Chapter 22
How To Make A Fortune
In The Great Stock Panic
With Strictly Limited Risk
Although Dad also played bull markets, what excited him most was the prospect of making money in bear markets. He dedicated much of his life to studying them, and teaching me everything he could. I learned four basic principles:
Principle #1. You don't have to wait until the next bull market to start profiting directly from the crisis. You can choose from a wide range of investments that are designed specifically to appreciate in falling markets.
Principle #2. When the market is falling, price movements are usually larger and swifter than when the market is rising. This opens up potentially dramatic profit opportunities.
Principle #3. Never underestimate how much a stock can fall. Some people say: "This stock has fallen so far already, it couldn't possibly get any lower. So I'll just hold on, or I'll buy some more." That's an often failed strategy based on a fallacious assumption.
The fact is, no matter how far the market has already declined, bigger declines are still possible. In 2000, for example, we saw stocks fall from the equivalent of $100 to $1. That means they fell by at least 50% six times in rapid succession; and each of those 50% drops was a major opportunity for profit.
Principle #4. Every investment that offers large rewards also implies large risks whether your strategy is designed for bull or bear markets. There are ways to reduce that risk, but you can never escape this basic principle; nor should you try. Instead, you should focus your attention on ways to limit and contain that risk so that it does not spill over into your keep-safe funds.
Limited Risk
Bear Market Vehicles
I'm sure he'd be in awe. But beyond the glamour and glitz, what I think would have been most intriguing to him is something that the average observer would not pay much attention to: The new bear market investment vehicles that have evolved in recent years.
Remember: Back in the 1920s and '30s, the only way to profit from a bear market was with outright short positions. You borrowed the shares from your broker. Then you sold them for that day's price. If the market went down as you expected, you bought the shares back at a lower price, returned the shares to the broker and pocketed the difference. But if the market went up sharply you could lose your shirt even house and home.
This is the vehicle Dad used, and yet he was able to parlay the $500 he borrowed from his mother into over $100,000.
But to make it work, he had to expose himself to potentially unlimited risk. He had to stay on top of his trades hourly, even by the minute.
Let's take a closer look at how Dad did it. Then, let me show you how you can do it today, with much less risk.
When Radio Corporation of America ("Radio" for short) was selling for close to $500 per share, Dad announced to his clients that it was going to fall apart. Unfortunately, he couldn't afford to sell short such a huge blue chip, because he would have had to put up too much money. So he shorted other stocks instead. But hypothetically, let's assume he went short Radio at $500. Here's how it would have played out:
First, he would borrow 100 shares of Radio from his broker.
Then, he'd immediately sell the shares for $500 a share or $50,000. Now he'd have $50,000 in his account.
The stock falls to $250. He takes $25,000 out of his account, buys the 100 shares back for $250 per share, and returns the stock to his broker.
The profit left in his account: $50,000 - $25,000 = $25,000, minus any commissions.
To start this transaction, however, he'd have to put up his own money. In those days, he could have put up just 10% or only $5,000. Today, you'd probably have to put up 50% or $25,000. Assuming a $25,000 initial investment, your return would be $25,000 on a $25,000 initial investment, or 100%.
That alone is a great return. But Radio continued to plunge ... all the way to $2 per share. With 50% margin, he could have doubled his money once as the stock fell from $500 to $250, doubled it again, when it fell to $125, again when it fell to $62.50 and so on. All told, his original $25,000 could have grown to $6.4 million.
And if he used 10% margin, a $5,000 investment would have grown to the astronomical figure of $8.4 billion!
Needless to say, in real life no one can consistently time their buys and sells to achieve these kinds of results. But it illustrates the amazing power of bear markets.
And you can see how it was possible to transform the $500 he borrowed from his mother into over $100,000. Today, outright short sales are certainly still a viable alternative if you are a professional or you have a professional adviser who can stay on top of it for you.
But for investors that prefer to be less aggressive, instead of outright short sales, I prefer vehicles that have built-in risk limitations. There are two such vehicles available to average investors today. I cover the first in this chapter, and the second in the next chapter.
Bear Market
Mutual Funds
Most of these funds aim to match the performance of a stock market index but in the opposite direction. When the index falls, the fund's value rises. When the index rises, the fund's value goes down. There is no time limit. Your risk is limited to the amount you invest. And you can never lose more or receive a margin call. Some examples:
Rydex Ursa (RYURX, www.rydexfunds.com, 800-820-0888). This fund is designed to appreciate 10% for every 10% decline in the S&P; 500 Index.
Here's how it works: The Ursa Fund basically maintains an open short position in the near-term S&P; 500 Index using the futures markets. But these positions are fully collateralized with Treasury bills and various money market instruments. So the fund never gets a margin call. More important, neither do you.
Meanwhile, the fund's money market securities earn interest. And this interest income covers transaction costs, operating expenses and management fees. The fund's expense ratio currently runs about 1.38% of assets.
Whatever income is left over gets paid out as a dividend. This dividend also helps cushion somewhat the decline in net asset value during periods when the stock market is strong. And during periods of market decline, it helps boost your profits to some degree. Warning: This fund is betting on declining stock prices. If the markets go up instead, your shares' net asset value will go down.
The Rydex Dynamic Tempest 500 Fund (RYTPX) is essentially the same as Rydex Ursa with one critical difference: It is designed to appreciate 20% for every 10% decline in the S&P.
Rydex Arktos works a bit differently. Instead of tracking the S&P 500 Index, it tracks the Nasdaq-100. For every 10% decline in the Nasdaq, the fund is designed to appreciate 10%. Since the Nasdaq-100 Index tends to be more volatile than the S&P 500, the fluctuations in this fund's shares will also be more volatile. That means higher potential profits and higher risks.
Instructions for buying these funds are the same as those for Rydex Ursa (above).
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