Fear Is In the Air
"The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances."
Benjamin Graham
Fear is in the air, and it’s leading a lot of people to take risks they otherwise wouldn’t take and make mistakes they might not otherwise make. The fear, of course, is that the U.S. may be headed for a so-called "double dip" recession, and that economic growth will slow. The conclusion – while not certain – is that this would be bad for stocks and the "stock market." Bad meaning that stock prices might decline.
I could describe at great length all of the many reasons why stock prices fluctuate. But few of them would matter much to you if you were of the opinion that a decline in stock prices was a bad thing. For some investors – on occasion – perhaps it is a bad thing. Like if all of your money was tied up in stocks and you needed to liquidate most of them, all at once. That would be a bad thing. But that would also reflect some very bad choices and irresponsible behavior on your part. For no one should have all of their wealth tied up in stocks, at any time.
And, if like many investors, you have a diversified portfolio of assets (including stocks/stock mutual funds, bonds/bond mutual funds, cash, real estate, collectibles, personal business interests, etc.), then periodic and temporary declines in the prices of stocks should be of little concern to you. More importantly, unless you are in a true net-liquidation stage of your life (in your eighties, or nineties even), you should welcome these periodic price declines as an opportunity to buy more stocks. Because it’s precisely in markets like this that true wealth is made.
Price and value are inversely related, nowhere more so than in investing. Yet with every temporary price decline (and they are all temporary), what is the first thing that many investors do? They sell their stocks – which have declined in price, and they buy bonds – whose prices have just risen (and whose future returns are now less certain). It’s what happened in late 2008 and the early part of 2009, and it’s what’s happening again today. These are the "risks" and "mistakes" that I alluded to earlier.
A client recently rationalized this strategy to me on the basis of the trailing 10-year returns on "the stock market", pointing out that "returns on the stock market were flat to slightly negative for the last 10 years." So he reckoned that this was a good time to sell stocks and buy bonds. But the logic underlying this argument is not supported by the facts. Stock market returns for the trailing 10-year period reflect a period that includes (just barely) the year 2000. The year 2000, as many of you will recall, is when the "tech bubble" burst and the NASDAQ index of stocks – to take just one aggregate – declined by more than 50%. But this was right on the heels of four straight years (1996-1999) of well above average returns on the market – as the bubble was inflating. Consequently, the base value on which stocks began the decade was artificially high to begin with. Had we not had the four straight years of extraordinary returns that we did, the trajectory of price changes over the ensuing decade would have more closely approximated the long-term averages, and the returns would almost certainly have been positive. Looked at that way, stock prices today may well be below their historical fair value.
But he was having none of this argument. He was determined to buy more bonds, and buy them now. And in so doing, he is almost certainly condeming himself to the same experience with bonds that he just described to me as a reason to avoid stocks. No one will know until well after the fact whether we are experiencing the beginnings of a bond market bubble today. But we certainly could be. As I write this today (Friday the 13thof August, as it happens), the yield on 10-year Treasurys stands at 2.7%. Subtract inflation and taxes from that and as surely as the sun comes up in the East and sets in the West, it strikes me that investors must lose money behaving this way.
So what’s the (understandably) fearful, but still (hopefully) rational investor to do? Have a financial plan and an investment strategy that’s suitable for your situation and circumstances and determine the appropriate allocation to stocks and bonds beforehand. Don’t – under any circumstances – have all of your money in stocks (or bonds, or any other asset class for that matter). Be diversified. Then be patient. Expect the prices of your investments to fluctuate over time with changes in current economic events. Keep the faith – faith in the resilience and magnificence of our economy and its proven ability to generate wealth and increase our standard of living over time, as it has always done before. And most importantly, don’t let your emotions (fear) get the best of you. Rarely, if ever, are the best decisions the ones we make when in the grips of fear.
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