December 8, 2008

We hope you are enjoying the holiday season with your family and friends.

For easier reading, we are going to model this Market Commentary after a newsletter for easier reading.

Please advise us promptly if there are ever any changes in your financial situation or investment objectives. Feel free to give us a call if you want to discuss anything further.


Paula Harris and Bill Harris, CFP

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In This Issue
Here is why we don't think we are looking at the next Great Depression
Emotions you might be feeling
Prudent ideas for this market
Here is why we don't think we are looking at the next Great Depression

The government is throwing everything at this problem, unlike what happened in the 1930s or even in Japan during the 1990s.  Even though the credit markets have been slow to thaw, the policy initiatives that have been put forth have been massive, synchronized globally and unprecedented in nature starting with central banks slashing rates.  In the early 1990s, Japan initially raised rates and then waited more than two years before they cut rates.  The U.S. did the same thing in the 1930s.  This time, however, the U.S. immediately cut rates when the credit crisis started.

The Fed's direct capital injections into the banking system as well as their direct involvement in the commercial paper market, opening the discount window to non-bank broker dealers and all but nationalizing Freddie and Fannie have been major steps in the right direction to attempt to fix the systemic problems.

The money supply in the 1930s shrunk by a 33%.  Today, it is up by 40% year over year.  During the Great Depression, we did not have economic stabilizers.  Today, we have unemployment insurance and the FDIC.  Both came into existence just after the Great Depression.  That doesn't mean things can't get worse from here.  At this point, we believe this is a "wicked bear market" brought on by financial panic.

Emotions you might be feeling

"You don't understand - it's different this time."
It is very common to feel that the crisis you are in right now is the biggest crisis ever. But whenever we hear the phrase "it's different this time," however bad things were in the past, they tend to mellow with time, thereby heightening the magnitude of the current crisis. Remember the oil embargo of the 1970s, "Black Monday" in the 1980s, the Savings & Loan, Long-Term Capital Management, the Asian/Russian collapses of the 1990s, the bursting of the tech and telecom bubbles in the early 2000s.  Remember the markets response to 9/11.  Things often look very bad when you are in the middle of them.

"I will get out now and come back in once it's safe."
Behavioral Finance is the study of why generally rational investors so frequently make seemingly irrational decisions about their money. One concept is known as the "gambler's fallacy". Think of someone playing blackjack in Las Vegas. How frequently might you overhear them say, "I'll know when it's time to get out"? And how frequently will they be wrong? It is natural human behavior to possess this "gambler's fallacy" - to have an exaggerated perceived ability to identify trends and predict turning points in those trends. Statistical investment facts indicate otherwise.  Investors tend to pile into the stock market just prior to a significant downturn, and pile out of the market just prior to an upswing; a complete inverse relationship.

average stock fund graph

Source: Davis Advisors Quarterly Newsletter, Fall 2008

"I've reached my point of capitulation - just get me out!"
It is quite common, when markets get especially tough, for many investors to simply throw in the towel all together.  Nothing like storing your money in nice safe, insured, bank CDs and Treasury bonds, right?  Unfortunately, no!  While burying your money in a coffee can in the backyard feels safe, it ignores the menacing effect of inflation.  The fact is that earning less on your money than the rate of inflation is the economic equivalent of incurring a loss in the stock market. The result is the same - your money will purchase less in the future than it does today.  An inflation rate of 4% per year will cut your purchasing power in half in only 15 years. No investor would accept a 50% loss on their stock portfolio over the same time frame, but somehow having inflation eat away at their money feels "safer" to many investors.

The other aspect to consider when investors feel the urge to capitulate is that it usually occurs at the absolute worst possible time - right at the point of locking in maximum loss.  Once again, we can look in our Behavioral Finance textbook and find an explanation for this behavior. The concept of "Prospect Theory" (a theory which earned it a Nobel Prize in Economics) says that humans dislike "pain" more than they enjoy "pleasure". In investment terms, investors have an asymmetrical view of risk.  They hate downside risk more than they enjoy upside reward. It is a highly understandable response to want to take flight and put your money in "safe" investments. But it is critical to remember that "risk" takes many forms.  It is not simply the volatility of the stock market. Selling out at the bottom, missing part of any recovery from that bottom, and the loss of purchasing power because of inflation are also forms of risk that must be considered.

Do the above arguments dictate that investors simply "hang in there" and wait for things to get better? Not at all!  They illustrate that decisions should be made in a rational manner with the long-term in mind. 

Prudent ideas for this market

Portfolios are depressingly down. It is completely appropriate to rethink your actual tolerance for risk and adjust your portfolios accordingly.  Let's face it: a discipline to follow traditional investment principles is very difficult in the current chaotic market.
Here are some ideas that are prudent in this market:
  1. Reevaluate your personal tolerance for risk. Now that they are experiencing the downside part of the equation is quite different (and quite lower) than they believed. If your time horizon or blood pressure does not allow you to endure volatile markets, then reallocate to a more conservative portfolio.  Keep in mind that your portfolio needs to beat inflation to be successful over the long-term.
  2. Improve your portfolio's "time diversification". If there is a certain amount of money you know you will need over the next 2-3 years, or which you simply cannot tolerate losing, then by all means move that money to a shorter-term, more liquid, more conservative sub-portfolio.
  3. Take advantage of the market downturn to rebalance your portfolio. While most investors would rather have gains and owe taxes, this is now a good time to make any portfolio moves you were holding back on because of the associated tax hit. Harvest any tax losses within the portfolio that you can use later to offset gains.
  4. Think opportunistically. Many smart investors (e.g., Warren Buffett) believe this current market environment has created some unbelievable opportunities. No one is predicting when or where the bottom will be, but if you are comfortable watching your investments go down in the short-medium term, you may be well rewarded in the long term.
  5. Don't panic, stay disciplined and think long-term. Cliché advice. It is a cliché because it is true. Whatever portfolio moves you decide to take, take them with the long-term in mind and in accordance with a well-thought-out investment strategy and objective.
  6. Be very wary of anyone offering simple or one-off answers.  Traders and stockbrokers love this market.  Fear sells.  They are making a fortune on commissions.  You need to look at your entire picture.
  7. Don't buy high and sell low.  This chart says it all:
happy trading graph
Source: Unknown - received as "spam" e-mail