Staying sane in wild markets
Volatile markets drive smart investors to make dumb moves. But not you, right?
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| William J. Bernstein is an investment adviser and author of "The Four Pillars of Investing." |
(Money Magazine) -- It's ugly out there. As of late July, Standard & Poor's 500-stock index was down almost 13% for the preceding 12 months. With the housing market on the skids and energy prices soaring, the economy seems more vulnerable than it has in decades. At times like these, you may be sorely tempted to flee stocks before your 401(k) gets any droopier.
Don't do it. The stock market is really just a mechanism that rewards investors for bearing risk. During buoyant economic periods, risks seem low. That pushes up prices, so you should expect lower returns going forward. Likewise, when risks seem high - as they certainly do now - higher returns should follow.
This principle is admittedly easier to recite than it is to follow, especially if you haven't been through a few market cycles. So until you have as many gray hairs on your head as I do, here's a primer on staying sane in volatile markets.
If you are going to be in the stock market - even if it's just a 401(k) account - you should take a little time to steep yourself in market lore. (It's painless: I recommend Edward Chancellor's "Devil Take the Hindmost" for an entertaining introduction.) When the market goes haywire, you'll be able to say to yourself, "I've seen this movie before, and I know how it ends."
Consider, for example, the story of the late 1970s, which saw double-digit inflation. By 1979, BusinessWeek declared "The Death of Equities." So-called paper assets like stocks and bonds could hardly be given away, while the wealthy and investment pros snapped up precious metals, real estate and collectibles. Who in their right mind would have bought stocks then? The smartest and most disciplined investors. In the 1980s the S&P 500 returned 404%.
Of course, it's easier to keep your head if you haven't just had your portfolio ripped to shreds by a bunch of speculative investments. A little history will help guide you past bubbles too.
Imagine you are at a party in 1999. Everyone is happily chatting about their favorite dotcom or their brilliant tech fund manager. Can you guess which ones will soon lose their shirts? Without the benefit of hindsight, it would be tough. The guy who was out on a limb on Enron, for example, might have displayed dazzling knowledge of discounted cash-flow analysis and the latest trends in broadband.
Were I allowed to ask just one question of partygoers, it would have been, "Who was Samuel Insull?" Answer: He was a financier and utilities tycoon who turned out to be a kind of Ken Lay of the Great Depression. (Insull was acquitted though.)
No, a little market trivia wouldn't have been enough to predict Enron's fall. But knowing how quickly the market can turn heroes into zeros can help keep you from going totally crazy for the next big thing.
It's useful to have an appreciation of what the modern markets can throw at you. You'll often read that stocks return about 10% a year on average. Don't focus too much on that figure. With today's stocks paying relatively modest dividends, future returns will probably be a bit lower. And besides, long-run averages mask the big short-term swings you'll need to be psychologically prepared for.
Instead, spend a little time staring at the graphic above and to the right. It plots the history of two-year returns for large-cap stocks. Why two years? That's how long most bear markets stick.
In two stretches over the past 50 years, the two-year losses on stocks exceeded 35%. So you should expect at least a couple of drops of that magnitude over your investing lifetime. (It can actually be worse: Losses hit 80% in 1932.) Now take the value of your IRA or 401(k), subtract one-third, and write that number down on a piece of paper. Can't stomach the result? I hope you aren't 100% invested in stocks.
Knowing that the market seesaws, you might be tempted to try to shift in and out of equities at just the right time. This is a fool's errand. There's little chance you'll get it right consistently. Instead, use your historical perspective as the spine stiffener you'll need to stick to a prudent asset-allocation plan. Let's say you've decided to hold 60% of assets in stocks. When prices fall, that means you'll have to buy more equities to stick to your target percentage. The good news is that you will be buying more as the bargains get better.
By the way, keep this plan to yourself. Your friends and family will bless you with many things; unfortunately, among them will be doom and gloom during bear markets. They'll solemnly inform you that you're crazy to stick with stocks, and before long you'll second-guess your plan. If the conversation at your next party drifts toward investing, I suggest you catch sight of a long-lost friend across the room. Tell him all about old Sam Insull. Better yet, talk about baseball.
William J. Bernstein is an investment adviser and author of The Four Pillars of Investing. 
