Two things happened recently that spurred me to write this letter. One, I attended a four day conference which included talks from four different prominent economists. Second, the stock market has fallen an additional 12% since the beginning of the year. Until the economy and the financial markets return to some sort of “normalcy,” we are committed to give you our best thinking on the market, and making sure you know we are available to help as best we can.
The answer to the question, “When Will It End?” is, of course, nobody knows. This was confirmed by the four economists I heard at the conference. In a refreshing bit of candor and a break from the media’s 24/7 talking heads, each of the presentations gave different insights, but none claimed to predict the future. Here are some thoughts and highlights:
One of the most significant characteristics of the current financial meltdown is that it has hit virtually all asset classes at the same time. Traditionally we use diversification among different asset classes – stocks, bonds, real estate, natural resources – to temper volatility, because historically they don’t go up or down in concert. When one is up, another might be down. Studies have repeatedly shown this method tends to produce a slightly higher rate of return for a total portfolio, but with lower volatility.
In the current crisis, volatility is way, way up. There are a number of statistical measures showing this as perhaps the most volatile market in history. I’m sure this comes as no news to you. At the same time, the correlation between different asset classes and sub-classes is approaching 1.0. A correlation of 1.0 means that when one class goes up one point, the other class goes up one point as well. In other words, they are moving in concert. Under these circumstances diversification provides no help.
There are two important points I am pulling from this:
1) I do not expect this high correlation to last. I have read nothing in economic theory or data that would lead me to believe that from now on all asset classes will move in lock-step.
2) There must be some tremendous investment opportunities available. If all investments have been driven down together by this market crisis, there must be some that were driven down despite having good economic fundamentals. I believe it is good economic fundamentals that make for a good long-term investment. The key is finding those particular investments that we expect will rise when this crisis is over.
Behavioral finance, sometimes referred to as investor psychology, plays an important part in what we feel and do. The last economic downturn of this magnitude in most of our lifetimes was the recession of the early 1980s. One major difference between now and then is that now we are living in a 24/7 news media world. I have commented on this in both euphoric markets and in terrible down markets. The non-stop media barrage has a huge impact on our emotions. We are all human and are wired to respond to this type of input. It’s why the largest inflows into the market are when the market is peaking, and why the largest outflows from the market are when the market is tanking. In other words, more investors are buying high and selling low, exactly the behavior that guarantees terrible results. I’ll be happy to send you the charts showing this data.
What is the antidote? One person at the conference said – only somewhat tongue-in-cheek – that “volatility increases the more you look at your portfolio.” In a sense this is true. I’ve posed the following scenario to a number of people, and get the same answers each time:
Let’s say you own a piece of rental real estate. You are breaking even on the cash flow. You’ve thought about selling it, but the real estate market has collapsed. You are not being pressured to sell. You don’t have a cash flow problem. Since the cash flow from the property is break even, it is not costing you anything out of pocket to hold on. Since the real estate market is way down, do you sell or do you keep the property until things improve?
Virtually everyone says they’d keep the property. You can see where I’m taking this. Stocks and real estate are different forms of equity investments. Yet why do people have one reaction to stocks and another to real estate? I think a lot of it has to do with the fact that the value of your stock investments is reported every day (every hour, every minute), yet you only find the value of your real estate when you make an effort to appraise property values or put it on the market.
The most important part of this story, though, is not to say you should feel the same about your stock holdings as you do your real estate holdings. The most important part of the story has to do with the fact that in the real estate example the property was breaking even from a cash flow standpoint, that it was not costing you anything to hold it.
This is where a very important part of our financial planning is making itself felt in our clients’ investment decisions. We have always emphasized having adequate cash reserves. As long as you are in a position where you do not have to sell stock holdings to raise cash you can afford to hold on and not “lock in your losses.” As one of the economists put it, “Can you survive this?” With proper planning, particularly around cash reserves, we can say “yes.”
I’d like to close this report with two recent and very relevant quotes:
“Given the tumultuous markets for the last year, it’s not unreasonable to ask, “Why worry about research when the world is coming to an end?” The answer is the same one I give to my clients. If the world does come to an end, it really won’t matter what we do with client’s investments; however, if it doesn’t, good planning has never been more important, given the losses everyone has sustained.” – Harold Evensky, CFP®, Journal of Financial Planning, February 2009
“We’re certain, for example, that the economy will be in shambles throughout 2009 – but that conclusion does not tell us whether the stock market will rise or fall.” – Warren Buffet, letter to shareholders, February 2009
As always, please call with any questions, comments, or concerns. |
