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We talk to potential new clients all the time, people who agree with our ideas about diversification, people who like the way we manage money. But many of them don’t want to commit. They want to stay in cash, or wherever else they are currently invested, until they are sure the market is going up again.
The feeling is understandable. But emotions are terrible investment guides. The biggest stock market returns are earned when emotional risk is the highest. By the time it feels OK to invest in stocks again, savvy investors should be getting more cautious.
In fact, you should be suspicious of the wisdom of any investment decision that feels extremely comfortable. Let me give you a formula to show what I mean by that. I hope you’ll spend some time thinking about it. You have my permission to cut out this message and tape it to the door of your refrigerator for an instant reminder of how investing really works.
When financial risk is high, emotional risk is low.
When financial risk is low, emotional risk is high.
If your goal as an investor is to achieve emotional gratification from buying and selling, you are usually going to be taking high risks without realizing it. Most of the time, you’ll think you are avoiding risks. But you’ll be doing just the opposite.
On the other hand, if your goal as an investor is to achieve long-term financial rewards, you will often have to do what is uncomfortable.
Buy low, sell high
Investors make money when they buy low and sell high.
Yet as strange as it seems, many times investors feel good when they buy high, after the market has been rising strongly. And many investors experience great relief, another form of feeling good, when they sell low, after the market has been dropping.
The trouble is, investors don’t get paid for doing what feels good. They get paid for taking intelligent risks, both financial and emotional.
That means getting out of the market when it doesn’t feel like the right thing to do, for instance when “any idiot” can see that the thing to do is take a third mortgage on the house to invest every available dollar in a runaway stock market. Equally, taking intelligent risks means getting into the market when it looks like there’s no hope, when all the news seems to be bad.
It really is quite simple. You can’t buy low and sell high unless you start by buying low. Stock market prices are creatures of supply and demand, and stock prices are low when demand is low. To buy low, you have to be a contrarian.
Likewise, selling high means taking profits when the conventional wisdom thinks the right thing to do is invest more money. A true contrarian would have lightened up on equities in 1999 and early 2000. At the time, this investor’s friends might have said it was a stupid move. But from the perspective of mid-2002, those friends might have a different view.
Of course this is obvious only in hindsight. Right now the future is totally unknown (come to think of it, that’s always going to be the case!), and it requires a significant leap of faith to defy emotions and jump into the market.
I could tell you that this is exactly the time to put your money into the market, and I could make a good case for that advice. I could have said the same thing in the summer of 2000 and again in the summer of 2001 – and I could have made a good case each time, too. Each of these three summers have seen stock prices lower than those of the summer before.
But it is quite possible stock prices will be even lower a year from now. There’s simply no way to know. So we are left with the only question that many people want answered: What should investors do now?
Determine your risk tolerance
Fortunately or unfortunately, depending on your point of view, the answer to that question is the same now as it has been forever. Investors should carefully determine their needs and their tolerance for risk. Then they should find or develop a strategy that meets their needs without exceeding their risk tolerance, a strategy they are willing and able to trust. Then they should stick with that strategy through thick and thin.
Study after study has shown that the greater an investor’s trust in a manager, whether it’s a fund manager or a private money manager, the greater that investor’s tolerance for risk. If you pick a manager solely because of a fund’s recent performance, you have very little basis for trust. Your confidence can be yanked away quickly in the first market downdraft.
One of the simplest and most effective strategies for people who are accumulating investment savings is dollar cost averaging (DCA). This is what people do who maximize their IRA contributions every year. And it’s what millions of working people do every payday by contributing to their 401(k) and similar retirement plans.
Unfortunately, I’m hearing more and more people say they are cutting back on 401(k) contributions, or suspending them altogether, because of the rotten stock market. A typical comment is: “I keep putting money in, and I’m tired of watching it going down.”
These workers will feel better, at least for awhile, when they suspend or reduce their contributions, or when they have their savings go into money-market options. But I’m afraid it will hurt them financially in the long run. How will they know when to take that money out of cash and invest it in equities? How will they know when to start investing new contributions in equities? Most likely, they’ll wait until they are “sure” the market has really turned the corner. And by then they will be facing much greater financial risk.
Some bearish investors are sitting on the sidelines, in cash, Treasury bills, CDs or money-market funds, and they are crying out “The sky is falling; the sky is falling.” These bears cannot hurt the market because they have nothing to sell.
But other bearish investors are still in the market – and scared to death to be there. They are “weak” investors, and until they are washed out of the market, the potential selling they could do remains a threat.
Once those shareholders are gone, the market has a chance to begin recovering.
Back to the question: What should investors do now? For most people, the answer is to have a calm, detailed discussion with a professional advisor who understands you and understands the market. Look at all your resources and all your needs as thoroughly and dispassionately as you can.
Then together with the advisor, make a realistic plan for getting from where you are to where you want or need to be.
The big problem is finding somebody who is worthy of your trust. Many of the most competent investment advisors work for insurance companies, brokerage houses and other parts of the industry that have built-in conflicts of interest when it comes to helping you. What they get paid depends on what you do – and that inevitably gives them a financial incentive to persuade you to do certain things, for instance buy load funds or high cost variable annuities, instead of others, such as buying no-load index funds.
Many investors, if they want to do the right thing now, will have to part with some “prized possessions” such as stocks or mutual funds they have grown attached to, and replace them with boring asset classes in index funds. This won’t feel particularly good. It may hurt investors’ pride. But it will undoubtedly decrease investment risk.
The future of the market
What I’m describing is a switch away from picking stocks and picking managers and toward accepting the returns of the market itself. This requires a leap of faith that many investors will find impossible to take. But history shows that investors who remain intelligently diversified can be amply rewarded after a tough market period.
