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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Market timing is not helpful to investors over their lifetimeOur Life and the Life Cycles of Markets Most people will participate in two or three large bull and bear market cycles during their lifetime. A complete market cycle seems to run between 15 and 30 years. The total gain during the bull phase averages between five and 10 times its starting price and the loss during the bear phase averages about one-third to one-half the price at the market peak. From start to finish, the total return of a cycle has averaged about 10% per year compounded, depending on the rate of inflation during the period. The average, inflationadjusted return of the market during a complete cycle is about 6% per year compounded. Over the last 80 years, there have been three secular (long-term) market cycles. The first began in 1921 and ended in about 1942. The second started in 1943 and ended in 1974. The third cycle started in 1975 and hopefully ended in 2003, although I am speculating on the end date. In each period, as the market went higher, more people jumped on the bandwagon, especially in the final years. This trend-following behavior led to the demise of considerably more investors at the end than had been in at the start. The net result of the market timing of sorts was a significant loss in capital for many investors and a loss in the publics faith in Wall Street. The stock market boomed in the 1920s, fueled by growth prospects after WW I and easy credit from banks. As a result, over 10% of the working population bought common stocks through brokers.1 In 1929 the crash began. The market downturn was slow at first. Then, as the Federal Reserve tightened credit and Congress enacted a new tariff on imports, the stock market collapsed. Over the next three years, prices dropped 82% from their highs and many people could not pay their banks for loans used to buy stocks. As a result, many major banks became illiquid and closed their doors. The banking crisis sent the economy into a tailspin and threw the country into a period of despair. The experience of 1929-32 stayed on the minds of Americans for two decades. Despite the fact that the absolute market bottom in stock prices was in 1932, public ownership in stocks continued to decline to a low of 4% in 1951. A turnaround in investor sentiment came at the end of the Korean War, in 1952, when a new generation of investors was emerging. As a new bull market pushed stock prices higher in the 1950s, more investors become enchanted. Many of these new investors were not in the stock market during the Crash of 29, so they were less influenced by events gone by. Also during this period, new telephone technology allowed brokerage firms to expand their reach to every city and town in America. Brokers even went door-to-door selling individual stocks and a new product called mutual funds. Renewed vigor fueled the market until the late 1960s. Then, the U.S. became more involved in the Vietnam War, draining the country of precious resources. This caused a peak in prices in 1968, although people kept buying the dips. Stocks as a percent of household financial assets hit a high of 38% in 1969. By that time over 16% of the adult population owned stocks, more than any other time in the economic history of the U.S. Unfortunately, as a result of continued deficit spending during the war, the U.S. dollar was weakening. One unintended consequence of the decline in the value of the dollar was an unprecedented outflow of gold from the U.S. reserves. In 1973, growing political pressure to curb the outflow of gold forced President Nixon to take the country off the gold standard, which pegged the value of the dollar to the price of gold. This major shift in monetary policy resulted in the collapse of the U.S. dollar and a surge in inflation. Since oil trades on the U.S. dollar, price of oil skyrocketed, which caused an Arab oil embargo, which created long lines at the gas pumps, a severe energy shortage, and ultimately, a deep recession. Between 1973 and 1974, blue-chip stocks fell over 40% and small stocks fell more than 50%. The rapid decline in prices and poor economic outlook drove many investors permanently out of the stock market for the second time in the century. The bear market bottomed in 1974. Then, from 1975 to 1992, the S&P 500 compounded at a 15.6% annual return, beating the return of bank CDs by 7%. Nevertheless, during this period, experienced investors preferred the safety of FDIC-insured bank deposits. Stock ownership fell back to the 10% level. Finally, in the early 1990s, a third generation of investors ventured into the stock market. The baby boomers started to become an investment force on Wall Street. Improved information and communications, along with a growing lineup of new and exciting mutual funds, fueled the rise in stock prices. By early 2000, there were significantly more stock investors as a percent of the adult population than ever before. According to Federal Reserve data, the number of households owning equities or equity mutual funds increased from 33% in 1989 to 52% by 2001. This increase was a direct result of more people participating in employer self-directed retirements accounts such as the 401(k). As the number of investors participating in the stock market rose, the amount of their participation also exploded in the 1990s. Stocks grew from 18% of median household financial assets