One of our investment management clients is a steel company whose retirement fund we manage a portion of using market timing. The head of this company's human resources department told me a story about what happened right after the Dow Jones Industrial Index plunged over 500 points in a single day in October 1987. The day of that crash, he said, almost all the employees who had discretion over their retirement accounts gave him instructions to get them out of the stock market.

That, of course, was not the best market timing on their part, since the crash had already occurred and they had already suffered the loss. These employees had plenty of company that day in wanting out. Many brokerage houses simply stopped answering their phones because there were almost no buyers at reasonable prices. That left many investors, brokers and traders utterly unable to execute orders. In some cases mutual fund investors called for hours before getting through to someone who could accept their "sell everything" order while others gave up in despair.

Though that anecdote is eight years old, I thought of it recently in connection with what has lots of money managers worried these days: the possibility that in a sharp market decline, hundreds of thousands of investors can easily bail out of stocks and mutual funds.

Mutual funds are organized to let investors turn their equities into cash at any time, in a hurry. Normal redemptions pose no problem for the funds, which are used to having purchases exceed redemptions. But consider the fact that mutual fund portfolio managers have in the past few years become the intermediaries for most American equity investors. Those managers are now among the largest buyers and sellers of securities, and what they do in the market has an immediate effect on security prices.

Many people think modern investors are patient enough to weather any storm. They think a "meltdown" scenario is preposterous. But if investors tried to bail out of the markets in a downturn, this very behavior could trigger the worst.

The meltdown scenario goes like this: For whatever reason, investors in droves decide the equities market is no longer so "user friendly." With their personal computers and touch-tone telephones, they place redemption orders in mass. Mutual funds are suddenly caught without the cash to handle the orders. Their inventory of stocks has been devalued by a market crash, and the funds' borrowing powers are strained or cut off. So the funds have only one choice: sell more of their portfolio holdings, taking further losses.

Normally if this pattern hit only a single fund, other funds would be there as buyers to snap up the inventory of equities. But in a general panic, where are the buyers for those shares? Certainly some institutions and individuals will be eager to buy equities at what they perceive as bargain prices. But in a general selling spree, the demand for shares, which many people believe is almost guaranteed, could vanish quickly, depressing the value of funds and the stocks they own. This would affect retirement and pension funds, insurance companies and other large investors. In a worst case, the market could spiral downward, the forces of supply and demand wildly out of balance.

WHY WORRY?

The people who think such a scenario is preposterous could be right, but I am among the worriers. Here's why. Reputable studies indicate that 75 to 80 percent of the money in mutual funds today has come in during the 1990s. In the past three and a half years, more than $370 billion has been put into equity mutual funds by investors eager to cash in on one of the longest bull markets this century. Most of those investors are relative newcomers to equities. Most have never experienced a real bear market. They don't know the anguish of tuning in the car radio on the morning commute to learn that they may have lost 5 percent of their life savings while they were in the shower.

The bulk of investors stayed put in the 1987 crash (and I can't resist pointing out that those who followed our timing systems were completely safe on the sidelines by then). But that crash was relatively short-lived. It didn't drag on for months and years. In fact, it was followed by a remarkably robust recovery that still continues.

Still, I am concerned. I know that people have a certain threshold for pain. Once they exceed that limit, their behavior starts to change, sometimes in unpredictable ways. Many investment managers believe most of today's investors can be counted on to buy-and-hold, through better or worse. But I'm not convinced. Consider marriage, a contract or commitment that's usually entered into by people who believe they won't change their minds later. Yet a difficult marriage can be very painful, and when the pain reaches a certain threshold, many people bail out. The divorce rate indicates that nearly half the marriages wind up as failures, despite most people's initial intentions and expectations. My son and business partner, Jeff Merriman-Cohen, hit the nail on the head one morning last month when we were talking about this. "If people are not going to buy-and-hold a marriage, they are not going to buy-and-hold their investments," he said. Unfortunately, I think Jeff is right.

