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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Instead of trying to predict bear markets, investors should simply be prepared for themBear Markets and Bad Investor Behavior History shows that the biggest risk is not being in the market when it drops, but being out when it rises. Jim Jorgensen I NVESTING FOR RETIREMENT usually means placing at least a portion your money in the stock market. The reason is that, over long periods of time, it is highly probable that the returns from stocks will exceed the returns from most other asset classes, such as bonds and money market funds. In addition, stocks provide a hedge against the erosion of principal caused by inflation and taxes. The extra gain expected from stocks is not without extra risk. There have been several periods when the market fell 20% or more in a short time and other periods when stocks did not outperform bonds or money market funds for a long time. When a deep bear market rolls around, it is often a brutal test of an investors nerves. Bear markets can be painful emotionally and financially. Individual investors have no control over the direction of the market. The only decision is to be in or out. When you are in and the stocks fall, you lose money. When you are out and stocks rally, you miss an opportunity. But losing money is only one of the issues. Bear markets can cause anxiety, frustration, sleepless nights, a feeling of hopelessness, and all kinds of uncomfortable side effects. Due to all the bad stuff a bear market can cause, wouldnt it be wise to find a market expert who will magically get you out of bad markets and into good ones? That is a nice dream, but it is not reality. Market timing does not work. No one can predict the direction of the stock market with enough accuracy to make any moneyand if they could, why should they sell their alchemy services to you? Instead of trying to predict bear markets, investors should simply be prepared for them. Successful investing hinges on the development of a diversified portfolio using an appropriate mix of lowcost mutual funds. This portfolio should include U.S. stock funds, foreign stock funds, bond funds, and real estate funds. A diversified portfolio significantly reduces the impact of a bear market on your portfolio, saving you money and makings you feel better as well. This chapter provides a brief overview of diversification techniques; more detailed information can be found in the Chapter 12, Asset Allocation Explained. Bear markets should only be a minor nuisance in your life and should have no effect on your retirement savings plan or your ability to sleep at night. They occur as a normal part of the economic cycle in every free-market economy and are a natural part of economic growth. If you live to be in your 80s or older, there is a good chance you will be involved in at least two lengthy bear markets during your life and many more short-term market corrections. Bear Markets Occur More Often than We Think When the stock market falls a lot, the mass media tends to talk about the decline like it is the end of the capitalistic system in America. Nearly every newspaper in the country prints a picture of some humbled trader on the floor of the stock exchange, hands holding his head, in complete, utter shock. The caption below the picture reads, Sell, Sell, Sell! or Market Breaks Support or Panic on Wall Street. (I think it is funny to note that most newspaper editors cannot tell the difference between a trader on the floor of the stock exchange and a trader in the commodity pits in Chicago. When they pick a file photo of a depressed stock trader for the newspapers, many times it is actually a picture of a commodities trader who has had a bad day trading pork bellies.) News about movement in the markets is so editorialized that, depending on which news show you watch or which newspaper you read, the reasons given for the market decline could be vastly different. A Los Angeles newspaper may report the market is down due to higher interest rates while a Chicago paper reports the market is down due to profit taking and a Boston paper reports the market is down due to poor earnings. Who is right? Who is wrong? Who knows? The fact is that the market is down because there were more sellers than buyers, at least on that day. One day in July 2001, The Wall Street Journal actually reported, With many traders on vacation, the market barely budged. It is amazing what passes for news. A market decline of 10% to 20% is known as a correction. Since Wall Street is paid to be bullish on stocks, the word correction is a nice replacement for the words lost money. When Wall Street firms say the market is in a correction, it is supposed to make you feel better about losing money because it implies the market is setting up for bigger gains in the future. Corrections occur on average every two years and generally coincide with some potentially harmful economic or global event, like Russia defaulting on its debts in 1998. A bear market is a correction of 20% or more. It is widely believed that bear markets coincide with economic recessions. This means lower sales at retail stores and higher unemployment. The truth is, sometimes a bear market forecasts a recession and sometimes it does not. It did not in 1987, but it did in 2000. Economic data is always behind actual economic conditions, so we never know if the market is telling the truth. A standing joke on Wall Street is that the stock market forecast eight out of the last three recessions. The following tables provide some interesting stock market data on negative years, market corrections, and bear markets in the U.S. The lesson to learn from this data is that bad market conditions occur more frequently than we think. Interesting Statistics ? Number of years the stock market was down more than 10%: 16 ? Number of years the stock market was down more than 20%: 8 ? Longest time for the stock market to recover to its previous high: 14 years. ? Longest time for stock returns to be lower than T-bill returns: 15 years This Time Its Different Bull markets dim the memories of bear markets over time. During long bull markets, people gradually forget that investing is risky and instead begin to feel this time its different. At the end of the long bull market from 