in 1991 to a historically high rate of 45% by 1999. As you can see in Figure 3-1, when the bear market rolled around in 2000, significantly more households had more exposure to equities than at any other time in history. Figure 3-1 puts a lot of this information in graphic form. The 52year chart compares the rolling three-year return of the S&P 500 with the percentage of household financial assets in individual stocks and stock mutual funds. For the entire period, the median household held 25% of its financial assets in stocks. The range was from a low of 12% in 1982 to a high of almost 50% in 2000. Using the data in Figure 3-1, I estimated the cost of long-term market timing decisions on a generation of investors. The median amount of household financial assets in stocks during the entire 52year period was about 25%. However, as a group, households moved in and out of the market based on prior period returns. Had the public maintained a constant 25% in stocks during the entire period, instead of changing the asset mix based on past market action, the total return of the static 25% portfolio would have been 3,554% versus a total return of only 2,967% from the trend-following strategy that the public followed. Market timing is not helpful to investors over their lifetime. You have nothing to gain by trying to increase stock allocations in a bull market and decrease stocks prior to a bear market. A better alternative is to decide on a static percentage of stocks and bonds that fits your needs and then maintain that allocation for a long, long time. More information on investment planning can be found in Part Three of this book. TIAA-CREF Study For a more detailed look at how investors reacted to the final years of the recent bull market, we turn to an in-depth study on retirement saving habits by mutual fund giant and retirement plan provider Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF, New York, NY).2 TIAA-CREF is a major provider of self-directed retirement plans to public service entities. These include schools, hospitals, universities, and state and local governments. The source for the TIAA-CREF study was the companys own vast database of retirement savers. By analyzing their own client data, the researchers tracked changes in equity allocations as people aged. Also present in the data is the effect of the bull market on asset allocations. From 1987 to 1994, investors with TIAA-CREF showed an increase in their acceptance of equity risk (Figure 3-2). The average 44-year-old in 1987 gradually increased his or her weighting to stocks from 42% to about 44% by 1994. Then, starting around 1995, investors in all age groups accelerated their allocation to equity, both with invested money and new contributions. By 1999, the now 56-year-olds had increased their retirement holdings to about 57% in equity, a 15% jump from when they were 12 years younger. At first glance, you may conclude that the increase in the equity exposure from 1987 to 1999 may be a direct result of the bull market, and some of it was. However, a closer examination reveals an interesting series of events. From 1988 to 1994, the cumulative return of the S&P 500 was 133%, yet the equity allocations for investors in the 40- to 50-year age group did not move very much. That was because a majority of those investors were putting new contributions into safer investments, such as fixed income annuities. This kept the stock percentage fairly stable. In addition, a small number of middle-aged investors were actively reallocating assets out of stocks as the market went up, which was proper action to take in a well-balanced investment plan. Perhaps the crash of 1987 and the market sell-off leading up to the Gulf War in 1991 instilled some caution in investors for a while, but the picture changed again from 1995 to 1999. During that period, the cumulative return of the S&P 500 was an astonishing 251%, which seemed to result in a significant shift in thinking across all age groups in the TIAA-CREF data, particularly among participants in their 40s and 50s. The conservative strategies exhibited earlier by some investors were no longer identifiable. Figure 3-3 illustrates a gradual increase in new cash contributions allocated to stocks over a 10-year period. In 1989, few investors were placing a large percentage of their new contributions into equities. By 1998, more than half the investors were placing more than 50% of new money into equitiesand half of those people were investing 100% in equities. The significant increase in equity exposure occurred for two reasons. In all age groups, people shifted allocations of new contributions away from safe investments into equities and they let equity gains ride without rebalancing their portfolio. Clearly, people believed that the past gains in the stock market were going to continue. Perhaps this shift in strategy was a result of greed, or perhaps it was a result hope, or perhaps peer pressure had something to do with the increase in risk. Regardless of the motivation, the shift to greater equity exposure as U.S. stock prices climbed to the highest relative value in history proved to be a costly mistake. The Calm Before the Storm Stock prices have reached a permanently high plateau. Irving Fisher, August 1929 We are in a new paradigm of stock pricing. Old models no longer work. Popular Wall Street saying, 1999 The four most expensive words in the English language are This time its different. Sir John Templeton There are a signs