It’s much too soon to have any historical perspective, but it seems obvious that the terrorist attacks on the World Trade Center and the Pentagon could prove to be a turning point in American history. One classical definition of “crisis” is a time of change, and the current situation certainly seems to fill the bill.

So how should investors behave in a crisis?

First, we should respond by keeping our heads. Last February, H. Bradlee Perry wrote a few paragraphs in The Babson Staff Letter about random, totally unexpected events that pop out of the blue and impact the stock market. I think one of the paragraphs he wrote is worth repeating here:

“By definition, such events are unpredictable, but because we know they will occur occasionally, we should be prepared for them by prudent portfolio construction – just as experienced ocean sailors never go on deck in any kind of wind without their safety harnesses hitched on. We should also recognize that these shocks will not be fatal to the sensible investor; they just have to be waited out.”

Most of us have no direct control over events as they are developing. But we do have control over how we respond to these events. That is what I’d like to address this month. As investors struggle to make sense of these new realities, they have five fundamental choices, which I’ll discuss. They all involve managing risk:

The terrorist attacks in September have been a gigantic worldwide wakeup call.

We have suddenly awakened to find the security we took for granted is an illusion.

We have suddenly awakened to find that the relative world peace we enjoyed is ephemeral.

We have suddenly awakened to find the financial future we envisioned is more elusive than we expected.

Our world’s external battles rage on military, diplomatic, political and economic fronts. Internally, many of us are struggling through a battle between intellect and emotion. On one side is blind reaction, driven by emotions, mainly fear. On the other side are discipline and reason.

Although the subject matter is new – the economic and financial aftermath of last month’s terrorist attacks and the U.S. resolve to fight terrorism on a global scale – the struggle between fear and reason is familiar.

For much of our lives, most of us struggle to reconcile what we feel like doing with what we believe or know we should do. Very few among us are so disciplined that our reason always rules our actions. Nor are many of us ruled entirely by emotions.

This struggle affects how we conduct our personal relationships, how we take care of our physical and mental health, how we care for or ignore our environment and of course how we conduct our financial affairs.

The stock market is where this struggle plays out for many investors. Our emotional interests seem to work against our financial interests.

When prices are relatively high, financial risk is also high, and the opportunity for gains is low. Yet at this time, emotional risk for investors is low, and people find it easy to buy investments that have been going up.

When prices are relatively low, financial risk is also low, and the opportunity for gains is high. Yet emotional risk is high, and investors find it hard to buy low-price investments that have been beaten up in the market and whose near-term prospects seem bleak.

Before the 1990s, the Standard & Poor's 500 Index on average suffered a decline averaging 30 percent every four to five years. This was normal and, even when difficult, expected. But for most of the past decade, that rule seemed to be suspended. Now, many of today’s investors are getting their first taste of bear. Not only do they dislike the taste, they don’t know what to do about it.

So let’s look at the first of the five fundamental choices that investors have.

At one end of the scale, investors can (apparently) eliminate risk by putting their money in cash, usually in CDs, T-bills or money-market funds. To many people, this seems like an easy choice. But it is not. No investment is truly free of risk.

The risk of cash is inflation. In a period of a year or less, this risk is usually negligible. But over long periods, inflation is a silent but powerful force that erodes wealth.

Table 1 shows what happens to the purchasing power of $5,000, which may seem like an ample monthly investment income for retirees, with inflation of only 3 percent.

A retirement period of 25 to 30 years is not uncommon these days, especially with many people desiring a retirement age of 60 or even younger. But as you can see, an income that fails to grow will lose more than half its purchasing power after 25 years. After 30 years, it will lose 60 percent of its value.

The message is clear: Cash is not a risk-free investment, and retirees need growth. How much growth they need is a function of future events and trends that can only be assumed. Table 2 shows (again assuming inflation of 3 percent) how much monthly income is required in future years to equal the current purchasing power of $5,000.

The moral is plain: Eliminating risk altogether is impossible.

At the other end of the scale, many investors still want to be aggressive in order to seek compound returns of 15 percent or more. Such returns, as millions of investors have learned in the past year and a half, come bundled with significant risk. “I’ve lost more than half of my money” is a complaint we’ve heard many times this year in the workshops I conduct and the emails I receive.

Some investors may have the extraordinarily high tolerance for risk that is needed to sit tight with such investments and even to make further investments in stocks and funds that have taken a beating.

But because we are ruled heavily by our emotions, there’s an enormous difference between theoretical losses that we know “might” happen when we first make an investment and real losses that happen after we make the investment. When the theoretical becomes actual, many investors find that their once-bold attitudes have turned into confusion at best, fear and bitterness at worst.

