Investor Capitulation, Part 1

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” – Warren Buffett.

I do not believe in the concept of market timing, because no one knows what the short term direction of the stock market will be. An educated guess is about the best anyone can make. That is why a buy and hold strategy, using a well diversified portfolio, works best for most investors.

Given their own, sometimes naïve, perceptions, investors can become either too optimistic or too pessimistic. Unfortunately, it is typically easier to identify these times after the fact.

It is very easy to make predictions that turn out wrong, even if you are very knowledgeable.

For example, former Federal Reserve Chairman Alan Greenspan warned about “irrational exuberance” in 1996. He clearly thought that the high stock prices of 1996 could not be justified. Nevertheless, the stock market went up in 1996, 1997, 1998 and 1999. Eventually, in March of 2000, stock prices began their steep decline. Needless to say, if you had heeded “Financial Guru” Greenspan’s warning in 1996, you would have lost out on 3 – 4 years of profitable gains.

In October 2002, after stock prices had fallen almost 50% from their previous highs, a lot of investors “threw in the towel” and basically gave up on stocks. They sold their holdings and stayed out of the stock market for several years. Many of those investors compounded their mistake by switching from equity mutual funds to variable annuities. (That is a topic for another post.)

Let’s assume that, right now, given the current economic climate, the majority of investors are pretty pessimistic about the future. How can we tell? There have been plenty of indicators. Stock prices have already declined more than 35% from their year-ago highs. Banks have been afraid to lend to each other. Institutional investors (pensions, university endowments) have been pulling massive amounts of money out of hedge funds. Many individual investors have been heavily selling mutual funds. And many people, and institutions, have flocked to short-term Treasury securities,  because they are known to be extremely safe investments, albeit very low yielding ones.

Now, suppose stock prices continue to fall, resulting in investors becoming even more pessimistic than they already are. How could this happen? Well, what if so many investors decided to redeem their accounts that hedge funds needed to sell off even larger amounts of stocks, bonds, and commodities just to fulfill the investors’ demands. What if individual investors continued to sell their stocks and mutual funds, only doing it in greater amounts and with far more urgency?

Panic Versus Capitulation

What is this called? Well, panic is one term. Capitulation would be another. You may be hearing this particular term more often now. What would capitulation look like? Probably like the end of the world. The Dow Jones Industrial Average would fall by 800 – 1,000 points or more in a single day. And just suppose that that the selloff continued for a second day. Imagine the ominous discussion on TV. Investors would feel discouraged, disgusted and positively sick. One reaction might be, “Get me out now, at any price!”

If that happens, and there are certainly no assurances that it won’t, then this may in fact be the best possible time to buy more stock. Of course, it is very difficult to even consider buying when prices are actually plummeting and everyone is afraid. (You should note that it is incorrect to say that there are “more sellers than buyers.” In point of fact, there is a buyer for every seller, or more aptly put, each share to be sold will be bought. It is just that the sellers are willing to accept lower stock prices than previously was the case.)

I do not know if the capitulation phase of the bear market will occur. In Prepare for the Revulsion Stage  Janice Dorn, Chief Global Risk Strategist, Ingenieux Wealth Management, Sydney, Australia predicts that capitulation of investors will probably happen. Here’s how she envisions it.

Now, we are likely to see a washout where just about everyone who has not sold will give up and sell. They will walk away from the markets and vow never to return again. This will be the complete revulsion stage. Only when this happens will the markets be in a position to begin to rebuild the technical damage. This will take time, and it now appears that the highs in the broad indices have been seen for many years to come.

People will have nightmares about the Great Crash of 2008 for years to come. They will lose trust in the entire financial system and in many of their advisors who allowed their accounts to lose somewhere between 25% and 50%. The small retail trader will leave the markets in disgust and distrust.

Dorn’s description is quite graphic. And she is saying that it is likely to happen. Make no mistake, she is predicting a once-in-a-generation change in investor perception. We’ll see if this extreme reaction comes to pass.

But please remember that stock market lows can only be identified in retrospect. Moreover, for people who follow a buy and hold approach, all of this may be of only intellectual interest. On the other hand, knowing that this kind of panic behavior can happen may steel you not to join the herd in selling at what may just be the wrong time.

photo credit: Bitterroot

Is It Different This Time? Part 4

“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.
 
