So What Do We Do Now?
This question seems to be at the top of the mind for most investors right now. You feel like you should do something to address what has been going on in the markets, but you aren't exactly sure what. Well, know that you arent alone in that regard. Evidence is mounting that even many professional investors have been frozen by indecision into doing nothing during these crazy times.
Let's see if we can offer some ideas that will help you work your way through this situation to a point of deciding whether you need to do something right now and to give you some sense of what you might do if action is necessary.
Do you have the "right" amount in stocks for your situation?
For those of you that are regular readers of this publication, it should not be surprising to you that we start with that question because this is ALWAYS the first place to start. All other decisions flow from the underlying question of "what is your desired asset allocation" - i.e., what percentage should you have invested in stocks?
So what is the "right" amount invested in stocks? The "right" amount would be the maximum amount possible that a severe market downturn does not affect your day-to-day lifestyle and does not cause you to become SO uncomfortable with your declining values that you feel compelled to sell out of stocks. Look, none of us likes it when the market goes down. We all feel a certain sense of anxiety at the notion that our paper wealth is declining. But if you are young, you are living comfortably off your earned income and the money you are investing is for retirement many years down the road, you can afford to be heavily invested in stocks; you are not affected at all today by the market decline and you can wait for a recovery. If you are older and distributions from your investments are an important part of the money you need to live every day, then you can't afford to have as much in stocks.
The other part - when do I have too much in stocks such that I will just become TOO uncomfortable with a big market decline - is a bit less objective to assess and difficult to grasp. Just as people tend to have the wrong instincts about their investments - they instinctively want to sell when the market goes down and buy when the market goes up- they have a tendency to understate their tolerance for risk when the market is declining and overstate it when the market is advancing. If you thought you had the right stock allocation for your risk tolerance (which is quite different from never having carefully looked at the question) but you now find yourself terribly uncomfortable and obsessing about the current market, perhaps you have overstated your true tolerance for risk. In that case, there would be two suggestions:
- Selectively look for chances to decrease your market exposure.
- Remember 10 years from now when the market is roaring and you are wondering why you are stuck in a portfolio that seems to be going not very far very fast, that you made the decision to be more conservative to reduce the downside risk.
But what if you have carefully planned your stock exposure and you are comfortable that you have had the right amount in stocks for your situation? Then what? Well, let's consider the options:
Sell Out.
I'm sure that nearly every one of us has been tempted with this idea. Of course, if we knew with certainty what was going to happen, it would be much easier to decide what to do. There are many now, talking with the benefit of hindsight, who assert that it was "clear" we were going to have problems like this. Well, if we knew for sure that were going to be the case, then we definitely should have sold out.
The problem with such a "timing-based" approach is it is predicated on the assumption that someone can actually accurately and repeatedly predict short-term market movements. I believe it was Warren Buffet who said "the market timer's hall of fame is an empty room". In other words, even if someone happens to call a short term move or two correctly, no one has proven to be able to do so regularly and reliably over time. History is littered with investment people who got it right once or twice and then lost it all being wrong the next time.
Take the situation right now. Without the benefit of hindsight that you will have next January, predict the market's return for 2009. I will tell you this - Bloomberg News recently reported that the average economist they surveyed predicts the S&P 500 will have a gain of 17% for 2009. However, the comment was made during the introduction of an economist who was calling for the S&P to drop to below 600 (more than a 25% reduction from its current level). So who do you believe - the "average" economist or this thought "outlier"? And consider - Bloomberg surveys many economists who on average believe the market will have a substantial gain, and yet who does Bloomberg put on air and talk to you? Why is that? Because "mainstream" thought is boring and not good television. To get and keep your interest, they need to have programming that is bold and "on the edge". That is fine; that's their business. But is this good information, then, to use in formulating investment strategies for your life's savings?
The problem with trying to "time" the market is that you might be wrong. And if you are wrong and instead of the market going down it goes up and you miss a major move because you are sitting on the sidelines, you have inflicted real long-term damage to the return prospects for your portfolio. On the other hand, if you are right and the market does indeed go down, if you remain in you will eventually recover so there is no permanent damage. If you have the "right" allocation of stocks (see above), you should be able to weather the storm and continue to live comfortably until the market recovers.
So long story short, the only way you should even think about selling out at this time is if it has become quite clear that you simply have too much investment risk in your portfolio for your risk tolerance. Even in that case, youve already paid a heavy price for your current misallocation, so adjust selectively. If you were working your way toward a more conservative portfolio over time, this is a time to temporarily suspend those plans. Look to reduce your equity allocations when the market is strong, not when it is weak.
Do Nothing
As alluded to above, this option has been a de facto popular option with many professional managers. It is rationalized by a "let's not throw 'good' money after 'bad'" type of argument.
If your manager is doing nothing in this environment, my strong advice to you is "get a new manager". If that manager who is frozen by uncertainty happens to be you, my advice is the same. You need to have a strong talk with yourself and ask yourself if you are truly up to the task of doing what needs to be done. The same managers who do nothing when the market is down and allocations to stocks should be increased do nothing when the market is up and allocations to stocks should be decreased. This is the "herd" mentality and is not the path to successful long term investing.
Just review the simple mathematics. If, for example, you invested $10 in a stock that lost 75% of its value last year - and unfortunately there are some stocks that did that or worse - you have $2.50 left. If you do nothing, what kind of return do you have to get on $2.50 to get back your $10 that you originally invested? 300%!! If you have done nothing, a 75% positive return - which takes you back to zero in terms of your measured return on the stock - actually only takes you back to about $4.40 in terms of your investment value. So there is a heavy price for inaction!
Buy More Stocks at Reduced Prices
In the above example, if you buy 3 times as many shares as you originally owned - that is, invest $7.50 more at the reduced price of $2.50 - you again have $10 invested. If that $10 investment experiences a 75% gain (in other words, a percentage gain equaling your loss), you now have $17.50. You can sell the $7.50 you invested when the market was low and your dollar return, like your percentage return, is back to even.
Believe me, I understand how emotionally difficult it is to make the tough decision to buy more stocks when most of the other people are selling. But if your stock allocation is right for you (again, see above), then your long-term investment success requires that you make the hard decisions and adjust your portfolio exposure to reflect what has happened in the market by buying more stocks.
In advising that this is a time to buy more stocks, bear in mind that we have no idea whether the average economist or the outlier discussed above are right in terms of what will happen to stock values in 2009. Obviously we HOPE the average economist is right, but we have no way of knowing over such a period of time. The reason we recommend you buy stocks now if your allocation is right for your situation is that even a further short-term deterioration in stock prices won't harm you. On the other hand, history suggests that sometime in the next 10 years you will be delighted that you were able to buy stocks at today's prices.
In Conclusion
So what do you do now? If you haven't had an assessment of or given serious consideration to your stock allocations, that needs to be done. If you need help with that, seek it. Don't be selling stocks unless your allocation is just way off base for your true risk appetite as we have come to learn about it in this market, and even in that case do so only selectively. If your manager - even if that manager is you - has been doing nothing in this period, that is not investment management. That is fate. Get someone who knows what they are doing and who will watch out for your best interests to help you. Be a selective buyer of stocks in this market and then wait like the rest of us for the certain recovery of unknown time frame.