“If you can keep your wits about you while all others are losing theirs, and blaming you, the world will be yours and everything in it, what's more, you'll be a man my son.. Rudyard Kipling.”
The Market Has Its Own Ideas...
No one has blamed me for the recent market upheavals (at least not yet), but I thought the part about “keeping your wits about you while all others are losing theirs” was particularly appropriate at this time. Thursday August 4th - after 7 or 8 days - I really can't remember- of stock market declines, I arrived at my office with some sense of relief that the most recent crisis “du jour” had been averted. Congress had just voted to increase the debt ceiling, in addition to making a modest attempt at spending cuts, which according to much of the financial media absolutely had to happen in order to avoid a catastrophic or cataclysmic market sell-off of “epic” proportions...at least that's what it sounded like.
Thinking we might have a quiet day, I was allowing my thoughts to drift toward the weekend and the hope that because the debt issues had been resolved, the weather would also cooperate giving me enough incentive to get to one of our excellent state parks and get in that hike I'd been postponing for several weeks because it's been too dang hot. As is always the case Mr. Market had a different idea and market indexes proceeded to post their largest single day point drops since 2008 when that “other” debt crisis was upon us, retreating below various support levels that by the end of the day resulted in an official “market correction”. (A market correction is most often defined as a 10% decline in the market as measured by any number of indices, such as the S & P 500, the Dow Jones Industrial Average, or the NASDAQ Composite Index.) As if that wasn't enough, on Friday (after the market closed) S & P downgraded the US's debt rating one notch. Moody's and Fitch had just recently reaffirmed their highest rating for US debt, by the way. Somewhere along the way my weekend got “lost” and on Monday things started out bad and got worse as the day progressed in what was viewed as a reaction to that downgrade, but in reality was the result, I believe, of the general realization that many things about our economy are just not getting better quick enough. Whatever the reasons, we were pushed near “bear market” levels by the end of the day with the three major indices declining between 5.5% and 7% depending on which one you like to follow. (A bear market is typically defined as a decline of 20% or more from previous highs).
Why Do We Think We Must React?
It's natural for us to feel that a response is required, that we must do something to react to these periods of so called “market crisis.” For one reason, the overwhelming majority of “advice” available on TV, on-line, or in many financial publications seems to be geared toward suggesting that you need to “react” to events or try to time the market or spend countless hours trying to select the right stocks etc... (Or worse, use their “picks”.)
However, many of us tend to do things that compound the problem creating more anxiety than before - and then we do it again - and again. Unfortunately some of us will get frustrated enough that we'll never want to invest again - in anything.
The Four Exercises in Sanity...
Here are 4 things you can do now in this market or any other for that matter, up or down, that should help you get through these tough market times with your sanity and your “wits” intact.
- Ask yourself: “Do I have a disciplined investment strategy I am confident in that is well diversified across non-correlated asset classes and is aligned with my unique and personal goals? Yes, this is a long question and really a few questions within the question and more than likely a question you don't ask yourself everyday. In fact some people, regrettably, never ask themselves this question and even more regrettably not ever asking yourself the question greatly increases your chances of not ever achieving real, long term investment success. But, if you can answer “yes” to this question, you can stop here, as you won't need response number 2 - you can skip to number 3. However, if the answer is “no”, then by all means proceed quickly to response number 2.
- Define your goals and objectives (being very specific), assess your current portfolio, and then modify your existing portfolio (or develop a new one) so that it represents a disciplined investment strategy you are confident in, that is well defined across major asset classes that are not highly correlated with each other and is aligned with the unique and personal goals you've just defined. (Naturally this one sounds like the first one, but the idea is to not have to go to number 2.)
- Rebalance your portfolio at some regular interval back to your original allocation targets - not confusing rebalancing at some regular interval with trying to time the market.
- Reassess your goals and objectives periodically and make adjustments to your portfolio to reflect any changes in these goals and objectives.
That's it. Now, granted, this represents a significant oversimplification of the investment process and I don't mean to pretend that it is a simple task. You'll need to work hard at it or get some help. There is also a good chance you've heard these before. They don't sound very interesting or groundbreaking, but for some investors, this represents a time tested approach to long term investing.
In Support of This Belief
The fact that I include myself in that group is supported by two studies performed in the past by some really smart people. The conclusions of these studies I believe still hold true today, despite being called into question at the end of the so called “lost decade.” I have no doubt the principals they espouse will come into question again as pundits are already calculating where the market is right now versus 10 years ago today (yes, it's down...at least as of the day I am writing this.)
The first study involved a theory developed by Dr. Harry Markowitz in 1952 (now known as Modern Portfolio Theory1), that supported the idea that overall portfolio risk could be reduced by combining various asset classes whose returns are not perfectly correlated and whose returns do not move in unison. I believe this theory has been unfairly criticized of late because some of the asset classes used are more closely correlated today than they were during the time the study was conducted. Ignored is the fact that it is still possible to build portfolios in this manner, just maybe not with the same asset classes used in 1952. I think what also gets ignored is that Modern Portfolio Theory never asserted that this approach would prevent short term declines in your portfolio or make your portfolio immune to market movements. It just asserted that it would reduce overall risk, including volatility risk.
A more recent study in 1991 (the Brinson study2) went a step further and asserted that which asset classes were used, and the extent to which each one is weighted in an investor's portfolio, are the most important decisions an investor can make. It concluded that 92% of the portfolio's long term performance could be attributed to this allocation decision, while only 8% of the long term performance could be attributed to market timing and security selection2.
How Should We Proceed?
While no method or belief or theory can guarantee or predict future results, the historical evidence suggests that an approach employing these theories can give you a very good opportunity to invest successfully over time. It also suggests that if you've built and maintained a portfolio using these principles, maybe the next time we have a bear market, market correction, or “crisis” as defined by someone, your “reaction” should perhaps be “no reaction” except to stick with your already disciplined strategy.
To give yourself a better opportunity to achieve your objectives, stick with your plan. Change your strategy if your objectives have changed, but not because of current events or any noteworthy market activity. Adhering to disciplined strategy will help you to take the emotion out of the moment. Making quick decisions based on emotion usually results in mistakes - mistakes that the average long term investor really can't afford to make. Having fully engaged in this type of strategy, the next time we have a market event, rather than wonder “what should I do” or “how should I react,” instead do something else you've been meaning to do, preferably something fun, since getting your investment strategy in line will be behind you now. As for me and my “lost” weekend, I'm postponing that hike to instead take the “free” fly fishing lesson I bought at a silent auction 11/2years ago - an “investment” of my time that the instructor says “will change your life.” That's an investment risk I can afford to take!
*Diversification and asset allocation do not assure a profit or protect against a loss in declining markets.
1Markowitz, Harry. Portfolio Selection, Journal of Finance, 1952
2Brinson, Gary P., Brian D. Singer, and Gilbert D. Beebower. “Determinants of Portfolio Performance II: An Update.” Financial Analysts Journal, May-June 1991.
E-mail Kimber with any thoughts you may have regarding this post.