Last summer, I had the opportunity to visit Yellowstone National Park, with its spectacular geo-thermal displays (including the Old Faithful geyser) and abundant wildlife, including buffalo, elk, deer and – of amusing interest to anyone involved in the markets – real bulls and real bears, all of which freely roam the Park’s forests, plains and roads.
The Park also has abundant signage warning visitors not to approach the wildlife. Why? Because wildlife can be unpredictable and potentially dangerous to humans. No matter how tame the animals might appear, and no matter how serene an image people might have of wildlife through watching television, the fact remains that even the most cuddly looking bear can easily attack a human with devastating consequences.
So it is with the stock market, at least figuratively. No matter how comforting the “long term” statistics and pie charts might look, no matter how consistent the annualized returns appear for a period, the stock market is a wild place of animal spirits that can turn on you without warning and with devastating consequences. As of this writing, the market has dropped roughly 50% in a year and a half. There is no shortage of coverage about the supposed causes of the current mess. Rather than spend time assigning blame, I prefer to ask the following questions:
- Where are we now?
- What have we learned?
- Given what we have learned, how are we choosing to respond?
Where are we now?
- Just the facts, ma’am. The market is in the tank; the economy is in a deep recession; unemployment is now 8.1% (its highest level in 26 years); housing prices have not yet stabilized; banks have not yet begun to lend in meaningful amounts. The government has taken strong action that should work; nevertheless, gloom and doom prevail.
- At the same time . . . Stock prices are at attractive levels; economic activity has not completely ceased; and 9 out of 10 people who want to work are in fact working. Recessions are cyclical; we are in what feels to be just about the worst part of this one now. Brighter days are ahead — even if we are not all able to see them now — as the cycle works its way through.
What have we learned?
- Everything is related. To think otherwise is to miss the nature of our universe. Example number one is the pundits telling us that the sub-prime lending crisis was an isolated issue that would be contained in a small corner of the U.S. housing market. Wrong. The sub-prime fiasco quickly spread into the prime markets and from there into every corner of the global credit markets, bringing lending to a virtual halt and international banks to their knees. The effects of the credit crisis continue to reverberate around the globe. Example number two is the pundits telling us that the so-called BRIC nations (Brazil, Russia, India and China) are growing so rapidly in their own right that a slowing U.S. economy would not have a large impact on the rest of the world. Wrong again. The U.S. recession has affected economies around the world. Put simply, if the American consumer stops buying electronic toys, what are the factories in China going to produce and for whom?
- Diversification among different stock markets is a bull market myth. In times of economic, political and/or geo-political crisis, all markets drop. So it has been the past year and a half, whether you have been in U.S. stocks, European stocks, emerging market stocks, large cap stocks, small cap stocks, growth stocks or value stocks. In all cases, you are down at least 40% and in some cases much more. Do not diversify one stock market by going into another stock market; diversify away from stocks by owning something other than stocks, e.g., treasury bills, high quality corporate bonds or perhaps gold.
- It is one thing to discuss your risk tolerance; it is another to live it. That is the secret blessing of this bear market – we are discovering through experience our true tolerance for risk. As mentioned above, we have no control over the market. The current volatility is a reminder of that fact, but can also be a guideline for investors in deciding how much of their portfolios they wish to put at risk.
Given what we have learned, how are we choosing to respond to where we are?
- And the winner is . . . To survive the epic clash between the desire for control and the unpredictability of the market, investors must accept that the only thing any of us can control is how we choose to show up in every moment. In investing terms, that means choosing how we react to market conditions and how we choose to invest.
- First choice: the mix. Assuming you choose to invest, the first decision is choosing the amount to invest in stocks versus cash and/or bonds. Many guidelines exist, including academic studies; rules of thumb; old-fashioned guessing; and the good old standby: the 50/50 split. My advice is to understand the risks and consequences and then listen to your heart. We have learned that the market is uncontrollable, unpredictable. We have experienced the downside for the past year and a half; remember that the market is uncontrollable and unpredictable on the upside as well. Start with a random split between stocks and bonds and see how you feel. Ask yourself, “on the road to future investment gains, if the market drops 50% for a period along the way, will I be able to stick it out?” Your gut will tell you if the split you have started with feels like too much or too little. Go from there.
- Second choice: the implementation. The second decision is choosing how to implement your mix of stocks and bonds. For most of us, the answer is to use diversified mutual funds. An important element of becoming a successful investor is to acknowledge our limitations; for most non-professional investors, stock picking is a limitation. The vast majority of mutual funds are managed by professionals with more experience and research resources than we have available to us. (How to pick a mutual fund is a topic for another day!)
- Third choice: watch. The third step is to watch, watch and watch. Keep an eye on your holdings, on your split between stocks and bonds and on the constantly evolving investment conditions. Do not be compulsive, but do recognize that it is in your interest to have a least a general idea of how your money is invested. Also, remember that nothing is written in stone. A truly creative investor realizes that at times it is appropriate to make a change in funds and/or a change in your mix between stocks and bonds.
Whatever your choices, be confident and have faith. If you have listened to your heart as well as your mind, you likely will emerge with an investment portfolio that works for you. Happy investing!