Once they reach that point, many investors abandon their focus on the long term and instead concentrate merely on “getting even and getting out.” This leads to generally poor decisions.

As we saw in the extraordinarily painful first week after trading resumed last month, investors often over-react. In this case, by some measures the market suffered its worst week since the 1930s.

Extreme times may seem to call for extreme responses. But here again, reason must battle with emotion. Because investing depends entirely on the future, and because the future is so difficult to discern, a moderate response is usually much more productive than an extreme one.

Instead of taking no risk, shell-shocked investors can find ways to simply take a bit less risk. Because markets can change so quickly, all-or-nothing responses very often backfire. That’s one reason we use multiple market-timing systems to govern our timed portfolios.

It’s usually pretty easy for investors to cleanse their portfolios of whatever has been risky lately. That might mean dumping emerging markets funds in 1998, technology funds late in 2000 or virtually all stocks in the fall of 2001.

This is almost guaranteed to make investors feel more comfortable, at least for awhile. But in the long run, comfort always has a cost. In return for peace of mind, investors should expect lower long-term returns.

Savvy investors will regard the world’s current crisis as a wakeup call. A wakeup call is an outside interruption, usually sudden, that causes a break in an otherwise peaceful state. When you get a hotel wakeup call, your choices are relatively simple: You can get up and get going. You can hang up the phone but keep yourself awake for a few minutes of “sleeping in.” Or you can hang up the receiver, put the whole thing out of your mind and drift back to sleep.

The quality of your day may depend on which of those choices you make.

Likewise the quality of your financial future will be influenced by the quality of decisions you make now.

If you want to reduce the risk of your portfolio, you have four ways to do it.

The primary way to reduce risk is by allocating more fixed-income investments to your portfolio. If you have equity investments, you can shift money into bond funds. If you’re totally invested in bond funds, you can move some of your money into money-market funds or Treasury bills.

Second, you can reduce risk by diversifying. One reason we have many satisfied clients these days is that our core strategies are very heavily diversified. Though the overall U.S. stock market has been quite disappointing for the past 18 months, value funds and small-cap funds have held up much better than large-cap growth funds. Diversification is almost always a good idea, and it reduces risk.

Third, you can reduce risk by adopting market timing. Timing, as we have said many times, is far from perfect. It’s not a substitute for either proper asset allocation or proper diversification. The timing systems we use call for moving money from an asset class such as stocks or bonds into a money-market fund, and vice versa. That means they keep investors on the sidelines some of the time. Every day that you’re in cash, you are exposed to less risk than if you are in the market. For that reason alone, timing is certain to reduce the risk of investing.

Fourth, you can reduce risk by upgrading the quality of your portfolio. If you own a speculative telecommunications or technology stock, you can sell it and invest in something more reliable such as General Electric. If you own a technology fund, you can sell it and invest in something more conservative such as a value fund. If you own a “focused” fund that invests in only a relative handful of stocks, you can sell it and invest in a Standard & Poor's 500 Index fund. If you own an emerging markets fund, you can sell it and invest in a widely diversified international stock fund. For fixed-income investors, if you own a high-yield bond fund, you can sell it and invest instead in a high-grade corporate or GNMA bond fund.

We still have two more fundamental choices to discuss. But first I’d like to explore one of my favorite topics: What investors can know and what they can’t know.

I believe that investment decisions based on knowledge are always sounder than decisions based on guesses. Decisions based on knowledge depend on experience. Decisions based on guesses depend on luck.

In the short term, the direction and the pace of the economy and the market is often unpredictable. Very few economists or analysts predicted the great economic boom of late 1999 and early 2000, when Y2K was looming as a grave threat. Fewer still predicted the abrupt downturn of the past 18 months. And nobody could have predicted the terrorist actions that touched off the current crisis.

Short-term forecasting is terribly difficult because so many factors influence the economy and the market, and their relative importance is different from one business cycle to the next.

In contrast, the long-term outlook for business activity (and thus for the stock market) is much more predictable. All the evidence of the past two centuries indicates that our country’s economy will continue to grow along with the population and productivity improvements.

History also strongly suggests that even the most severe problems don’t last forever. The free-market U.S. economy is self-correcting. It’s true that the solution to one problem often creates a new problem. But each new solution also creates new opportunities. Oil shortages of the early 1970s led to soaring energy prices and many new conservation laws.

Farther back, the great depression of the 1930s and World War II of the 1940s eventually paved the way for half a century of unprecedented prosperity and growth in this country.

History tells us that stock prices in the long run rise and fall in line with changes in corporate profits. And profits rise and fall with changes in sales. In the short term, many economic forces including inflation, recessions, boom times, bust times, government regulation, competition and others all seem to alter this relationship. In addition, the mood of investors is subject to swift, sharp swings that are impossible to predict.

Economic and stock trends almost never turn out just the way that most people expect them to. Even the most capable economists and analysts are unable to consistently forecast the future with much accuracy. The reason, once again, is the high number of variable influences, including hard-to-predict political forces.

Many investors, especially inexperienced ones, spend far too much time and energy trying to forecast what essentially cannot be forecast: short-term trends. They could increase their odds of success by concentrating that time and energy on proper asset allocation.

Times change. Moods change. Needs change. One useful thing investors can do now is to accurately define their needs.

Just two years ago, millions of investors were heavily focused on growth. Some just couldn’t get enough of it. A few openly scoffed at the notion that a compound annual return of 15 percent was a worthwhile thing to strive for. They wanted a list of mutual funds that were likely to double in the next year.

Now, millions of investors are heavily focused on safety and protection. For many of them, growth seems like a memory or a fantasy. A compound annual return of 10 percent seems very attractive.

In truth, almost every investor needs both growth and safety. But different investors should pursue those objectives in different ways. When you’re figuring out what you should do, age is a very important variable.

To achieve safety, older investors should look to fixed-income investments such as bond funds. If you’re retired or nearing retirement, keeping the assets you have accumulated may become as important as – if not more important than – making your assets grow.

Young investors already have the safety of sheer time. If you’re in your 20s or 30s, you don’t need protection from volatility. You need growth.

Many young people think times like these call for pulling back into safer investments. But they are mistaken.

Thoughtful market veterans understand that stocks ultimately reward all sorts of investors. But the market does not reward everybody at the same time. Older investors should want higher stock prices so they can convert whatever investments they need into cash for living expenses. Younger investors should want lower prices so they can buy a piece of the future at a reduced price.

Strange as it seems, many investors should consider doing this. The current bear market has spooked some investors in their 20s, 30s and 40s. In their IRAs and 401(k) accounts, they have sold equity funds and fled to the comfort of bond funds and money-market funds. That is only robbing them of the opportunity to get the growth they need.

I’m not advocating selling S&P 500 Index funds and replacing them with technology funds and “focus” funds that rely heavily on stock-picking. I’m not advocating loading up on individual stocks or (something many investors do in 401(k) plans) the stock of the company they work for. I am advocating smart risks, not speculations. People with time horizons of 10 years or more should have most of their investments in equity funds instead of bond funds and cash.

No matter what choice you make for dealing with risk, there are a few other things every investor should do now.

First, it’s important to accept the reality of what is so. Many investors don’t even open their monthly or quarterly statements. Don’t be among them. Investors who don’t know the facts cannot face up to them or respond to them appropriately.

You can, of course, pretend that what’s so really isn’t so. This is called denial. While it may seem comfortable for awhile, it can lead to rotten results.

Second, figure out what your needs are. Make the distinction between what you need and what you want. For retirement, you probably need a way to continue most if not all of your pre-retirement income, with some provision for inflation. There’s a fairly well-defined process that will help you determine how much you should have in investments when you retire. This is not a difficult process, but it requires looking at a number of factors that can vary greatly from person to person and household to household.

This year, many investors have realized that they are not satisfied with the results they have achieved on their own. In the 90s, investing seemed easy. But now more and more people realize that making money – and keeping those gains – is more of a challenge than it seemed.

This fall’s crisis suggests that we could see even tougher times ahead. I think every investor should use this as an occasion to meet with a financial professional.

A properly conducted financial checkup can’t guarantee anything about the future of the markets or your investments. But your odds of success go up dramatically if you get competent, unbiased help from an advisor who has no financial or emotional attachment to your situation. And this leads me to:

Finally, if you can take the time to do so, attend one of the free, no-obligation workshops that I conduct for serious investors. You’ll always find a link to the current schedule and an online registration form at our Web site, FundAdvice.com. Or call our office at 1-800-423-4893.

My objective is to have every participant leave knowing his or her risk tolerance and proper portfolio allocation, including how much should be in stocks and how much in bonds, how much in timing and how much in buy-and-hold. And if I have done my job right, every participant will know exactly what mutual funds to use to accomplish those things.

If it’s impossible for you to attend one of my workshops, the best substitute is to watch one of them on video. “How to Build and Manage a Million-Dollar Portfolio” is a four-hour, three-tape set available at public libraries. If your library doesn’t have it, ask your librarian to order it directly from Tapeworm Video, one of the nation’s largest video distributors.

You can also order this video directly from our office for $59.95, including shipping. Use the phone number above to place your order.

Whether you experience it in person or on video, this workshop is the best way we have ever found to help people make better investment decisions. I hope you will take advantage of it.

 

 

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