This Too will Pass

Woot! This is every investor’s idea of fun. Yesterday marked the fourth anniversary of the stock market’s current bull run. Meaning that the the stock market hit bottom on March 9, 2009, and has been trending upward since. The S&P 500, a broad index of big stocks, closed at 676.52 at the market bottom four years ago. It closed at 1556.22 today. The Dow Jones Industrial Average closed at 6,547.03 back on March 9, 2009. It closed at 14,447.29 yesterday. That’s a 131% gain for the S&P, and a 120% gain for the Dow. Spread over the four years, that gain is equivalent to a 23.35% annual return for the S&P, and a 21.88% annual return for the Dow. And the closing numbers for both of those indices are an all-time record. I’ll say it again: Woot!

Now before the celebration gets out of hand, I should remind you of a couple of things. First, this too will pass. The market will not head up forever. Somehow people have a hard time not believing that whatever is happening in the market right now will continue ad infinitum. When markets are tanking, advisors have the difficult job of convincing frightened investors that the collapse isn’t permanent; that the storm will break one day; that there is nothing to fear but fear itself; that their goals and dreams will not be well-served by abandoning ship when the seas get rough. Bear markets have come and gone before, we tell them, and this too shall pass.

Oddly enough, we have to give the same speech when unreasoning fear is replaced by irrational exuberance in a long-running bull market. Suddenly people who have been timid and principal-obsessed want to go all-in on small company stocks. They throw caution to the winds as they start imagining what their portfolios will look like after fifteen consecutive years of 20% gains. While I hate to be a wet blanket, I must caution those people that they have better odds of being struck by lightning than they do of seeing this run continue at this pace for years to come. Year over year growth of 20% or more has never been the norm, and there is no reason to think it is about to become the norm. The uptrend will invariably turn down again. The party is never permanent. This too will pass. If you can’t take the inevitable heat, now’s a good time to get out of the kitchen.

But I hope that’s not you. Because over long periods of time, the up days have always outnumbered the down days. The history of the stock market is of a long upward march regularly punctuated by catastrophic (albeit temporary) declines. The spoils belong to those who can stay disciplined through the ups and downs.

This brings up the second thing we need to discuss. Most investors don’t achieve anything near the index returns in their own portfolio. Why? Because when markets are tanking, they start to fear the decline will be permanent and bail out. That’s called selling low. And when the market turns around, they are slow to believe it, until record highs and euphoria convince them to buy back in. That’s buying high. You’re supposed to buy low and sell high. It just works better that way. But as one sage observed, the stock market is the only market where customers are unwilling to buy during a big sale. They want to wait until prices go back up before buying. If you doubt this, consider the fact that over the last several years, stock mutual funds have been suffering net outflows. That means more investor money was leaving the funds than was coming in. This finally changed about a month ago, as the markets were approaching new record highs. Consistently buying high and selling low will not make you prosperous.

How can you avoid the temptation to buy high and sell low? When you make your next IRA contribution, and when you have the opportunity to change your 401(k) allocation, consider this strategy: Put the most money into the asset class that performed the worst over the last twelve months. Put the smallest portion of your investment into the category that performed the best. You’ll be buying more of what’s on sale, and less of what’s marked up. You should consider reallocating the entire account balance (not just the new contribution) along those lines. You’ll be selling high (the stuff that appreciated the most) and buying low (the parts of your portfolio that are cheapest). It won’t feel right. It never does. But it’s smart strategy if followed consistently. So sell the winners, stock up on the laggards, and say it with me: Woot!

Flip a Coin for Financial Security?

Three minutes before the start of a football game, the team captains meet at center field with a referee for a coin toss. The captain of the visiting team calls the toss. Winner of the toss gets to choose whether his team kicks off or receives to start the game. (There are other choices he can make, but we’re going to keep this analogy simple.)  One thing is certain: the winner of the toss will not receive accolades for his skill at predicting future outcomes. Everybody knows that the outcome is random, and that his odds of being right are 50-50. If he calls it right five times in a row, we call him lucky, not good.

On May9-10, Bloomberg Global surveyed 1,263 of their subscribers to poll them about their take on the economic future. Poll respondents tend to be financially savvy people: economists, investment bankers, hedge fund managers, and generally sophisticated investors. When asked if the S&P 500 Index would be higher six months in the future, 48% said yes. But 50% said no. And 2% were honest enough to admit they had no idea. So disregarding the honest 2%, half answered the question yes, and half answered no. I can say without any doubt that half of them are right. But then you’ll probably go and spoil things by asking which half.

