your holdings, you would have been fine. Better than fine, in fact. Assuming your other 19 stocks earned an average return, you would have ended up with a 41% gain after two years. No matter how hot the stock, it always has the potential to blow up. The only way to protect yourself is to diversify, diversify, diversify.

Spread the Wealth

Blue-chip stocks led the most recent bull market, as big, powerful companies like General Electric, Wal-Mart and IBM exploded for huge gains. But that wasn't always the case. Back in the 1970s, the bad economic news never seemed to stop coming, and the biggest, best-known stocks suffered through five bear markets from 1966 to 1982.

Fortunately, small-company stocks came to the rescue. By 1975, after the worst of the '70s bear markets had ended, profits started to take off for a new breed of young, nimble corporations -- especially those involved in computers. While big companies languished, the stocks of small ones soared almost 131%, adjusted for inflation.

The moral: Just as sophisticated investors never bet the bank on a single stock, they rarely concentrate their holdings in one narrow band of the market. Instead, they spread their assets across a diversified range of big, small and international stocks, as well as other more stable investments, like bonds and money-market accounts.

This strategy, known as asset allocation, takes advantage of the market's one certainty -- that you never really know what's going to perform well and when. While small stocks saved the day in the late 1970s, they've lagged badly more recently. But if you're properly diversified across the two groups, one will buoy you while the other tries to drag you down.