when the stock market may be getting a little overvalued. For example, nearly everyone is bullish. Even longtime Wall Street bears become bulls, or at least they stay quiet to avoid a public whipping. Trying to make a case for lower stock prices is about as popular as screaming anti-American slogans during a Veterans Day parade. Second, stock prices go up for any reason and on any news. Even bad news is good news. For example, if a report comes out that predicts lower interest rates, stocks go up on the prospects for an increase in economic activity. On the other hand, if the report predicts higher interest rates, the market still goes up because that means inflation will stay in check, which is good for the growth of corporate earnings. Another sign that the market may be getting expensive is that absolute nobodies reporting financial news become huge celebrities. These people host financial TV shows and radio shows and write investment books that say nothing of value. Worse, the general public actually pays good money to buy these books and hear these people speak at investment seminars. Finally, and most important, the public is sold on the idea that this bull market is different. That means forget everything we ever learned about relative value of assets or risk avoidance principles and blindly jump into the market because its going up! It is interesting to observe that stock prices tend to decrease in price volatility during the final phase of a bull market, which tends to reinforce the false belief that stocks are now somehow safer and that this bull market is different. As you can see from Figures 3-4 and 3-5, stock prices surged in 1996 while the volatility of day-to-day price changes dropped to historically low rates. Prices just kept going up and up and up. It was a self-fulfilling event, for a while. Volatility picked up in late 1998 after Russia defaulted on its debts and the U.S. markets shuddered. But the increase in volatility did not persist. Within a few months, the market was hitting new highs day after day and volatility was falling again. This again reinforced the belief that the market was in a new paradigm and that we were in a new economic era. By this time it was hard to find any naysayers. Most people were convinced that our economy and the stock market were poised for unprecedented acceleration in the new century. After the Shakeout From the beginning of 2000 to the summer of 2002, millions of retirement savers lost huge amounts of money from the portion of their investment accounts invested in the stock market directly or through mutual funds. In addition, large numbers of people lost their jobs as large numbers of new-era companies collapsed and hundreds of technology start-up companies disappeared. Many employees with these companies had their entire net worth riding on company stock options and stock incentive programs. For them, the idea of retiring early in life was replaced by the need to file for unemployment compensation. A national cry for fairness swept the nation as investors looked to place blame for their misfortunes. Legal claims against Wall Street firms hit a historic high. Thousands of people sued their brokers for unsuitable investment advice. Congress, the Securities and Exchange Commission, and several state attorneys general launched independent investigations. Many corporate executives were indicted and charged with fraud. Investment bankers fired thousands of employees as new business dried up and profits slumped. Mutual fund companies closed or merged hundreds of aggressive growth funds in an effort to bury the performance numbers of the disasters they had on the books. The added regulations and new changes in the securities industry were on par with the massive regulatory changes that took place in the post-depression era in the 1930s. Individual investors also pulled in their horns and changed the way they invested. People had heard of investing at their risk tolerance level, but never really knew what that meant until they lost a lot of money and panicked. On the plus side, young people were no longer quitting good-paying jobs to become day traders, because day traders were broke and looking for traditional jobs themselves. For most investors, it was their first taste of a real bear market, and they did not know how to act because they did not know what was going wrong with their portfolio or how to fix it. If anything good came of the experience, it was that many investors finally realized they needed to develop a viable investment plan for retirement, one that could last through a complete market cycle. They also learned that the money made in the late 1990s was a result of luck and not investment skilland maybe that means they will not believe the Wall Street hype about how they can beat the market. This press release from Boston-based research firm DALBAR, Inc. gives us some indication of hope: Boston, MAJune 4, 2001. In a national survey of 1,450 households with incomes of $50,000 or more, DALBARS Turmoil 2001 report found that the downturn in the equity market during 2000 and 2001 has been sufficiently extensive to cause consumers to make changes in their investing preferences. This is in direct contrast to DALBARS Turmoil 1998 report, a study of 1998s extreme but brief volatility, in which investors remained relatively unshaken by short-term market fluctuations. Among the changes identified in this updated report are: A general shift to more conservative investment