Today’s New York Times has two editorials, both of them well worth reading; one was written by Nobel prize-winning economist Paul Krugman and the other by Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway, who is touted as one of history’s most successful investors. At first glance, their respective opinions seem to be diametrically opposed, but that is only true if you don’t understand how the stock market works.

In Let’s Get Fiscal, Krugman assesses the outlook for the economy saying that there is “grim news coming in about the real economy.” Summing up the economic situation, he states,

Just this week, we learned that retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep-recession levels, and the Philadelphia Fed’s manufacturing index is falling at the fastest pace in almost 20 years. All signs point to an economic slump that will be nasty, brutish — and long.

Krugman predicts that the unemployment rate, which is already above 6 percent, “will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century.”

“And how long will it last? It could be very long indeed.”

Upon reading that, it would be understandable if you decide to sell all of your stocks and put the money from the proceeds “under the mattress,” so to speak. If you’re at all in agreement with Krugman’s analysis, you might want to buy “safe” CDs or, if you are totally freaked out, short-term U.S. Treasury securities, that are paying very close to zero interest.

That understandable inclination of reacting to bad current news, and worse predictions of the future, though perfectly natural, would likely also be entirely wrong. The reason is that the stock market looks forward. What is already known is “priced in the market.” Stock prices have already fallen in anticipation of a worsening economy. If and when the economy declines further, that will only confirm what we think we know now, so stock prices may not decline any more from where they currently stand.

In other words, as an investor, you cannot read the news or even someone’s prediction on where the economy is going and “profitably” act on it. In the stock market, “what everyone knows is not worth knowing.”

Please note, that nowhere does Krugman give any advice on what to do as an investor. That’s not his area of expertise. I am only projecting what a knowledgeable layman might conclude from reading Krugman’s observations.

That brings me to Warren Buffett’s opinion piece. It is an understatement to say that Buffett is a very, very, successful long-term investor. He’s been called, among other things, the Oracle of Omaha and the world’s greatest stock market investor, and an empire builder. His favorite holding period is “forever.” He certainly does not try to time the market, as he believes no one can do that successfully. (There is a lot of academic evidence that people who do try to time the market end up with terrible results.)

In Buffett’s Buy American. I Am, he agrees with Krugman’s basic thesis on the economy.

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

But here is the seeming paradox. What is Buffett doing?

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.

Since no one can forecast the short term direction of the stock market, Buffet continues:

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

This is typical Buffett — folksy, but right on. He then writes about the Great Depression and World War II, and notes that buying when things look bleakest was the right strategy. He concludes that “bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.”

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later.

This is my fourth post in the series called Is It Different This Time?  Feel free to read the others, especially if you are ready to hit the panic button and sell your stocks and/or stock mutual funds.

photo credit: notsogoodphotography

Is It Different This Time? Part 3

“We are not going to have a depression, and we have survived financial crises before. A century of investing experience, as well as insights from the field of behavioral finance, suggest that investors who bail out of equities during times like these are almost always making the wrong decision.” – Burton G. Malkiel.

Alex Berenson’s October 11th article in The New York Times Those With a Sense of History May Find It’s Time to Invest is well worth reading, especially if you are discouraged enough to be considering selling your equity mutual funds and putting the money in CDs.

The four most dangerous words for investors are: This time is different.

In 1999, technology companies with no earnings or sales were valued at billions of dollars. But this time was different, investors told themselves. The Internet could not be missed at any price.

They were wrong. In 2000 and 2001 technology stocks plunged, erasing trillions of dollars in wealth.

Now investors have again convinced themselves that this time is different, that the credit crisis will push economies worldwide into the deepest recession since the Depression. Fear runs even deeper today than greed did a decade ago.

But in their panic, investors are ignoring 60 years of history. Since the Depression, governments have become far more aggressive about intervening when credit markets seize up or economies struggle. And those interventions have generally succeeded. The recessions since World War II, while hardly easy, have been far less painful than the Depression.

Berenson goes on to quote various investors and economists who believe that the pessimism is overdone and that this is a good time to buy rather than sell stocks.

If there is good and wise policy, and government moves effectively, this need not play itself out in ways like the Great Depression, which is the image that is playing itself out in people’s mind. . Government action typically does not work immediately, and banking crises around the world often require multiple interventions. – Stephen Haber, an economic historian and senior fellow at the Hoover Institution.

