Issue: 97
Sent: 12-02-2008 10:15:02
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When in Doubt - Part 1
Markets are somewhat volatile at the moment, to put it mildly. As I mentioned last time, panic selling and rushed buying in such times is not a good approach. So what is the right thing to do in the face of such uncertainty?
If it is a long-term investment, then the answer is simple in theory, although some may find it hard in practice. Quite simply, do little or even nothing. Sit tight, and wait it out. As I point out in the much more detailed article in Digest, markets have gone through such gyrations countless times in the past and they are likely to do so in the future, but the long-term trend had been up.
If it is a short-term investment and the investor is upset at losing money, questions should be asked why the money was exposed to such risk in the first place.
A recent article from Wharton dealt with this issue and put things in perspective when it said that he worldwide collapse of stock prices has many victims, including pension funds, insurance companies, hedge funds and financial services firms. It went on to add that such investors have the ability to withstand a steep sell-off. As they so rightly point out, some will even use short-sales or derivatives bets to profit on falling prices. In other words, they will be able to exploit the situation and make money even when the market is falling. Not something the average investor is up to.
So what about Joe Bloggs who is trying to save, perhaps for retirement via a Self Managed Fund? They could all too easily be led into the headlong rush to sell, usually at the worst time. I can't help but wonder how many sold at or close to the bottom of the dips and then rushed back in at or close to the peaks, only to see the market dive down again, no doubt leading them to repeat their mistakes all over again.
Knowledge@Wharton interviewed a number of experts on this issue, including Jack Bogle, founder of the Vanguard Group, and Princeton economics Professor Malkiel, author of A Random Walk Down Wall Street.
While Professor Allen from Wharton suggested that investors would be smart to flee stocks for the safety of short-term fixed interest securities, most of the others suggest that the best response is no response at all. Namely to sit tight and assume that, over the long run, stocks will continue to produce the inflation and bond-beating returns they have for more than a century. As I pointed in Digest, markets are like yoyo's. They move up and down, but if you are using a yoyo on an escalator, the trend is upward (the Digest article has a graph showing this effect).
However, market movements can affect the makeup of a portfolio. As the panel from Wharton point out, if a small investor were inclined to do anything, the best move would be to regularly adjust their holdings as assets change value in order to keep to the desired allocation between stocks, bonds and cash. Professor Herring from Wharton stated he is highly skeptical about the ability of most investors to predict turning points. Consequently he suggests that most people would be best served by staying with their strategic allocations and rebalancing if market moves have taken them too far from their targets. Sounds a very sensible and rational approach, although trying to persuade clients to buy stocks that have fallen may be a little problematic. They should think of it as a buying opportunity.
But what about the fears over a recession in the US and its flow on effects to the rest of the world? As Professor Allen from Wharton points out in order to be successful in shifting towards cash and then back to stocks, we must first be able to determine whether we are indeed going into a recession.
Unfortunately, that is not easy as Professor Marston points out "We won't know that until about 12 to 18 months after the recession begins. That is the average time it takes the National Bureau of Economic Research (NBER) business cycle dating committee to decide that a recession has begun. The NBER identifies recessions' beginnings and endings but always after the fact because of delays in collecting relevant information.
However, even if an investor knew these dates, they would need to know when to leave the market and when to enter it. Sounds easy but actually it is not. The fact that markets usually start falling before a recession starts, is not the real issue, the fact that the lead time varies, is. As Professor Marston explains, over the last nine recessions, the lead time has varied from one to 13 months."
The Wharton article goes on to explain that typically, stocks start to rise before a recession ends, but in each of the nine recessions, from 1953 through 2001, the rebound started at a different point, ranging from eight months before the end of the recession to, in one instance, 12 months afterward.
However, investors should be encouraged by the fact that stocks tend to rebound smartly from the low reached in or around a recession. Gains from the market bottom were 59%, 34% and 39% after the recessions of 1982, 1991 and 2001, respectively.
There is more, but that will have to wait until next time.
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