Were You Really Surprised by the Market Downturn?

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Just as investors were starting to hope that the worst was past, last week the stock market suffered its worst decline in nearly seven years.

Headlines attributed the slump to unexpectedly bad economic numbers. But you have to wonder: unexpected by whom?

Of course, no one can anticipate exactly what’s going to happen next in the stock market or the precise timing of economic developments, even if they seem more or less inevitable. But think back 12 years or so. Didn’t everyone know that technology stocks were flying too high and were destined to come crashing down to earth sooner or later? Ditto for housing prices a few years ago?
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Surely investors today are aware of the broad outlines of America’s financial problems, even if they don’t know all the specifics or precisely how things will play out. We’re dealing with known unknowns here, not Rumsfeldian unknown unknowns.

What specifically went wrong last week? Job creation was lousy, unemployment went up and housing prices continued to fall. In fact, analogies with the Great Depression have started to take shape for both employment and housing.

Most people are aware of all these dangers, however. A recent Rasmussen poll found that 66% of Americans worry the government will run out of money and 50% think the U.S. will go bankrupt.

And these concerns aren’t just the expression of perpetually negative partisan politics. Even the avowed liberal Robert Reich, Bill Clinton’s Secretary of Labor, is warning that the current administration’s policies may well be inadequate to prevent the U.S. economy from falling back into recession.

The bad news is out – in fact, it’s in your face. So what are you supposed to do about it?

Wall Street traders like to say that in a recession, cash is king. And so they sell many of their stock holdings, build up cash reserves and wait for a great buying opportunity.

But if you’re an individual investor, that just isn’t practical. Whether you’re a retiree who needs investment income to live on or someone in prime earning years trying to build your savings for the future, you need to be able to manage an ongoing portfolio through bad times as well as good.
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Traders may be able to profit from jumping in and out of the stock market, but long-term investors rarely do. If you miss just a few crucial days when stocks have a sudden big rebound, your long-term average return will suffer irreparably. Also, in a sluggish economy the yield on cash (adjusted for inflation) is typically low, so you will be losing ground every day you are out of the market.

Successful long-term investment management depends on three things:

First, take into account the potential dangers you can foresee, but accept that you can’t predict when they will actually occur. If you’re worried about the economic outlook, favor less-volatile investments in your portfolio. If you fear the return of serious inflation, prepare for that. (I’ll discuss how in a future column.)

Second, follow sound conservative investing principles, even if they make you look uncool when some class of investments is booming. Success doesn’t come from being able to brag at cocktail parties about how you flipped a luxury condo for a fast profit or how you doubled your money in an initial stock offering. If your broker let you get in on the LinkedIn IPO and you doubled your money in a day, buy your broker a steak dinner. But congratulate yourself on successful networking, not smart investing.

Finally, remember that you’re in a marathon, not a sprint. And more than half the struggle is inside your own head. Prepare for what you can anticipate, don’t think you know more than you possibly can, don’t get giddy when times are good, don’t lose heart when the outlook is discouraging. Look for big, dominant companies. Favor low valuations, strong balance sheets and high yields. And stay the course.