“I think in years to come — I wouldn’t say months to come — we will perceive this as being a great value-buying opportunity. Two and three years from now, it will seem very smart.” - David P. Stowell, a finance professor at Northwestern and a former managing director at JPMorgan Chase.

“This is the opportunity of a lifetime. The most important securities are being given away.” – Martin J. Whitman, a professional investor for more than 50 years.

photo credit: Sheffield Tiger

How Wall Street Became a Giant Hedge Fund

 “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” – Warren Buffett (2003).

Some people are placing the blame for our current financial crisis squarely on the shoulders of greedy Wall Street financiers. They have a valid point. At least part of the problem can be attributed to greed. How and why greed undid some of the great financial institutions is best told by a Wall Street insider.

“Andy Kessler is a former hedge fund manager turned author who writes on technology and markets.”

His article, The Demise of a Giant Hedge Fund - The old Wall Street is dead. Long live the new Wall Street, appeared in the October 13, 2008 The Weekly Standard.

Wall Street is really just a compensation scheme. Firms generate sales, and employees get half the money. Yes, half. The rest, after expenses goes to shareholders. Sweet deal.

By 2002, Wall Street firms, despite being flush with huge balance sheets of capital to generate returns with, were no longer making money in their bread and butter business of stock and bond trading, investment banking, and money management. The one group making money were these weird guys with math Ph.D.s creating exotic securities, derivatives, pieces of paper backed by pools of assets, maybe airplane leases, or home mortgages. The neat thing about derivatives is that no one but the person who created them knows what they’re worth, so you can sell them at huge markups. Woo-hoo. Mammoth departments were created all over Wall Street to securitize everything that moved. With the Fed forcing low interest rates in 2002-2004, the higher the yield the better.

Subprime home mortgages, because of higher risk (ooh, don’t say that word), had high yields and moved to the top of the list. When not enough of these loans could be bought from banks, firms like Bear Stearns and Lehman set up entire loan-origination subsidiaries, and in true Wall Street style were aggressive and rose to the top of the market-share tables. If you want to know why Wall Street CEOs made so much, it wasn’t from trading your 1,000 shares of Apple stock.

Still, those profits weren’t enough. Their customers were making great money buying Wall Street’s derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.

…all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it’s a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets flashed green. Risk was a four-letter word best not said in polite company.

Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time. Deleveraging a balance sheet leveraged at 30 to 1 is not easy or pretty when everyone is doing it along with you. And this is not the customer panic-selling and paying fees to Wall Street, it’s Wall Street doing the selling, pushing prices into the irrational range and turning companies belly up overnight.

Is this the end of Wall Street? More like the start of a new one. At the end of the day, Wall Street is not about the names on the door, it’s about the people inside. There were great people at Lehman and Enron, Bear Stearns and AIG. Those who have a nose for making money will join other firms, or hedge funds, or start their own shop. Still, I’m pretty sure that half of those employed on Wall Street in 2007 will be doing something else by January.

And the new Wall Street? There’s only one direction. It’s back to basics. Not quite back to the old white shoes-blue blood partnerships of the past but certainly that business model. With a lot less capital, sit on the edge of the stock market and provide access to capital for the next set of great companies. Take ‘em public, bank ‘em, and grow with ‘em. It may not be as exciting as the last few years, but it beats getting dumped in the East River.

My Conclusion

In the end, greed was a big factor, but so was a complete failure to manage risk, properly. Top management at some investment banks, supposedly intelligent people, essentially bet their whole company on a strategy that amounted to putting too many eggs in one basket. They ending up owning “exotic securities, derivatives, pieces of paper backed by pools of assets.” They did not understand these securities any better than the people they sold them to.

And because there was no transparency or regulation, the investment bankers could take on as much risk as they wanted to. So they used way too much leverage. They simply took more risk than they had the ability to take. These bets were very profitable, until things went the wrong way. And, because they used such a large amount of borrowed money, there was just no margin for error.

And when many on Wall Street tried to “deleverage” at the same time, i.e. they all tried to sell at once, there was no one on the other side of the trade. There were not enough buyers, so there was no liquidity, just when it was most needed.

See the quote at the top of this post.