If a severe bear market comes down the pike, many of the "new" investors who have entered the market in the past few years are likely to react with confusion at best and panic selling at worst. A seasoned golfer knows that a bad day is just a bad day, and usually knows how to learn from mistakes. But a beginning golfer may conclude from just one bad outing that he isn't cut out for that sport, and decide to move on to an activity that offers a more enjoyable experience. Likewise, even a seasoned investor knows that a bad trade, a bad quarter or a bad year doesn't mean anything is necessarily wrong with his strategy. But a newcomer may react emotionally, suddenly concluding that investing is just too stressful to be worth it.

I'm afraid that the owners of the vast majority of the money now in mutual funds are not emotionally prepared for a major decline. People saw quick, robust recoveries after the crash in 1987 and the bear market of 1990. If they think those quick recoveries are "normal" market behavior, they could be in for a rude awakening.

HOW MUCH PAIN CAN YOU TAKE?

The way we advocate using market timing is not really fun. It's a mechanical strategy that requires a mental toughness that is often contrary to an investor's gut reaction and intuition. The part of this business I like the most is meeting one-on-one with clients and potential clients, learning as much as I can about them in order to design a suitable investment plan. One of the most important things we need to know is each person's pain threshold. In order to get where they are going, they will undoubtedly have to endure some investment pain when they have lost money on a trade or a series of trades. Yet most people I talk to have no clear notion of their thresholds for investment pain.

Just as important as the pain of losing money is the pain of under-performing, doing worse than some other investor or some other strategy or some standard such as "the market." In fact, under-performance is often the most painful part of investing, and it applies equally to buy-and-hold investors as to those who use market timing. As Jeff pointed out, we rarely lose clients to the pain of losses. We lose clients to the pain of under-performance.

WE FEEL THE PAIN TOO

Believe it or not, this pain is equally hard on us. As market timers, we constantly compare our performance to the performance of buy-and-hold investors. We're also constantly looking over our shoulders to see how other market timers are doing. And very, very few brokers or investment managers ever become completely immune to the pain of informing clients that they have sustained major losses. In fact, this pain often discourages brokers and managers from telling their clients the bad news. Unfortunately, that sometimes means the clients and the money managers don't act when they should to cut their losses.

WILL THE DEMAND FOR EQUITIES KEEP ROLLING ON?

Some in our industry think the demand for equity funds will have no end in the foreseeable future, especially with the "baby boom" generation nearing the intense pre-retirement years when saving and investing typically becomes a high priority. Some people believe the market still has a "backlog" of hundreds of billions of dollars just waiting to be invested. However, an article in this month's issue of Mutual Funds Magazine reminds us that a huge pent-up demand for stocks is no guarantee against a bear market.

Most of today's investors weren't in the markets in the late 1960s, when it looked like the market would keep rising all through the 1970s, fueled in part by a huge backlog of demand for stocks. That demand was fueled in part by an influential report by the Ford Foundation. The report took most pension fund managers severely to task for ignoring the long-term potential of equities. Rather quickly, many pension funds began dumping bonds and buying stocks.

Yet in spite of this major movement into equities, the U.S. stock market peaked in 1968, to be followed by the most painful bear market since the Great Depression. The Dow Jones Industrial Average lost more than 40 percent of its value in the early 1970s, and it didn't regain its late 1960's levels for 15 years.

To quote the Mutual Funds article: "What went wrong? The same thing that could go wrong now." Despite the presumed demand for hundreds of billions of dollars in equities, the supply of those equities totals several trillion dollars, that is, all the stock that is currently outstanding. And if institutional money managers conclude, for whatever reason, that stocks are overvalued, money will find its way out of stocks and into bonds or money market instruments. And that will inevitably depress the prices of those stocks. Through IRA and 401(k) accounts, individual investors increasingly can move large amounts out of stocks and into something else. And as individuals become more sophisticated, they are likely to take more advantage of the convenient switching options that our industry has given them.

SO WHAT DOES THIS MEAN?

What does this mean for you as an investor? Maybe not a great deal. I'm certainly not suggesting there's any reason to panic about the market. But if the investment industry has overestimated the pain threshold of the public, there is a huge risk lurking somewhere in today's market. Anybody who thinks the public will remain calm and fully invested through a major market decline simply does not understand human psychology.

