Fear is never far from investors’ minds, especially during tumultuous times like these. Nervous investors will always find plenty of authors, gurus, prognosticators and analysts who are willing and able to feed these fears.
Fear isn’t necessarily bad. It’s one of the two primary psychological forces that drive the market (the other, of course, being greed). When you’re ready to buy an asset, you want to get the lowest possible price. Logically you should hope that the seller is fearful and eager to sell.
Fear can also be useful by reminding us that risk actually exists and bad things can happen when people plunge ahead in spite of warning signs they should be noticing.
However, it’s easy to get carried away and lose sight of the facts. This can happen to even the smartest investors. A case in point is one of my clients (I’ll call him Jim here, though that’s not his real name), a veteran scientist with a distinguished career at a large, successful company.
Late in May, Jim wrote me a brief email. He said he’d been reading a book that suggested the Dow Jones Industrial Average, then trading at around 8,000 and higher since then, could fall to 777. That would be a loss greater than 90 percent.
Jim admitted he didn’t think it will necessarily get that bad, but he said he believed a Dow of 4,000 is possible. “I remember the Jimmy Carter days, and it was not pretty,” Jim wrote, referring to what was then called “stagflation,” the combination of a stagnant economy and high inflation.
Jim asked if I had any ideas about what he should do in the face of those memories and predictions “other than stock up with food and ammo and build a nice bunker to hide out in.” He said gold “is looking better all the time.”
Normally I would have picked up the phone and done my best to talk him down from his fearful perch. But, having a little time available, I decided to research some facts. As a result of that research (with help from Larry Katz, research director at Merriman), I put together an email response.
With Jim’s permission, I’m happy to share that response here in the hope it might help others who are dealing with some of the same fears.
Ouch! 4,000 would be bad. While 4,000 is possible, so is 12,000. One never knows. Seriously, I understand your concerns about the policies of the current administration and a potential return to the Carter years of high inflation. These concerns have been expressed by a number of other clients.
Attached is a recent article written by our research director, Larry Katz, that examines inflation and how our portfolios are designed to address this concern. I would encourage you and Joyce to read it at your earliest convenience.
It’s true that inflation was relatively high and there were plenty of reasons for concern and anxiety while Jimmy Carter was president (January 20, 1977 to January 20, 1981). But when I look below the surface, the picture I see isn’t quite as dire as what you are seeing.
I was especially interested in how the Standard & Poor’s 500 Index performed and how a 60/40 (stocks/bonds) allocation similar to our 60/40 allocation performed. In my analysis, I tacked on an additional year (1981) to reflect a second negative year for the S&P 500 and another year of double-digit inflation:
|Year||Return of S&P 500||Return of 60/40 allocation||Inflation|
The compound annual rate of return of the S&P 500 over these five years was 8.1 percent. The compound annual rate of return of the 60/40 allocation over these five years was 13.5 percent. Annual inflation in these five years averaged 10 percent. Bonds did not fare so well when adjusted for inflation, but the 60/40 allocation still managed to deliver impressive returns.
One important reason was that half the equity part of that allocation was in foreign stocks (as we recommend today), which tend to outperform U.S. stocks when the dollar is in decline. During the Carter years, the U.S. dollar was rather weak; ironically, the weakness of the dollar is a concern of many investors today. Yet that decline can be a boon to investors who own non-U.S. stocks.
Back to your concerns. If you believe the market is going to 4,000, then quite obviously the rational decision would be to get out now. But as you know, 4,000, or any other level for that matter, is not a fact. It’s a belief or a prediction, Jim.
I agree there are plenty of things to be concerned about these days, and I certainly don’t have to remind you of them. Yet there also are plenty of reasons to be optimistic. For every concern you have, I probably could counter with a reason for optimism, and for every reason for optimism you have, I probably could counter with a cause for concern. That’s almost always the way it is.
Many investors act as if they know which path the market will take, and they stake their financial futures on their confidence. However, over and over and over again, history shows us that such confidence is seldom warranted.
My colleagues and I believe it’s impossible to know what the market will do in the short term. So we don’t try to tailor our investments to any predictions. Instead, as you and I have discussed many times, we design our portfolios to address a wide range of economic and market environments that may unfold over the long term.
A balanced portfolio of stock and bond funds like you and Joyce have will never be concentrated in the hottest-performing assets at any given time. But just as surely, it will never be concentrated in the worst-performing ones either. We believe that carefully crafted massive diversification is the best way to find the right balance of risk and return.
You mentioned gold. It certainly has been in the news a lot lately. But as the attached article by Larry Katz points out, gold as an investment hasn’t always been the answer in the short run, and it has proven to be a poor strategy over the long term.
So in answer to your question, I guess my answer would be yes, I do have an idea for you. It’s the same idea you have heard from our firm for years, but it’s always worth reiterating. My idea for you and Joyce is to keep your thoroughly diversified portfolio in an equity/bonds balance that is consistent with your investment objectives.
You are 57 and Joyce is 51. You need to be exposed to equities to achieve a rate of return in excess of the rate of inflation over time. As we have discussed, Joyce is a little more risk averse than you, so her allocation is approximately 48/52 (stocks/bonds). Your allocation is 67/33. Your combined allocation is 60/40, and it is my opinion that this remains a suitable allocation for you two.
I understand the dynamics of fear. As we have discussed from time to time, I share some of your concerns. But with all due respect, Jim, I think it would be a serious mistake to let your current concerns and your strong political views determine your investment strategy. It’s an easy trap, and sometimes I catch myself being drawn toward that same trap. But I hope you’ll remember that regardless of your political beliefs, administrations and political trends come and go. Countries, economies, capital markets, companies and individuals all evolve over time. Pendulums swing.
When I entered this business in 1986, the prevailing attitude was that Japan could do no wrong, that America had lost her way and was on the road to ruin. Remember that? Remember how concerned some people were when the Japanese bought Rockefeller Center in 1989? And then it all changed. Japan imploded, and mutual funds that were focused on Asia declined significantly.
Then in the middle and late 1990s, large U.S. growth stocks were booming so much that it was tough to even have a thoughtful conversation about diversification and asset allocation. Nobody wanted to even consider investing in foreign stocks. Many people believed that proper diversification required only a couple of Janus funds, an S&P 500 Index fund and a sprinkling of technology stocks like Sun Microsystems, Microsoft, Cisco Systems and Dell Computer. And then came 2000, and everything changed. Pendulums.
You asked for my opinion, and I’ll give it to you in the knowledge that it’s only an opinion and many people may have different views.
Frankly, I must tell you that I flat-out disagree with the author of the book you are reading. I believe the world is in the process of recalibrating and, as has happened so many times throughout the ages, the remarkable human sprit will triumph. We will adjust, we will address many of these concerns, and then we will move on to better times.
This belief system requires faith in the future. Mine is based on many years of watching the way that individuals, institutions and even whole societies can emerge stronger after going through extremely unsettling times.
Finally, thanks again for your note. It gave me a good opportunity to ask myself the questions you were asking, and to look once again at what I believe are the right answers. As always, please do not hesitate to call or email me with questions or concerns of any kind.