To be continued …

Is It Different This Time? Part 2

“There are no guarantees, but throughout our history investors have been rewarded for long-term investing in stocks, for staying the course through short-term noise, and for being prudently diversified.” – Joni Clark.

Today the S&P 500 fell almost 4%, after being down twice that amount.  The Fear Factor is here big time.  No one knows whether stocks will fall further or will move higher in the next few months.  I believe a long-term approach is the only strategy that works and that some historical perspective is needed now.

Note that the October 13th Time magazine continues a long tradition of scary headlines and covers.  Dramatic covers sell magazines. But the media do us no favors by trying to scare us into selling and encouraging us to wait on the sidelines until economic conditions look better.   There is evidence that it always looks bleak in the middle of a financial crisis.  However, in the past, selling at that time has been a big mistake.

This article comes via Charles L. Stanley’s blog.

Breaking News: It’s Not Different This Time by Joni Clark, Chief Investment Strategist of Loring Ward, is food for thought and provides some needed historical perspective. To underscore her position, Clark cleverly displays old Time magazine covers and briefly discusses the respective article context. With the benefit of 20/20 hindsight, she shows how we survived all of the previous crises.

Here is my favorite quote:

“In an age of economic anxiety, real and rising concerns about whether free enterprise can surmount the problems of inflation, energy and productivity. The relentless daily pounding of dismal news drives deeper the public’s conviction that the economy is in a profound and morose crisis.”

Does that sound familiar to you? Well, the quote is from Time magazine’s article Capitalism: Is It Working? The cover story for April 21, 1980.

The more things change, the more they stay the same.

In a supreme understatement, Clark says, “The headlines have not been good this year.”  Well, neither were they good in the past.

But, Clark observes:

“If you’d had the courage and conviction back in the early 70s to ignore Watergate, the oil crisis, Vietnam and inflation and invested $100,000 in the S&P 500…and then if you’d taken a long-term perspective and not worried too much about the S&L crisis, the 1987 “panic,” the tech bubble and all the other speed bumps along the way, you’d now have more than $3,800,000.”

Her conclusion is the one I quote at the top of this post. It is my strong belief, as well.

Understanding The Financial Crisis

“Panic can cause a prudent person to do rational things that can contribute to the failure of an institution.” — William A. Ackman of the hedge fund Pershing Square Capital Management.

In 36 Hours of Alarm and Action as Crisis Spiraled by Joe Nocera, a gaggle of New York Times financial reporters have given us a valuable look at the panic that both Wall Street and Main Street recently experienced. Their behind-the-scenes story helps explain the urgency and scope of the bailout plan that Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson proposed. Here is a brief summary of that article.

Forget the picture of depositors anxiously lining up outside a bank’s door, waiting to get their money out as soon as the bank opened for business. Nowadays, it is hedge funds pulling their money out of investment banking firms such as Morgan Stanley and Goldman Sachs. There was also a run on money market funds, a fairly recent innovation, which most investors had assumed were as safe as bank accounts.

Investors large and small had been aware of the gathering problems and the ad hoc solutions to them. And while it is somewhat difficult to identify the actual tipping point in terms of a real financial panic, it’s widely accepted that the Lehman Brothers’ bankruptcy had serious consequences. The fear was that Morgan Stanley would be next. One thing led to another, events cascading with no one in control.

Here are some relevant quotes from the article.

Up and down Wall Street, hedge funds with billions of dollars at Goldman and Morgan Stanley, another storied investment bank, were frantically pulling money out and looking for safer havens.

Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors — not small investors — were panicking the most. Nobody was sure how much damage it would cause before it ended.

This is what a credit crisis looks like. It’s not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people can’t see. It’s banks refusing to lend to other banks — even though that is one of the most essential functions of the banking system. It’s a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman — both of which reported profits even as the pressure was mounting. It is panicked hedge funds pulling out cash. It is frightened investors protecting themselves by buying credit-default swaps — a financial insurance policy against potential bankruptcy — at prices 30 times what they normally would pay.

It was this 36-hour period two weeks ago — from the morning of Wednesday, Sept. 17, to the afternoon of Thursday, Sept. 18 — that spooked policy makers by opening fissures in the worldwide financial system.

Wednesday, Sept. 17, was one of those dark, ugly market days that offers not even a glimmer of hope.

