With doomsday unlikely, it may be buying time

• No new trades.

Strategy Lab is MSN Money's stock-picking challenge. To learn more about the game -- and the contenders -- click here.

This has been a tough round of Strategy Lab. Market downturns of more than 10% do not happen every year. When they happen in the space of just a few weeks, it usually means something significant has changed that warrants a re-evaluation of our investments.

This time, the significant change was the subprime mortgage crisis. In August, I felt pretty confident that my portfolio would do well in spite of the subprime situation because I didn't own any of the subprime lenders. In hindsight, I misjudged the severity of the crisis and particularly its impact on the broader market.

Doomsday scenarios

At the start of the crisis, some people predicted that losses from subprime mortgages would be so large that the stability of the entire financial system would be called into question. Goldman Sachs (GS, news, msgs) estimated that subprime-mortgage losses would reduce bank capital to such a degree that the lending capacity of the entire banking system would be reduced by $2 trillion. This doomsday scenario, from a firm that is admittedly net short subprime mortgages, raised the specter that the crisis would cause a credit crunch of gigantic proportions that would push the whole economy into a recession.

As it has turned out, the losses reported so far are less than one-half what Goldman Sachs estimated, and the resulting reductions to bank capital have been made up for through the sale of newly issued preferred stock. The shareholders of the banks that made these bad loans have been diluted, but the impact to the broader economy will most likely be much less than the doomsday scenario predicted.

In times like these, the natural instinct is to sell stocks first and ask questions later. But giving in to this instinct is not an investment strategy. In fact, it is precisely when everyone is afraid that the best bargains are available.

I'm beginning to think the write-offs at Citibank (C, news, msgs) and Merrill Lynch (MER, news, msgs) that were announced on Tuesday mark a turning point. Both firms have already changed their CEOs. The new CEOs have every reason in the world to write off everything they can right now so they can't get blamed for it later. Therefore, these write-offs probably reflect the true extent of the problem, and it's even possible they may have gone overboard. Things will likely get better from here for both Citibank and Merrill Lynch.

Buy when we're down

My portfolio did not perform this round because I did not react quickly enough to the subprime crisis. Over the past two years at Strategy Lab, we've gone through probably a dozen sharp market downturns that were quickly corrected. I call them panic attacks.

If I traded in response to each panic attack, I would quickly drive up expenses and reduce returns for my mutual fund's shareholders. Instead, I look for stocks that I think are doing something so significant that if they execute well, they could double the company's value within two years. Before I buy them, I have to do the research to have the confidence to hold on to them during one of the market's frequent panic attacks.

It's hard to tell the difference between a panic attack and a downturn. For me, the difference is whether anything significant has changed. This round, something significant did change.

In the short term, the market exerts a strong influence on the price of any stock. But over several years, a stock's price is much more affected by what the company does than by what the market does.

The best time to buy stocks at a good price is when the market is down big for reasons that have no impact on the company. That means that now may be a great time to buy some stocks! One indication that this may be so is that Chris Rees, one of our mFOLIO Masters, who has averaged more than 30% a year for the past six years while holding 22% in cash (on average), is now fully invested.

Before the next Strategy Lab round starts, I'll be reviewing my positions in light of the significant changes we are seeing in the market. Since the next round does not start for another few days, I'd like to offer readers a chance to find out what I've decided to do even before the next round begins. If you are an investor in our fund, or would like to be, click here and I'll send you an investor's kit and a form to fax back to me so that we can start a free, one-year subscription to Marketscope (our newsletter), which our agreement with Forbes allows us to make available to investors in our fund.