At some point the stock market will bottom out, although when that happens is anyone’s guess. But when that eventual time does come, what happens next is relatively predictable based on past history.
Once the dust does finally settle from this recent market downturn, turn on CNBC or Bloomberg News and watch how the usual suspects describe in elaborate technical fashion why the stock market is now extremely oversold, how the S&P price/earnings ratios are now at historic lows, how there is lots of value in the market at these bargain basement prices and who is buying what at what price.
Technical charts and graphs you need a PhD in Economics to decipher, will be shown ad nauseam to prove their point. The stock market will start to rise over time and investors who sold the stock portion of their portfolio during this recent crash will be challenged as to when to get back into the market.
Long-Term Focus
You’ve heard this adage over and over again, that investing in the stock market requires a long-term focus. As true as that adage is, when the stock market goes in only one direction -up- for a couple years in a row, often times investors suffer from acute memory loss, denial about the actual amount of risk their taking and only see the upside potential and block out the downside risk. For a real life illustration of what this type of investor behavior looks like, check out the blog I wrote back in May: Invest-Pray-Love.
Rebalancing Your Portfolio
As an investment advisor, I use asset allocation models when designing a client’s portfolio strategy. Asset allocation as most investors know is a method that helps you decide how much money to invest in various asset classes such as equities, bonds, cash, real estate, etc. For a little more detail on model portfolio allocations, check out this example on the Vanguard website.
Let’s keep it simple and say before the market started tanking recently, you had a 60% equity allocation and a 40% bond allocation. Once we hit a bottom in the stock market and you assess how your portfolio performed, there’s a very good chance your portfolio will now look something like 52% equity and 48% bonds. That’s because your bonds acted as a hedge against the loss in the stock market, just as planned, and they went up in value as the equity portion went south.
If there’s one mistake I see long-term investors make over and over again, it’s forgetting to rebalance their portfolio once things have stabilized. There’s another often used adage and it goes like this - sell your winners and buy your losers. This investment strategy offers you the benefit of locking in your bond profits and using that profit to buy what are now much lower costs on stock mutual funds.
What happens in real life though is that many investors forget to apply this golden rule. They get so freaked out by the downturn that they freeze and are unable to take action. Eventually, the profits they could have locked in begin to evaporate over time and when they’re prepared to take action, the prices for stock mutual funds have increased mightily and the bond profits they could have locked in have disappeared. It’s a classic tale of being a day late and a dollar short.
Another Crazy & Wild Day on Wall Street
Today, Wed, August 10th, the stock market dropped another 500+ points after going up over 400 points yesterday. That high volatility is the reason you need a long-term perspective when you invest in the stock market - so you’re able to ride out the storm.
On a personal note, I’ve been an investor in the stock market since I was 13 years old and received a significant cash booty from my Bar Mitzvah that needed to be invested. Now in my early 50’s, after experiencing multiple market crashes, I feel battle tested and ready because I’ve seen this movie before.
Investors panic during a crash, sell all their stock holdings at the worst possible time, the market eventually bottoms out and the bargain hunters swoop in and pick up the pieces and make out like bandits. I’ve seen this movie too many times and here we go again for an encore presentation. Get out the popcorn.
Some of my clients that I spoke with this morning that have also seen this movie before are gripped with fear and thinking as many people do in times like these, this time it’s different, this time the global economy is really going to collapse!
Until I saw the games Wall Street plays enough times myself, I used to also fall prey to the fear mongers that seem to be coming out of the woodwork declaring the sky is falling. You can see this fear manifested in the price of gold as well as the stock selloff.
Could this crash, unlike all the other crashes before it be THE ONE? The one that destroys our global economy as we know it? I guess it could be, but I think the odds are pretty darn low. And if this is truly the one that is different than all other crashes, as unlikely as that could be, in that worst case scenario, dollars, euros, gold, Swiss francs - they’re all moot in that absolute worst case scenario.
As we go through the next few weeks and most likely months of volatile markets, do your best to stay above the fray. Review your long-term investment strategy, stay centered and grounded as best as possible, keep your wits about you and please remember, unrealized losses in your portfolio remain unrealized until you sell and they become real.
And one final note: Yesterday the Federal Reserve announced they’re going to keep short-term interest rates near zero percent for at least 2 more years. That practically guarantees interest rates on CD’s. money market accounts and savings accounts will remain near or below 1% until 2013. This is how the Fed nudges investors back into the stock market. Keep that in mind.
Photo by ginnerobot