Within seconds of the market opening, the Dow was down 160 points. Among the big losers was Morgan Stanley. Despite the strong earnings it had disclosed late Tuesday, its stock continued to plummet. By noon, the Dow was down 330 points. It rallied in the afternoon, but went into free fall in the last 45 minutes, closing down 449 points.

And that was just what investors could see. Behind the scenes, the credit markets had almost completely frozen up. Banks were refusing to lend to other banks, and spreads on credit default swaps on financial stocks — the price of insuring against bankruptcy — veered into uncharted waters.

Moreover, the drain on money funds continued. By the end of business on Wednesday, institutional investors had withdrawn more than $290 billion from money market funds. In what experts call a “flight to safety,” investors were taking money out of stocks and bonds and even money market funds and buying the safest investments in the world: Treasury bills. As a result, yields on short-term Treasury bills dropped close to zero. That was almost unheard of.

In the stock market, Mr. Ehrlich of UBS was horrified by the plunge of Morgan Stanley’s shares, given the stellar earnings. “It felt like there was no ground beneath your feet,” he said. “I didn’t know where it was going to end.”

By Thursday morning, the need for dramatic action had grown even more urgent. In Asia, stocks had already closed lower. To quell fears before the opening of European markets, the Fed and other central banks announced they would make $180 billion available, in an effort to get banks to start lending to each other again. The Fed had agreed to open its discount window to make loans available to money market funds to prevent further runs.

But it was to little avail.

For a number of reasons, the administration’s original bailout plan did not pass the House of Representatives. Last night, the U.S. Senate passed a somewhat different version of the bill; now the House gets another chance.

To be continued …

Is It Different This Time? Part 1

“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.

Scary Headlines

Lately, it seems that all we have been reading and hearing about are falling real estate values, failing national banks, global brokerage firms in dire straits, and stock prices plummeting in markets all over the world. This is no fun, no fun at all. Surely, we are in big trouble. You may believe that our current financial problems are “unprecedented.” For a different view, though, read on.

Needed Perspective

Dimensional Funds Advisors Vice President, Weston J. Wellington, offers perspective on how the current market downturn compares to past bear markets. His short, 17-minute presentation Is It Different This Time?  shows how resilient markets have really been.

Video highlights include brief discussions of past articles from Time, Newsweek, Fortune, and Business Week, which shows how past crises and bear markets were covered. What is surprising is how often the word “unprecedented” gets used.

photo credit: sorian

Coping Skills for a Bear Market

“These recent events offer a ringing endorsement of broad diversification and a consistent portfolio strategy as the best way to deal with uncertainty.” – Weston J. Wellington.

Ron Lieber writes the Your Money column for The New York Times. His beat covers everything from credit cards, student loans, frequent flier miles, paying bills online to tips on negotiating the buying of a house.

Lately, he has written two interesting columns on investing during a Bear Market.

On September 13th, he wrote Memo to the Uneasy Investor: Be Strong.

He argued against the temptation “to climb under the covers, money safely in the mattress, and hide from a world that has surely changed forever.”

He recognizes that our psychological makeup may not be suitable to successful investing.

Your natural inclination is probably to sell everything and invest in certificates of deposit or throw the proceeds in a money market fund. In fact, evolution insists on these feelings.

“We had survival mechanisms built in to avoid sitting around debating whether we should run away from the saber-toothed tiger,” Mr. Benningfield said. “That’s the fundamental problem with long-term investing. Our skills aren’t really that transferable to the challenges involved.”

But he counsels being brave and following your plan.

Investing in the middle of market gyrations isn’t just a question of controlling the urge to sell indiscriminately. It’s also about taking a close look at the contents of your portfolio and then forcing yourself to fix an asset allocation that is out of whack and to buy in sectors of the markets that are out of favor.

On September 27th Lieber delved into psychology more fully in The Financial Adviser as Hand-Holder. He interviewed “financial planners and investment advisers who got their start as psychologists or studied the field as graduate students, plus a few ringers who are adept observers of minds and money, even though they have formal training only in the latter.”

I asked them this: At this troubling moment, what’s the best way to reorient how we think about money, before we make any rash decisions about what to do with whatever we have left?

Their conclusions include “the markets will eventually recover” and “We have time on our sides.”

Managing our money is a process that unfolds over decades, not days. It’s easy to forget that, when one company after another is falling victim, week after week, and we can track their disintegration on an hourly basis.

“I think reminding people in this environment of why we’ve chosen the investment strategy that we have is a good thing for those who are a little bit antsy,” said Constance Barber, a certified financial planner with Barber Financial in Natick, Mass., who got her start as a school psychologist. “We’ve usually not set this up because it’s money that you’ll need tomorrow.”

Even if we don’t need the money right now, it doesn’t feel good to look at a retirement portfolio and find that it’s down 15 percent from its peak a year ago.

“People rely on selective memory when they’re only looking at losses from the high point that the portfolio reached,” said Victoria Collins, who has a Ph.D. in social psychology from the University of California, Berkeley and has worked as a certified financial planner for more than two decades.

This was a point echoed by many people I spoke with this week. On one hand, it’s certainly depressing to be down to $340,000 from $400,000, for instance. The basic math doesn’t help the mood either, given that after a decline of 15 percent, a portfolio needs to gain 17.6 percent just to get back to $400,000 again.

We can mimic that mindset if we choose, or we can consider what our balance was, say, a decade ago. Chances are we’ve made a lot of progress since then, if we’ve been saving all along. “There are clients who will say, ‘Yes, it’s down, but look where I started,’ ” said Ms. Barber, the former school psychologist. “ ‘I’m hanging in there, and we’ve come a long way, baby, and it’s O.K. for now.’ ”

One tricky part about the last several weeks is confronting all the headlines declaring this the worst financial crisis since the 1930s. “Most of the individuals that I find who need more handholding are the ones who’ve had some connection with the Great Depression,” says Ms. Collins, the Berkeley Ph.D., who is now an executive vice president and principal with Keller Group Investment Management in Irvine, Calif.

These people tend to be retirees, who may have had parents who told them stories about living through the 1930s or are old enough to remember it themselves. If they have little or no earning capacity now, they feel especially helpless when they see parts of their portfolios disappearing.

“I try to remind them that even they don’t need all of that portfolio today,” she said. “You’re only withdrawing a certain amount.”

Ms. Rich suggested that people reach out to someone else to discuss their situation if they don’t have a hybrid financial adviser-shrink to counsel them through the crisis. It could be a peer, a family member, a member of the clergy or staff at a senior center.

My Perspective

Bear Markets are neither unusual nor unexpected. Depending on exactly how you count, we have had 13 Bear Markets since World War II.

Repeat after me, “Bear Markets happen.” Stock prices fluctuate. Risk shows up at unexpected times.

If you cannot accept that, you might consider keeping your money in CDs. But if you follow that strategy, you have little chance of earning a decent return. In fact, after taxes and after inflation, you may achieve a negative return. Your strategy may appear to be less risky, but, in my opinion, you are fooling yourself.

Over the long term, taking on acceptable risk through a diversified portfolio of stocks, bonds, money market funds and other investments will pay off in higher returns. If you had ignored all of the Bear Markets since World War II and had kept fully invested in such a portfolio, you would be way ahead of someone who followed a very conservative approach.

For a discussion of why we should accept Bear Markets see my earlier post.

photo credit: mitchgibis

Bear Markets: A Necessary Evil

“Bear markets are the mechanism that serves to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans—with the anticipation of bear markets built into the plans—and the discipline to adhere to those plans.” – Larry Swedroe.

The author of The Only Guide to a Winning Investment Strategy You’ll Ever Need: The Way Smart Money Preserves Wealth Today, Larry Swedroe always writes clearly and succinctly, and he conveys a great deal of information in a short time. 

This post is a summary of his excellent column Bear Markets: A Necessary Evil.  It is the best article I have read on investing strategy in general and during a Bear Market, in particular.

If you are a serious student of investing, I highly, highly recommend that you read the entire article, which obviously has more detail than this summary.

A necessary evil can be defined as an unpleasant necessity; something that is unpleasant or undesirable but is needed to achieve a result. An example of a necessary evil might be taxes. Investors should also view bear markets as a necessary evil.

His key point is important, but subtle:

Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than one-month Treasury bills (which is considered the benchmark riskless instrument). Since they are riskier, the only logical explanation for investing in stocks is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (the expected always occurred) investing in stocks would not entail any risk—and there would be no risk premium.

Bear markets are necessary to the creation of the large equity risk premium we have experienced. Thus, if investors want stocks to provide high expected returns, bear markets, while painful to endure, should be considered a necessary evil.