products, but no overall decrease in total saving; Movement away from individual securities and single-sector funds towards products with greater diversification; and, Investors have a better understanding of both the need for financial planning and the risk they can accept. Bear Markets in Other Asset Classes So far in this chapter we have talked about bear markets only as they pertain to stocks. However, bear markets occur in the bond market also. When interest rates go up due to a surge in inflation, bond prices can drop almost as fast as stock prices. Since 1926, there have been 21 negative years in the long-term government bond market. Two of the worst returning years for long-term government bonds were 1994, down 7.8%, and 1999, down 9.0%. In addition, since 1926, there have been six five-year periods when bonds were negative, most recently from 1977 to 1981, down 1.1% annually. The market for gold and precious metals peaked over 20 years ago and has been in a multi-decade bear market ever since. The price of gold touched its record high of $850 per ounce on January 21, 1980 and is currently trading at one-third that price. The 1980s were the decade of the Rising Sun. Japans resurgence in manufacturing and banking turned that countrys stock market into a global powerhouse. The Nikkei average was so powerful, it was the first market to fully recover from the 1987 global market crash. By early 1990, the Nikkei was trading above the unprecedented level of 30,000. But that was the last time that market traded over 30,000. Boom typically leads to bust, and for the next 10 years the Nikkei slid backwards, losing nearly two-thirds of its value. Over the last few years the Nikkei has bounced along in the mid-teen range. There is always a bear market occurring somewhere in the world. There is nothing unusual about a bear market in a free market economy. It is a natural phenomenon. Even though our government and business leaders try to mitigate the damage during a downturn, there are no easy solutions or quick fixes. Market pessimism has to run its course. Sometimes a bear market can last a long time, especially if that market went very high during the late bull phase due to extreme optimism. This was the case with the price of gold in the late 1970s, the Nikkei in the 1980s, and possibly our own stock market in the late 1990s. The only cure for a bear market is time. Business economics need time to catch up with prices. The lesson for investors is to be well diversified and rebalance the mix when needed. Having several different types of investments in a portfolio means that while one is up, the other is down, and that means selling a little of the one that went up and buying some of the one that went down. This rebalancing method runs against the trend-following nature that we all feel, but it is the proper way to manage a retirement portfolio and protect it from the ensuing bear market. Chapter Summary Bear markets can be very painful to people saving for retirement, especially those taking too much risk in their portfolios. Since it is impossible to know when the next downturn in the market will occur, wise investors should be prepared. This means having a longterm investment plan, which includes broad diversification, and sticking to that plan during all market conditions. Bear markets themselves are not the biggest threat to investors; it is the events leading up to a bear market that get people into trouble. Investors tend to become overly optimistic about prospects during the last phase of a bull market, when prices are already high. The euphoria of easy money tempts us to abandon the logic of a welldiversified portfolio and put more money into risky assets. Investors allow their stock winnings to grow, while committing even more capital. No appeal to reason will stop some people from risking much more than they should. When the bubble bursts and the market collapses, overly committed investors are shocked and bewildered. They cannot believe that the future has turned against them. There is a natural tendency to get mad at the market and at their brokerage firm or mutual fund company. Sometimes the bewilderment leads to very poor, emotional decision-making, such as increasing risk further to catch up faster or deciding to get out of the market when the time is right. A wise investor would never put himself or herself in that situation, and you shouldnt either. The instinct to follow a market trend, as wrong as it might be for investors, is very difficult to overcome. The only way to mitigate the urge to dive into a bull market or jump out of a bear market is to create an investment plan that fits your needs, implement that plan, and then stick to it through thick and thin. Key Points 1. Bear markets occur frequently and are normal part of the economic cycle. 2. Contrary to good business sense, the typical investor tends to buy more stocks after the market goes up and sells stocks after it goes down. 3. Trying to time market movements is futile. A better plan is to decide on an appropriate amount of stocks to own and keep that allocation during all market conditions. Notes 1. Charles R. Geisst, Wall Street: A History , New York: Oxford University Press, 1997. 2. How Do Household Portfolio Shares Vary with Age? John Ameriks, Columbia University and TIAA-CREF Institute, and Stephen P. Zeldes, Columbia University and National Bureau of Economic Research. September 25, 2000. |
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