1982 to 1999, some hot stocks began to look like free ATMs, spitting out money month after month, with few interruptions. During this period, the investing public battled for position in line to buy these risky stocks and the mutual funds that held them. This behavior was highly encouraged by Wall Street firms that make a lot more money when people buy stocks instead of bonds. Mutual fund companies, insurance companies, financial magazines, financial television shows, and every other industry segment that benefited from more public participation in the market also cheered as the market moved higher. In early 2000, about the time a majority of investors started to pin their worldly happiness on the daily close of the NASDAQ, the floor dropped out. In disbelief, many investors reacted by purchasing more shares of stocks that lost money, thus increasing their equity exposure. This was perfectly logical at the time. A popular mantra that worked well during the bull market was buy the dips, so that is what people did. A few unfortunate investors even took equity out of their homes to increase their exposure, believing that now was their big chance to get in. All of this buying was not without Wall Street urging. Experts called the pullback a technical correction and assured the country that a rally would soon take the markets to new heights. Well, the market did not recover as the experts predicted. There was a small rally in prices, and then a fizzle, and then another small rally, and then a big fizzle. At that point, there was doubt and confusion; smart money started selling. But analysts on Wall Street continued to pound the table, insisting that a rally was near. Alas, no rally developed; prices only went lower. Soon, more selling, as institutional traders rushed for the exit. Many small investors got trampled in the stampede, especially less experienced people who had never seen a bear market. During a bear market, stocks usually decline much faster than they advance during a bull market. As a result, investors lose money very quickly, which tends to lead to a loss of confidence in the system. Depending on how much damage was done to a personal portfolio during a bear market, an investor could decide to stay out of stocks for a long, long timeand in some cases for life. The two worst bear markets in the twentieth century caused two generations of investors to shun stocks for decades. A large number of investors who borrowed money to buy stocks in the Roaring 20s got caught in the Crash of 1929 and never committed to the stock market again. Years later, many investors who were pelted in the brutal 1973-1974 bear market stayed out for years, despite a quick recovery in prices. The latest bear market has caused many people to cut stock exposure significantly and some people have vowed never to trust Wall Street again. In Search of a Crystal Ball You cannot predict the next bear market. Nevertheless, human beings want to believe that somehow they can find a way to know when to get in and when to get out. Vast amounts of time and money are spent looking for undiscovered information or unique trading strategies that have predictive value. But, so far there are no winners. The people looking for a crystal ball are no dummies. The list of Nobel Laureates who lost money trying to find a mathematical solution is quite long. John Nash, Robert Merton, and Myron Scholes are three who come to mind. Nash tried to develop market-timing systems using mathematical models based on game theory, for which he won the Nobel Prize. He did not succeed. Merton and Scholes were the architects of intrinsic formulas that mathematically predicted the risk and return in hundreds of markets. Those models eventually led to the 1998 collapse of Long-Term Capital Management (LTCM). The failure of LTCM was so potentially devastating to the global economy that the Federal Reserve had to orchestrate a bailout by several Wall Street firms. So, is there a crystal ball that can predict the market? If Nobel Laureates cannot find one that works, then there is no point for us to try. If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting whats going to happen to the stock market. Benjamin Graham Investor Beliefs About Trends Despite overwhelming evidence that the market is not predictable, most investors cling to the belief. It has even become common in our everyday speech. After the market goes up, we routinely say it is going up, and after it goes down, we routinely say it is going down. In truth, we only know where the market has been, not where it is going. The simplest form of market prediction is trend following and, by nature, we are all trend followers. This means we believe that past price trends will continue into the future. If the stock market goes up, most people think it will continue to go up; if the market goes down, most people think it will continue to go down. In early 2002, John Hancock Financial Services conducted a random survey of 801 people who invest in 401(k) and other retirement plans. When asked what they believed the return of the stock market was going to be over the next 20 years, the average answer was an annualized gain of 15%. Where did the respondents get that number? Ironically, for the preceding 20-year period ending in December 2001, the annualized return for the stock market was 15%. Respondents unconsciously extrapolated past returns into the future. The media reflects popular opinion in news stories. In 1979, after several dismal years in the stock market, most magazines were predicting 10 more dismal years. The August 1979 issue of BusinessWeek ran a cover story titled The Death of Equities. The article recommended that investors abandon the stock market and buy bonds linked to the price of gold, which had soared to $600 per ounce. Ironically, the story ran very close to the bottom of the market for stocks and the top of the market for gold. It is very hard for people to fight the urge to follow trends. But it is necessary to resist the temptation if you want to be a successful investor. I am not recommending betting against a trend, but this book advocates cutting back on those markets that make gains, following a continuous rebalancing strategy. You will read more about rebalancing in Parts II and III. |
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