Risk Premiums and Investment Discipline

“The bottom line is that the outperformance of stocks relative to Treasury bills” entails risk.

And it is a virtual certainty that the risks will show up from time to time. Unfortunately, we cannot know when, or for how long, the periods of underperformance will last, nor how severe they will be.

It is during the periods of underperformance when investor discipline is tested. Unfortunately, the evidence suggests that most investors significantly underperform both the stock market and the very mutual funds in which they invest.

The reason for the underperformance is that investors act like generals fighting the last war. They observe yesterday’s winners and jump on the bandwagon— buying high—and they observe yesterday’s losers and abandon ship—selling low.

Why most investors fail

1. Investors allow their emotions to impact their investment decisions. In bull markets, greed and envy take over and risk is overlooked. In bear markets, fear and panic take over, and even the well-thought-out plans can end up in the trash heap of emotions.

2. Investors are overconfident of their ability to deal with risk when it inevitably shows up.

3. Investors often treat the likely (stocks will outperform Treasury bills) as certain and the unlikely (a severe bear market) as impossible. The result is that they take more risk than is appropriate—and when the risks show up they are “forced” to sell.

The Keys to Successful Investing

1. The first key to successful investing is to have a well-thought-out plan. That plan includes an understanding of the nature of the risks of investing. That means accepting that bear markets are inevitable and must be built into the plan.

2. Those investors that avoid excessive risk taking are the ones most likely to be able to stay the course and avoid the buy high/sell low pattern that bedevils most investors.

3. Understand that trying to time the market is a loser’s game. A loser’s game is one that while it is possible to win, the odds of doing so are so low that it is not prudent to try.

Summary

It is difficult for most individuals to control their emotions—emotions of greed and envy in bull markets and fear and panic in bear markets.

Bear markets are a necessary evil in that their existence is the very reason that the stock market has provided the large risk premium and the high return that investors have had the opportunity to earn.

But there is another important point that investors need to understand about bear markets. Investors in the accumulation phase of their investment careers should actually view bear markets not just as a necessary evil, but also as a good thing. The reason is that bear markets provide those investors (at least those that have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns.

It is only those that are in the withdrawal phase (e.g., retirees) that should fear bear markets. The reason is that withdrawals make it more difficult to maintain the portfolio’s value over the long term. Thus, investors in the withdrawal phase have a lesser ability to take risk and should build that into their plan.

The bottom line for investors is this: If you don’t have a plan, immediately sit down and develop one. Make sure the plan anticipates bear markets and outlines what actions you will take when they occur (doing so when you are not under the stress that bear markets create).

To repeat, this entire post is a summary of Larry Swedroe’s article.

The words are his; I just happen to agree with them wholeheartedly.

Remaining Calm While Stock Prices Plummet

“If you can keep your head when all about you
Are losing theirs and blaming it on you” – Rudyard Kipling.

Based on today’s results on Wall Street, it looks like we are in for another roller coaster ride this week. Even though we emphasize long term investing, it is difficult to ignore such wild swings in stock prices.

According to a recent column in the Wall Street Journal, “The U.S. financial system last week was rocked by the biggest crisis since the 1930s — and the federal government responded with a multi-pronged intervention that is the most sweeping since the New Deal.”

We do not yet know how much the bail-out plan will ultimately cost the American taxpayer, nor do we know how it will be implemented or how it will all turn out in the end. There are, naturally, dissenters who question the plan or at least some of its ramifications, especially the issue of moral hazard. (More about that later).

That said, I would like to take a moment to recognize Brett Arends, a columnist, who counseled calm and restraint, before and during the stock market’s turmoil. Brett Arends writes R.O.I., or Return on Investment, daily for the Online Journal. On the evening of September 17th, after the Dow Jones Industrial Average had fallen by 450 points, when most people were extremely nervous, Arends put out a video called Reasons to Stay in the Market.

He advised investors not to overreact, and that after such a fall in prices, it is a better time to be buying, rather than selling.

On the morning of September 18th, before the new U.S. government intervention was announced, he followed up with a column called Ten Reasons Not to Sell Your Stocks.

“I’ve seen this sort of panic enough times to have a little perspective. I’m certainly not urging you to rush out and put all your money into the stock market. Your investments should be based on your own financial situation first, and the situation in the markets second.”