This sort of 50/50 breakdown is not uncommon. Back in January, a Bloomberg poll found half of respondents declaring that a state or major U.S. city would default on its municipal bonds this year. But 46% — nearly half — thought that prospect unlikely. You can bet that the half that turns out to have gotten it right will say they were good, not merely lucky. The truth is there are way too may variables, both seen and unseen, that impact the outcome for anyone to “know” what’s really going to happen. But that won’t keep half of them from claiming they did.

This would be of little consequence if it were not for the fact that so many people make investment decisions based on the predictions of People Who Claim to Know. They buy gold at $1500 per ounce because their favorite guru claims it’s going to run up to $2500 per ounce this year. They move into (or out of) stocks. Or Treasuries. Or emerging market debt. Or commodities. All because of what somebody or other says is going to happen next.

Like a coin toss, all economic predictions have only two possible outcomes. They will prove to be correct, or they will not. But do you really want to risk any part of your hard-earned nest egg on something like a coin toss? I know I don’t.

Here’s a better idea: Acknowledge that the future is both unknown and unknowable. Instead of looking for a guru to follow with a great record in the coin toss, consider trying to build an “all-weather portfolio” that will allow you to make progress toward your financial goals under a wide variety of possible conditions. You want investments that will benefit if the dollar weakens, as well as investments that will benefit if it strengthens. You want to be prepared for inflation and deflation, expansion and recession. Rather than having to know what’s next, you can know that you are prepared for a variety of possibilities. I go into this whole concept in much greater detail in Chapter 11 of Making Mammon Serve You. It’s recommended reading, if I do say so myself.

Building an all-weather portfolio is not a piece of cake, and it’s not an exact science. But it sure beats betting the ranch on a coin toss.

Nightmares for Sale

The world is coming to an end. Again.

A friend sent me a link to a video entitled The End of America. The voiceover solemnly warns about the coming collapse of the U.S. dollar, and predicts riots, martial law, mass arrests, and that sort of thing. A bad time will be had by all – except those who are wise enough to subscribe to the newsletter the video promotes. They’ll learn a way to invest that saves them from the coming carnage.

We’ve seen this movie before. Remember Y2K?  That was the talk of the 1990s. Everybody was predicting economic meltdown then, too. It seemed that the end of modern civilization would come as the result of a computer glitch.  See, back then, computer memory was kind of scarce.  To save memory space, dates were always programmed with two digits each for day, month, and year: 12/31/97, for example.  Everyone knew that “97” was short for 1997. Since the first two numerals in a year were always 19, they were dropped to save memory. Then the realization dawned:  When the year 2000 came, computers wouldn’t know what to do with 01/01/00. Would your credit card companies think it meant the year 1900?  Would they charge you 100 years’ worth of finance charges on recent purchases? Would utility companies shut off service thinking that payment was 100 years overdue?  Would stock markets grind to a halt?  A million different doomsday scenarios were developed.

Just to dip their toes in the murky waters of digital destruction,  some people even turned the dates ahead on their VCRs. [For the benefit of younger readers, a VCR was the device that oldsters used for watching movies before there were DVD players or streaming video. ;-) ] When rolled to the double-aught year, most VCRs froze. They wouldn’t work, and the date could not be reset.  This was taken as proof positive that all the world’s computers would do likewise.

Of course, Y2K turned out to be a whole lotta nothin’.  Civilization did not end. Computer programs got patched or rewritten. The world let out a collective yawn and went about its business.

But many financial writers love a scary story, and employ them all the time.  Market crash!  Double-dip recession!  Your job outsourced!  What to do now! And every so often, a plausible nightmare scenario comes along that really grabs everyone’s attention the way Y2K did. I think there’s a part of most people’s psyche that actually likes imbibing a good dose of fear. How else do you explain the popularity of roller coasters and vampire movies?

Still, fear has no place in your personal finances. It can lead to paralyzing inaction, or worse yet, to taking crazy actions in preparation for extreme events that never come to pass. If you sink all of your money into building an underground bunker and stuffing it with canned goods and precious metals to ride out the apocalypse, you’re going to have serious regrets if this latest end-of-life-as-we-know-it turns out to be a bigger dud than Y2K.

In the end, the doomsayers make one mistake over and over. They extrapolate an ever-growing problem, such as our national debt – but they never extrapolate a growing ability to fix the problem. So inevitable disaster is always looming. Fortunately, history is not on the side of the nightmare salesmen. And it never has been.

I’ll say more on this, and how it relates to your financial decision making, in a future post. For now, let’s settle on what to call this gloomy brand of financial forecasting. Disasterology?  Apocanomics?  Chime in with your suggestions.  The winner (in the sole, arbitrary, and final opinion of yours truly) gets the internet immortality that comes with coining a new phrase!