I think it's wise to be wary, especially in times like these when optimism is widespread. If you've never lived through a major bear market as an investor, I encourage you to listen to people who have. Be especially wary of the trap of thinking it just can't ever happen again, because it can...and probably will. Personally, I continue to think your best defense against a potential market "meltdown" is the use of market timing. Whether you time the markets on your own following our systems or you hire a professional to do it for you, a disciplined approach is likely to help you avoid most of the worst losses of any serious bear market.

In addition, I think every sophisticated investor should have an idea how much investment pain he or she is willing to tolerate. I can't tell you what your threshold should be. But I can share with you how I have determined my own pain tolerance. I don't suggest yours is or should be the same as mine. But if my thoughts help you come up with your own, then this is a worthwhile exercise.

INVESTING IS ABOUT ULTIMATE CONSEQUENCES,
NOT HOW YOU FEEL TODAY

When people are in severe pain, whether it's physical, emotional or financial, they often lose the ability to make good decisions. Stopping the hurt can become the top priority, regardless of the possible ultimate consequences. But investing money should be about ultimate consequences, not about relieving immediate pain. Decisions based on pain and emotions are almost always counterproductive, and that's one reason it's extremely valuable to have a plan to turn to when things start to hurt.

Here's my own pain management plan. I have two types of money invested. The first is money that I don't expect to ever need for myself. These funds will ultimately go to our children, though it is still in our name and our control. I assume that my ultimate demise is not imminent, and that I have enough time remaining to invest this aggressively. Using a combination of aggressive funds with market timing and margin, I try to achieve an average annual total return of 20 to 25 percent. This is a goal that I think is reasonable for aggressive investors with a high tolerance for risk.

My pain threshold for this money is a loss of 20 percent in one year. In other words, I am willing to continue this plan knowing that I could lose that much, though I think it is highly unlikely because of market timing. I want to emphasize that any loss at all would be painful for me and a loss of 20 percent would be very hard to accept. However, I think I could tolerate it for this money. (By the way, this threshold means I could not invest in the Standard & Poor's 500 index on a buy-and-hold basis, because that index has fallen on average, greater than 20 percent, once in each five years since 1960-and the average decline has been more than 30 percent.)

A BAG-LADY PERSONALITY

My other investments are for my own retirement and the security of my wife, Doll, and Lisa, our four-year-old daughter. I know that I can reach my personal financial goals if I continue to earn at least an 8 percent compound rate of return. I have decided to try to achieve 12 percent annually, to give me a substantial margin for error. And I believe 12 percent is achievable within my tolerance for risk. That tolerance is more limited with this money. I have what you could call a "bag-lady" personality, worrying that I might be broke tomorrow. With my retirement money, I am willing to accept no more than a 10 percent annual loss. My own retirement investments are allocated among bonds and equities, both U.S. and international. All this money is managed with market timing and about 25 percent of it is invested using moderate leverage.

What happens if my investment losses exceed my pain thresholds? In either case, a loss of greater than 20 percent (for my estate's money) or 10 percent (for my retirement money) would prompt me to reevaluate my whole strategy. I have arranged my investments to perform within my pain limits. A loss outside those limits would mean that my carefully crafted investment strategies had become inadequate to deal with circumstances that had changed beyond what I understand now. This would put me in unknown territory, and I don't know for certain how I would respond. Probably one response would be to start saving more money each month to try to make up for the loss. And I would consider taking a less aggressive investment posture in the future, perhaps emphasizing bonds more, equities less.

I don't really expect this to be necessary, because the timing systems I use for myself and our clients should protect us. But I don't buy into today's widespread market optimism. I'm concerned that an extended bear market could stop the flow of money into mutual funds. If Joe Public becomes a net seller of stocks, who is going to buy all the stocks they want to sell? Who will snap up all those hot technology stocks when the market is devaluing them?

I suggest you try to determine your own pain threshold, perhaps reducing it to numbers as I have done. This requires you to understand yourself, and that in itself can be very beneficial. Remember that when you pass your pain threshold, your decisions are apt to be more risky. That's why a plan is always a great thing to have tucked away in a drawer somewhere.

 

 

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