Greece is making progress with its bondholders on a debt swap. Under the program, holders of Greek bonds will exchange their securities for new bonds with longer maturities, lower interest rates and face values that are over 50% lower than those of the existing bonds. Greece is required to complete the swap in order to get new loans from the European Union and the International Monetary Fund. We’ll know whether the Greek government’s targeted participation rate of 90% is reached tomorrow morning at 1:00 a.m. Eastern time.

For private creditors who hold Greek bonds, this is not a good deal. However, it may be the best deal they can get. Greece is in financial distress, and its only other alternative is default. Though some investors are refusing to participate in the swap, their options are limited. Greek bondholders are dealing with a borrower that is effectively broke.

The refusal to participate in the swap is a calculated move. Whether it will ultimately result in a better outcome for those investors is a question I cannot answer. The holdout investors, many of which are reported to be hedge funds, may seek compensation through credit default swaps or they may turn to international courts. The price they paid for the bonds is another unknown factor that will ultimately impact their returns on the investment.

The extent to which the Greek bonds were bought on a purely speculative basis and the extent to which the purchases were based on the assumption that the bonds were undervalued is another unknown. Speculation can provide profits, but by its very nature, it can also result in large losses. Assuming a security will appreciate in price when there is a significant amount of data showing that the downside risks are high is an act of hubris.

Both speculation and hubris have resulted in large losses throughout history. Speculation played significant roles in the Internet bubble of the late 1990s and in last decade’s housing bubble. Hubris has led to the downfall of many traders and firms, one of the most notable being the hedge fund Long-Term Capital Management. Yet the lessons of history are often forgotten, ignored or simply not learned.

I see examples of this today. Take Red Hat (RHT) for instance. The stock trades at 67.7 times earnings and 8.9 times sales, even though earnings are projected to grow by less than 10% this fiscal year. Another example are investors who have allocated a significant portion of their portfolio to gold, either directly or through ETFs like SPDR Gold Shares (GLD), because they are absolutely certain that U.S. inflation and interest rates will soar in the next few years.

There is nothing wrong with making a specific investment when you feel confident about the possibility of making a profit or protecting your net worth. Such choices become dangerous when they represent a significant portion of your portfolio, however. Risks are often real, even if a security’s or fund’s price action does not currently reflect them. More importantly, the future always evolves in ways that are not easily predictable to those living in the present.

This is why you should devote most of your efforts to properly diversifying your portfolio and rebalancing it as necessary. If you want to speculate on a security or a future outcome to economic and fiscal events, set aside a small portion that you are financially able to risk losing. If you make the right trading decisions, you’ll add to your portfolio’s returns. If you guess wrong, you can still sleep well at night knowing your mistakes have not severely affected the overwhelming majority of your portfolio.

More on AAII.com

• 15 Short-Cuts and Biases That Lead to Bad Investment Decisions – Many common decision-making, measurement and risk-taking biases can adversely impact your returns, as this article explains.
• The Psychology Behind Common Investor Mistakes – Six common errors of perception and judgment that lead to investment losses are discussed in this April 2000 AAII Journal article, which is in .pdf format.
• What Investing Errors Have You Made? – If you are willing to admit to them, tell us on the AAII Discussion Boards.
• AAII Local Chapters – Meet other AAII members and see investing experts at our local chapter meetings, which are held in cities across the country.
• Don’t forget to take the Sentiment Survey.

The Week Ahead

No members of the S&P 500 will report earnings next week.

February retail sales and January business inventories will be published on Tuesday. Also on Tuesday will be a one-day Federal Open Market Committee meeting. Wednesday will feature February import and export prices. The February Producer Price Index (PPI), the March Empire State manufacturing survey and the March Philadelphia Federal Reserve survey will be published on Thursday. Friday will feature the February Consumer Price Index (CPI), February industrial production and capacity utilization and the preliminary March University of Michigan consumer sentiment survey.

Federal Reserve Chairman Ben Bernanke will speak publicly on Wednesday.

The Treasury Department will auction $21 billion of 10-year notes on Tuesday and $13 billion of 30-year notes on Wednesday.

Friday will be a quadruple witching day, meaning both options and futures contracts expire.

AAII Sentiment Survey

Bullish sentiment fell to a 10-week low but remained above its historical average even as bearish sentiment reached a 2012 high in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 2.1 percentage points to 42.4%. This is lowest level of optimism since December 29, 2011. Nonetheless, bullish sentiment is above its historical average of 39% for the 11th consecutive week and the 12th out of the last 13 weeks.

Neutral sentiment, expectations that stock prices will remain essentially unchanged over the next six months, slipped 0.1 percentage points to 28.6%. This is the fifth consecutive week that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.2 percentage points to 29.0%. This is the highest level of pessimism since December 29, 2011. Even with the increase, bearish sentiment is below its historical average of 30% for the 10th consecutive week and the 11th out of the last 12 weeks.

Individual investor sentiment continues to be optimistic, even though bearish sentiment has risen during the three out of the past four weeks. Rising gasoline prices and a return of volatility to the markets on Tuesday intensified some of the underlying worries about the pace of economic growth and Europe’s sovereign debt problems. Even so, many individual investors remain more focused on signs that the economy is improving and the overall gains stocks have realized since last November.

This week’s special question asked AAII members if their 6- to 12-month outlook for U.S. economic growth has changed since last fall. Respondents were evenly split between those who said they are now more optimistic about the economy and those who said their outlooks have not changed.

Here is a sampling of the responses:

• “I am more positive as economic indicators have improved.”
• “I do not believe the economic outlook has changed since last fall. We continue to limp along with high unemployment.”
• “No change in my outlook; I still expect slow growth with an increasing risk of inflation.”
• “I’m somewhat more optimistic for the U.S. economy, but there are too many outside influences (China, Iran, Europe, etc.) that could have a negative affect.”
• “Yes, for the better, though I expect that this improvement will not favor all industries and sectors the same.”

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor