When markets turn south, anxiety turns north
Pundits inflame this anxiety with their worthless predictions:
- Pundit 1: “Equities are cheap again! Value investors should open their checkbooks!”
- Pundit 2: “The worst is yet to come! Cash is moving to the sidelines!”
There is nothing lucky about owning equities when prices have just fallen. The problem is that, over time, trading tends to underperform not trading because tops and bottoms are impossible to call in advance.
A Moral Obligation
As a financial advisor, I am responsible for tens of millions of other people’s money. I have a moral obligation to get them a comfortable retirement.
I am not immune from the anxiety of a downturn, but I am responsible for investment plans that rely on the judgement of head over stomach, and experience has taught me a few things.
Top 10 Things to Remember When Markets Drop
10. It takes two to trade
Someone has to own every share of stock, and every bond. During a downturn, buyers tend to be savvy, long-term investors. Don’t forget: this is what you aspire to be!
9. Cash never “moves to the sidelines”
When one person trades shares for cash, the other party is always trading cash for shares.
During a downturn, companies have the same number of shares, but these shares are changing hands at lower prices. This is only a problem if you suddenly decide you need cash instead of shares, because you will only get offers at prices that bargain-hunters are willing to pay.
8. Financial media exist to sell audiences to advertisers
Leaders of media companies earn bonuses in exactly one way: by growing advertising revenue. You will not get the truth from financial media because it is boring and therefore unprofitable.
As Nobel Prize winner Merton Miller said in an interview with Barron’s, “Don’t quote me on this, but I’d say don’t read Barron’s…because it will only tease you about investment opportunities that you’d best avoid.”
7. Pundits are usually wrong
We have plenty of hard evidence in the form of bad, documented predictions, but I’m not going to quote academic papers today. Instead, I’ll quote Warren Buffett, who said it best: “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”
The stakes are so high, yet we simply cannot see around the bend. It takes real brains-over-stomach discipline to accept this.
6. “This time is different” is something we’ve heard before
I have an entire presentation consisting of bear market media coverage dating back to the early 1970s. Email me if you want to see it. Here are three examples, each a decade apart:
5. Crises are the source of equity returns
When stocks and mutual fund share prices decline, you own the same amount of a productive asset, you just can’t sell it for as much. This up and down movement in current market prices is the definition of volatility.
Because volatility sucks, investors with shorter time horizons are willing to take lower expected returns to get rid of it. This is why bonds have lower returns than stocks, and why different investors should have different amounts of stocks and bonds.
My job is to help investors find an appropriate balance between risk and reward given their need and willingness to take risk. Then I go spend that risk efficiently so as to generate maximum returns. But all equities have volatility – this is an unavoidable part of the risk/reward equation.
4. Crises force tough political decisions
Measured by the consistency of returns over many decades, the governments that safeguard capitalism have done a remarkably decent job for almost a century, through worse times than ours.
What we need today are politicians who will do the right thing, even if it is unpopular. Crises tend to bring out the best in people. We will very probably look back on this era of unprecedented deleveraging as another crisis weathered.
Sometimes it is helpful to remember that other parts of the world, including China and India, are struggling to prevent their economies from growing too quickly. You are exposed to international and emerging markets, right?
3. Corporations are surprisingly healthy today
Corporations react faster than governments, and their houses are clean. Across the S&P 500, corporate earnings and revenue are both up about 13% from this quarter last year. On top of that, corporate cash balances stand at a record $1.9 trillion.
American companies boosted their capital spending by about 21 percent in the first quarter and kept up a similar pace in the second quarter, putting them on a track for their biggest-spending year since 2006.
Money spent on stock buybacks and takeovers both rose more than 60 percent in the first half of 2011 vs 2010.
America’s companies may not be creating jobs, but like a good portfolio, they are ready to weather bad news if necessary, and to create wealth should the economy permit.
2. Rebalancing always works
There is one time when investors can sell during a downturn: when they sell what went up and buy what went down. This isn’t effective if done weekly, but it works amazingly well if done once a year.
Here’s a graph of how an allocation similar to what I use in IRA accounts would have done with and without rebalancing, from January of 2008 through December of 2010.
1. If your investment plan sucks, you must change it
Investors sometimes make the terrible mistake of “waiting until it comes back up” to sell. As long as your ratio of stocks and bonds remains roughly the same, you can sell every equity you own and buy all new equities at any time.
Any capital losses in your old portfolio will be balanced out by future capital gains in your new portfolio. The IRS lets you keep capital losses until they are offset by gains, so you lose nothing by fixing your portfolio during a downturn.
Fine, but what should I do
Asset prices will always move up and down. If you hate how down feels, then reduce the percent of assets you have in the stock market. Your long term expected returns will go down, but you will sleep better.
If you aren’t sure what you should really do, then get some help, either from a knowledgeable friend or a competent professional.
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Further Reading:
- Next Blog Entry: Trade Like a Beltway Insider
- Why Ross Asset - Learn about working with Brendan