We went to the history books to find out what happened in the four calendar years after multi-year market declines of the 20th century. We looked at four asset classes: U.S. large-cap stocks, U.S. small-cap growth stocks, international large-cap stocks and international small-cap stocks.
You’ll see what we found for U.S. stocks in Table 1, below, and Table 2.
Our data for international stocks goes back only to 1970, and the only multi-year decline we found was in 1973 and 1974. In the subsequent four years, international large-company stocks had a total return of 227 percent, and international small-company stocks had a total return of 382 percent.
As often as we can, we remind readers and clients that future returns won’t be the same as past returns. This historical perspective doesn’t tell us where we’re going from here. But the pattern from the 20th century is fairly clear: Multi-year losses were followed by pretty strong four-year periods.
Market sentiment
Being a contrarian doesn’t mean you have to defy the conventional wisdom with your whole portfolio. What it means is being skeptical. Three years ago, in mid-1999, the prevailing mood among investors was wild optimism. Sure, Y2K was hanging over our heads and stock prices seemed pretty high by historical standards. But we were in the middle of a boom fueled by technology that looked as if it was opening a path to a whole new economic future.
Three years ago, a contrarian/skeptic could have said: “I just can’t believe things are quite this good. I’m going to take half my money out of the market in case I’m right.” In hindsight, anybody who did that back then would look pretty smart right now.
This summer, a contrarian/skeptic could say: “I just can’t believe things are quite this bad. I’m going to put half my money in the market in case I’m right.”
That’s the seat-of-the-pants school of market timing, and sometimes it works. It’s better than what I call the “I can’t stand it anymore” timing system. That’s the system in which investors finally buy into a bull market when they can’t stand to be on the sidelines any more (often near the top of a market cycle) and finally bail out when they can’t stand to keep losing money (often near the bottom of a cycle).
Market timers are much more likely to succeed if they use mechanical, trend-following systems like those we have advocated for many years. And buy-and-hold investors are much more likely to succeed if they develop their portfolio very carefully to address their risk tolerance, then simply let the markets do their things. Neither one of these approaches is easy, and each one has periods of significant underperformance. But remember, investors aren’t paid to do what’s easy. They are paid to do what works.
As Warren Buffett said: “Investing is simple. But it’s not easy.”
Knowing yourself
If the bear market has done any good, it has taught a whole generation of investors that “risk” is not just a theoretical concept.
Many investors have finally learned the hard way that risk is real. To benefit from that lesson, they now must learn to understand risk and account for it in the way they manage their portfolios.
Successful investors know themselves, and that means they know how to deal successfully with the unknown. This is what risk is all about. And it’s what the future of the market is all about.
We’ve written a lot about risk over the years, and some of it is worth repeating now.
What is risk? The American Heritage Dictionary defines risk as “the possibility of suffering harm or loss.” Other definitions use the words danger, uncertainty and hazard.
Let me rephrase it into my own definition: Risk is a possibility that you invite into your life, the chance that you could lose something important. That something might be your physical safety, a relationship or something financial.
This definition is useful in a couple of ways. First, it says that risk is not theoretical, as in statistical measurements. It is about really losing something. In the realm of investments, it is about losing money. Second, the word “invite” is important, for it implies that risk is not something that’s imposed on you from the outside. Risk is something you choose and accept.
| IF THE BEAR MARKET HAS DONE ANY GOOD, IT HAS TAUGHT A GENERATION OF INVESTORS THAT RISK IS REAL. |
In a response to a question from an investor a few years ago, I elaborated on the idea of “invite” as it applies to investment risk. Here’s what I said:
“When you invite someone into your home, you obviously should plan for what you will do if that person accepts the invitation. To do otherwise would seem mighty odd. And when you make an investment, it’s silly not to have at least some plan for what you’ll do if the investment loses money.
“When you bought this mutual fund, did you have a plan? I doubt it. If you had a plan, you wouldn’t be asking me what to do. And without a plan, I say you were not a very good risk-taker.
“You are not alone. Far too many investors take risks without realizing what they are doing. And when they experience a loss, they don’t know what to do.
“You also say you made a mistake by investing in this fund. I suspect you believe that because in the short term, it didn’t turn out the way you wanted it to. But I don’t think the investment itself was the mistake. I think you bought that fund because you thought it would go up right away. I say your mistake was speculating for short-term profits without having a long-term plan.”
Risk is inevitable
Obviously, nobody invests money hoping to lose it. So why take a risk at all? Essentially because risk is inevitable.
“Risk-free” investments like T-bills, CDs, savings bonds and money-market funds have a high degree of perceived safety, and they are fine for short-term savings. But over time, inflation erodes the purchasing power of that money. It’s virtually certain, for instance, that the 10-year CD you buy today, even with all the accumulated interest, will buy less in 2012 than it buys today.
Higher risk and higher potential rewards go together. This is a basic fact of investing life. In general, the more risk you are willing to take, the more return you may receive. But this rule of thumb implies that you take intelligent risks based on understanding and knowledge instead of random risks based on bravado and recent hot performance.
Intelligent investors know how to manage the risks they take, and they know how much return they need to accomplish their objectives. This, in the end, is what successful investing comes down to.
Neither you nor I nor anybody else can control what the market does. Like the weather, it will do its thing, regardless of what that means to us humans.
However, an advisor can help you design a portfolio to weather the worst expected storms. And if you can control your emotional reactions, you can make the most of the opportunities that come your way while you avoid the worst of the damage that pummels unwary investors.
If your portfolio is not properly positioned for your needs, you should fix that now. Some people know what they “should” do, but they’re waiting until they are sure the market has turned around before they take action. This is a mistake.
Here’s something else you can put on your refrigerator:
It’s never the wrong time to do the right thing. But it is always the wrong time to keep doing the wrong thing.
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