Stocks — Part 1: There’s a major market crash coming!!!! and Dr. Lo can’t save you.

I’m feeling testy today.  I just finished an article in Money Magazine and reading this magazine is, in and of itself, enough to make me testy.

This particular piece is an article on page 87 of the March 2012 edition interviewing Dr. Andrew Lo.  Dr. Lo is an economist and finance professor at MIT’s Sloan School of Management.  There are a couple of impressive photos of Dr. Lo looking serious and imposing.  Here’s one:

Dr. Andrew Lo

I’m going to tell you what he says and why he’s wrong.  You can see the article here if you’d like:

Oh, and that major market crash that’s coming?  Don’t worry.  I’m also going to tell you why it doesn’t matter.

First, in fairness to Dr. Lo, I have no quarrel with most of his ideas.  In fact, it is very possible the good folks at Money didn’t quite get it right.  Perhaps they simply didn’t put the emphasis correctly.  Maybe someday Dr. Lo and I will have a few laughs over a cup of coffee on this.  Or not.

Basically Dr. Lo contends that the long-held theory of efficient markets is morphing into what he calls the”‘adaptive markets hypothesis.”  The idea is that with new trading technologies the market has become faster moving and more volatile.  That means greater risk.  So far so good.

But he goes on to say this means “buy and hold investing doesn’t work anymore.” Money then points out, and good for them, that even during the “lost decade” of the 2000s buy and hold would have returned 4%.

Dr. Lo responds:  “Think about how that person earned 4%.  He lost 30%, saw a big bounce back, and so on, and the compound rate of return….was 4%.  But most investors did not wait for the dust to settle.  After the first 25% loss, they probably reduced their holdings, and  only got part way back in after the market somewhat recovered.  It’s human behavior.”

Hold the bloody phone!  Correct premise, wrong conclusion.  We’ll come back to this in a moment.

Money:  So what choice do I have instead?

Dr. Lo:  “We’re in an awkward period of our industry where we haven’t developed good alternatives. Your best bet is to hold a variety of mutual funds that have relatively low fees and try to manage the volatility within a reasonable range. You should be diversified not just with stocks and bonds but across the entire spectrum of investment opportunities: stocks, bonds, currencies, commodities, and domestically and internationally.”

Money:  Does the government have a role in preventing these crises?

Dr. Lo:  “It’s not possible to prevent financial crises.”

In the on-line comments a guy named Patrick McGuinness nails it:  “So, markets are efficient except when they’re not. And buy and hold doesn’t work because most people don’t stick to it at the wrong time.  OK wisdom, but is this news?”  Gold star, Mr. McGuinness.

Let me add, Dr. Lo’s recommendation (since he contends “buy and hold” no longer works) is to buy and hold lots of different stuff.  Huh?

Let’s accept Dr. Lo’s premise that markets have gotten more volatile and will likely stay that way.  I’m not sure I buy it, but OK, he’s the credentialed economist.  We can also agree that the typical investor is prone to panic and poor decision-making, especially when all the cable news gurus are lining up on window ledges.  We certainly agree that it is not possible to prevent financial crises.  More are headed our way.

So the question that matters is, how do we best deal with it?

Dr. Lo says:

Treat the symptoms.

He defaults to the all too common canard of Asset Allocation (later in this series we’ll discuss how and when AA can be useful).  He would have us invest in everything and hope a couple of those puppies pull thru. To do this properly is going to require a ton of work understanding the asset classes, deciding on percents for each, choosing how to own them, rebalancing and  tracking.  All this to guarantee sub-par performance over time while offering the hope of increased security.  I am reminded of the quote:  “Those who would trade liberty for security deserve neither.”

jlcollinsnh says:

Toughen up bucko and cure your bad behavior.

Take the cure.  Recognize the counterproductive psychology that causes bad investment decisions and correct it in yourself.

To start you need to understand a few things about the stock market:

1.  Market crashes are to be expected. What happened in 2008 was not something unheard.  It has happened before and it will happen again.  And again.  I’ve been investing for almost 40 years.  In that time we’ve had:

  • The great recession of 1974-75.
  • The massive inflation of the late 1970s & early 1980.  Raise your hand if you remember WIN buttons (Whip Inflation Now).  Mortgage rates were pushing 20%.  You could buy 10-year Treasuries paying 15%+.
  • The now infamous 1982 Business Week cover:  “The Death of Equities,” which, as it turned out marked the beginning of the greatest bull market of all time.
  • The Crash of 1987.  Biggest one day drop in history.  Brokers were, literally, on the window ledges and more than a couple took the leap.
  • The recession of the  early ’90s.
  • The  Tech Crash of the late ’90s.
  • 9/11.
  • And that little dust-up in 2008.

2.  The market always recovers.  Always.  And, if someday it really doesn’t, no investment will be safe and none of this financial stuff will matter anyway.

In 1974 the Dow closed  at 616.  In 2011, 12,217.  If you had invested $1,000 then, it would be $66,892 by this past New Year’s Eve.  That is a 12% annual return thru all those disasters above.

All you would have had to do is Toughen up and let it ride.  Take a moment and let that sink in.  This is the most important point I’ll be making today.

3.  The market always goes up.  Always.  Bet no one’s told you that before.  But it’s true.  Understand this is not to say it is a smooth ride.  It’s not.  It is most often a wild and rocky road. But it always, and I mean always, goes up.  Not each year.  Not each month.  Not each week and certainly not each day. But take a moment and look at any chart of the stock market over time.  The trend is relentlessly, thru disaster after disaster, up.

4.  The market is the single best performing investment class over time.  Bar none.

5.  The next 10, 20, 30, 40 years will have just as many collapses, recessions and disasters as in the past.  Like the good Dr. Lo says, it’s not possible to prevent them.  No question, every time your investments will take a hit.  Every time it will be scary as hell.  Every time all the smart guys will be screaming:  Sell!!  And every time the guys with enough nerve will prosper.

6.  This is why you have to toughen up and learn to ignore the noise, stay the course and ride out the storm.  Oh, and Buy!

7.  To do this, you need to know these bad things are coming.  They will happen.  They will hurt.  But like blizzards in winter they should never be a surprise.  And, unless you panic they won’t matter.

8.  There’s a major market crash coming!!  And there’ll be another after that!!  What wonderful buying opportunities they’ll be.

The world isn’t going to end on our watch.

I tell my 20-year-old that during her 60-70 odd years of being an investor she can expect to see 2008 level financial meltdowns every 15-20 years or so.  That’s 3-4 of these economic “end of the world” events coming her, and your, way.  Smaller versions even more often.

Thing is, they are never the end of the world.  They are part of the process.  So is all the panic that surrounds them. So, of course, is all the hype that will surround the 3-4-5 mega bull markets she’ll see over those same years.

About those the financial media will be confidently saying “this time it’s different.”  In this too they will be wrong.

In the next few posts in this series we’ll discuss why the market always goes up, and I’ll tell you exactly how to invest at each stage of your life, wind up rich and stay that way.  You won’t believe how simple it is.  But yer gonna have to be tough.

Disclaimer:  Like everything on this blog, this is only sharing ideas.  You are solely responsible for your own choices.

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