A major challenge to successful investing is sifting through the information overload. In particular, what passes as prevailing wisdom can change even more often than the markets themselves. The recent market crash severely tested both long-standing conventional thinking and ideas that were widely held just before the decline.
The world is “decoupled” from the US – Not long ago it seemed the rest of the world had gotten the economic upper hand on the US. The dollar had been weakening for several years, our growing trade deficit put trillions of dollars in foreign hands and the large emerging BRIC (Brazil, Russia, India, China) economies were the engines of global growth. International investments easily outperformed many other areas. But the decoupling argument seemed to ignore that the US is still 25% of the global economy, and when that 25% sneezes, the rest of the world still gets a cold. Despite the US housing market’s role as the epicenter of the global financial crisis, the dollar has largely regained its status as the preferred destination when investors fly to safety. The dollar has recovered more than 20% against most major currencies, and developed international stock markets have declined10% more than the US market. Emerging markets have performed even worse, lagging the US by fully 20%.
Timing the market is folly – Timing the market is always seductive, but the unpredictability of short-term market swings makes success very unlikely. Indeed, all but three of the trading days in October saw triple-digit changes in the Dow, for the first time ever there were two days with 1,000 point intraday swings in the Dow, and the market has registered historic daily moves both up and down. The logic behind this axiom is indisputable – to successfully time the market, both the decision to sell and the subsequent decision to buy must be correct, and repeatedly making those decisions correctly is nearly impossible. The market timer usually gains no financial advantage and must agonize over a series of unnecessary decisions. (In fairness, the anxiety of market timing may be matched by that of riding out market gyrations.) The easiest way to fully capture the market return is to stay invested over the long term.
But is making portfolio adjustments based on broad market moves really market timing, and isn’t it a good idea? Techniques such as tactical asset allocation and portfolio rebalancing are intended to capture gains and reduce losses rather than hit market highs and lows. If pursued with discipline, these techniques can indeed make for a less bumpy ride, but long-term results are still quite similar to the overall market.
Gold is the ultimate safe haven – The theory is that in times of crisis global investors will move to gold as a universally recognized asset with value, especially when financial assets are struggling. Gold has indeed had a great seven-year run, touching $1,000 an ounce earlier this year. Unfortunately, that was also the period when other assets were also performing well, though few did as well as gold. Since the financial crisis has gained steam, gold itself has lost 20% and gold mining stocks have fared worse than the broad market. The dollar’s recent strength has hurt gold (because gold is priced in dollars), jewelry makers are buying less as economies slow, and some gold bugs believe that central banks have increased gold lending, which would push down prices. Gold remains a volatile investment whose value is largely based on fear and speculation.
Emotions are dangerous to investing – Succumbing to impulse and fear can lead to quick decisions which will later lead to regret. In hindsight, many emotional investment decisions are made at the worst possible time and simply lock in losses. Major changes in investment strategy should be based on changes in life circumstances, altered objectives or, ideally, the attainment of the financial goal.
The week of October 6 presented a graphic example of how panic can disrupt markets. Each day, trading began calmly as investors hoped to see signs of stabilization. As the day went on, those signs did not materialize, and the stock market began a slow decline. In the last half hour of trading, trading volume skyrocketed as panic set in and a stampede of selling ensued. By week’s end the Dow had dropped 18%.
Alternative investments are the way to go – Alternative instruments venture beyond the traditional areas of stocks, bonds and cash, whether in the assets used (real estate, oil and gas ventures, commodities) or in the investment structure (structured notes, hedge funds). The global demand for commodities was seen as nearly insatiable, driven largely by the BRIC countries. The weak dollar contributed to the high price of oil and gold, and the “peak oil” theory held that global supply of oil could not keep pace with demand. The wide-ranging strategies and big gambles of hedge funds often produced impressive returns.
The crisis has exposed alternatives as yet another area with its own types of risks. Commodity prices have dropped significantly, commercial real estate is under pressure from lower consumer spending, tightened lending and overbuilding and the leverage which magnified hedge fund returns now magnifies their losses. Alternative investments will continue to play a legitimate role in a well-diversified portfolio, but only to the extent that the risks are recognized and understood.
Diversification is the best way to reduce risk – This bedrock of conventional wisdom has only been reinforced in the current crisis. Many risks, such as risk unique to a specific industry or an individual company, can be diversified away through broad investments in the stock or bond market. The risk of an overall market decline, which cannot be completely avoided other than by leaving the market, can be balanced by diversification in different types of markets. One of the hallmarks of this crisis is that there was barely any place to hide from disruptions and potential losses, as even money market funds and bank deposits needed government intervention to restore confidence.
As with many proven concepts, the value of diversification was seemingly abandoned by some professional investors. A recent analysis by Credit Suisse found that nearly 60% of the pension plans of S&P 500 companies held more than 60% of their assets in stocks, and 17% of those plans had more than 70% in stocks. Higher returns create pension plan surpluses and reduce the need for future contributions by the companies. Unfortunately, the stock markets of 2008 quickly turned large surpluses into deficits.