Arends added, “If you are panicking and getting ready to sell everything and hide under a rock, here are ten reasons why you shouldn’t.”

1. Oil prices just slumped.
2. Mortgage rates have tumbled.
3. A measure on Wall Street known as the “Vix” just went through the roof.
4. Uncle Sam is finally waking up and getting involved in the crisis.
5. There’s an old Wall Street saying: The time to buy is when there’s blood on the streets.
6. Even one of the most notorious bears is starting to concede some shares are reasonably valued.
7. Big money managers are bearish.
8. If you sell everything and move your money into “safe” places like cash or bonds, you will be running right smack into another risk: inflation.
9. The housing market is about to get two big doses of help.
10. America is finally getting the wake up call it needed.

I’d like to highlight and comment on a few of his “reasons.”

4. Uncle Sam is finally waking up and getting involved in the crisis.

Better late than never. If Mr. Bernanke and Mr. Paulson had taken strong, clear action a year ago, maybe some of these blow ups might have been averted, or minimized. But it’s good news that they stepped in during the AIG debacle, and it’s good news they are letting other firms swap illiquid assets for cash.

Arends wrote these comments before the big bailout proposal was announced. While it is true that the details have to be worked out and agreed upon, on the table (finally) is a comprehensive plan that aims to restore confidence and allow banks to do what they are supposed to do – raise money from investors and lend money to consumers and businesses.

As mentioned in a previous post, we have been going from one crisis to another, using a case-by-case approach that just has not worked.

5. There’s an old Wall Street saying: The time to buy is when there’s blood on the streets.

How about now? Blood isn’t just on the streets – we’re hip deep in the stuff.
There are no guarantees, but history has usually been pretty kind to those who invested after the market had plunged this far and just hung on for years. Sure, there may be plenty more bad news to come. But the collapse in share prices has already priced plenty of that in. Investors are, at long last, getting paid something for taking the risk of owning equities.

Fair enough. By the way, it was Baron Nathan Rothschild, an 18th century British financier, who has been quoted as advising, “The time to invest is when there is blood in the streets.” In other words, buy when everyone else is selling out of fear. This maxim may be easier said than acted upon.

We have definitely gone through a very rough patch, when fear was endemic. At a minimum, it is usually not a good time to sell when everyone is panicking. And after stock prices have fallen, the expected return in the future is higher, not lower.

8. If you sell everything and move your money into “safe” places like cash or bonds, you will be running right smack into another risk: inflation.

Savings account are a great place to keep ready money, but not for long term investments. They are only paying maybe 3% before tax. As for long-term Treasuries? These so-called “safe” investments are fool’s gold. They’re yielding barely 4%, again before tax. I wouldn’t buy them with counterfeit money.

In my opinion, this is a bit of an exaggeration, but I can see his point. Preserving purchasing power is just as important as preserving capital. But bonds do have a place in a properly diversified portfolio. In any event, research shows that short-term bonds have a better risk- return profile than long term bonds.

10. America is finally getting the wake up call it needed.

We’ve been living in a funny-money economy for years. Everyone from college kids to the federal government has been surviving on credit card debt and pretending it could go on forever. It was impossible to get really positive again until that came to an end. It takes a real shock for that to happen. Like this one.

Yes, we are all paying attention now, which is a good thing. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson have turned themselves into the new 21st Century version of the “Dynamic Duo,” impressing upon Democrats and Republicans the importance of working together as a team, for the good of the country.

We’ve had other financial crises in the past, so it helps to have some perspective. When you are living through a tough time, it always seems unprecedented. (This one sure does!) But we have solved serious problems before. From past experience, it is realistic to be a long term optimist.

Conclusion

I advise clients not to follow the stock market on a short term basis, but how can you not, when the evening news leads with it almost every single night? It’s as though the news consists of the stock market/credit crisis first, and then everything else. It almost makes you wish for a good old fashioned political sex scandal, just for a change of pace.

Could things get worse yet? Yes, but, then again, maybe not. If you have a diversified portfolio, based on a sensible long-term plan, stick with it. Talk to your advisor about rebalancing and possible tax loss harvesting. If you have a very concentrated position in one stock, irrespective of which stock it is, consider selling some of it and investing in a more diversified portfolio.

photo credit: Vibrant Spirit

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