An eNews Update to our Quarterly Newsletter November 2008
Nosce te ipsum (Knowing thyself)
The global real estate boom we have enjoyed since the start of the millennium has morphed into a threatening global credit squeeze.
On one hand, the current crisis should come as no surprise, as every past financial bubble has been followed by panic. On the other hand, bubbles have never been truly recognized until after they have already burst. In turn, panics have always come as a “surprise”. It is the seemingly unique nature of every bubble that makes people believe that: “this time is different”.
The object of infatuation of every bubble may be different: a tulip bulb, a barrel of oil, a dotcom stock or a collateralized mortgage obligation. It is these differences that are responsible for hiding the true risks by making people believe they live under a new “paradigm”. The actors involved, the political, historical and economic circumstances also change, confusing things even further.
While on the surface all financial booms and busts may look different, they all have the same root cause and the same conclusion. The root cause is - using someone else’s money to take on too much unfamiliar risk.
How can every crisis have the same root cause? Why can’t our society, collectively, learn an otherwise common sense, simple lesson from the past? Don’t take on too much risk with other people’s money.
When it comes to assigning blame, the list is long, but the most straight forward answer may be found in our very human nature. Hundreds of thousands of years of evolution have programmed our DNA to be fearful in the face of danger and greedy in the face of opportunity. These basic traits have served humans very well when hunting for food while avoiding predators.
The emotions of “fear” and “greed” that made humans so successful on Earth, lead to self destructive behavior as investors. The history of financial markets is very short relative to the entire history of humankind. It is therefore natural that human instincts have not yet adapted to the seemingly “peculiar” ways of financial markets.
In their perverse behavior, markets tend to do the opposite of what people expect them to do. They crash out of the clear blue sky in perfectly good economic times and start to climb like mad when the collective mood is at its darkest and the economy is written off for dead.
Markets are forward looking, meaning today’s prices already reflect the reality we collectively anticipate to await us around the corner. The more “obvious” an “opportunity” appears, the more heavily markets bid up prices well ahead of that opportunity has the chance to materialize. Conversely, the greater a future threat, the more violently markets sell off well ahead of such threats become reality.
Acting against their best long term interest, investors tend to pile in and buy around market tops (when they feel good) and rush to sell around market bottoms (when they become fearful). It is this “crowd” stampede behavior that creates both market “bubbles” and “panics”.
While feeling fearful after market declines is perfectly natural, we must recognize that acting on those fears may be very dangerous for our long term financial wellbeing. Prior to the current credit crisis there were three market declines on record in which prices fell by more than 40%. The Great Depression of 1929-1932, the oil embargo of 1973-1974 and the dotcom bubble burst of 2000-2002.
To quantify the cost of acting based on fear, we will track the fortunes of two hypothetical investors through these most significant market declines on record.
Investor A resists the impulse to sell and stays invested through thick and thin
Investor B sells out after the market declines by more than 40%, but buys back into the market one year later as the situation seems to have improved
Let’s see how they fared:
1929-1932 – market* declined by 83%. Following the decline, in 1933 the market* had a positive 54% return
After the end of the decline, Investor A rebuilds the 1929 value of the portfolio in 4 years (by year end 1936)
Having missed the 1933 rally, Investor B had to wait 14 years (until 1946) to rebuild the portfolio to 1929 levels
1973-1974 – market* declined by 43%. Following the decline, in 1975 the market* had a positive 37% return
After the end of the decline Investor A had to wait 2 years (the end of 1976) to rebuild the portfolio back to its 1972 levels.
Having missed the 1975 rally, investor B had to wait 7 years (until year end 1981) to rebuild the portfolio back to the 1972 level.
2000-2002 – market* declined by 45%. Following the decline, in 2003 the market* had a positive 29% return
After the end of the decline, Investor A rebuilds the original 1999 value of the portfolio in 4 years (by the end of 2006)
Having missed the 2003 rally, Investor B is still waiting to regain the 1999 portfolio value
2007 - ???? – as of the time of this article the market* has declined by 43% since its October 2007 highs
How long will it take investor A to rebuild a portfolio to its 2007 value? What will be the return in the first rebound year? No one knows ahead of time. History indicates rebounds are powerful, come unexpectedly and the “low hanging fruit” is picked over short periods of time. Investors need to stay invested in order to capture the lion share of any rebound.
We strongly encourage investors to maintain their long term strategic investment posture. In turn, we are working hard to position portfolios to benefit from opportunities created by market declines. As illustrated, missing the initial stages of a rebound following a substantial market downturn can cost stock investors anywhere from 4 to 10 years of recovery time.
Since we do not believe human nature has changed, we are confident that at the conclusion of the current crisis, we will collectively emerge on a stronger footing and economically thrive again.
In order to navigate through the crisis and prosper as investors, we believe it is essential that we recognize and address our otherwise perfectly natural instincts by standing up to feelings of euphoria and panic alike. As financial advisors we feel it is our duty to protect investors to the best of our abilities. Such protection includes warnings against how investors may be inclined to react under conditions of stress.
*as measured by the S&P500 Index. Past performance is not a guarantee of future returns.
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A REGISTERED INVESTMENT ADVISOR
The Retirement Planning and Wealth Preservation Specialists Since 1972
