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On the market and other Friday notes. October 10, 2008

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From Investopedia---Capitulation: In the stock market, capitulation is associated with "giving up" any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling.

For those who are wondering it is now apparent that capitulation is what is going on at Wall Street this week.  When will it stop?  Don’t know!  But we do know that this is not a once in a lifetime occurrence.   Since WWII there have been 10 bear markets (greater than a 20% decline) in the S & P 500.  That averages out to one every 6 years or so.  The average decline was 31.5% in these bear markets.  Two (1973-74 & 2000-2002) were around 50%.  Currently we are at around a 41% decline.  This feels like it might be one of those 50% declines.  The point is that this is not unusual in any way unless it goes to -60%. 

The second point that this drop does not have a corresponding fundamental reason.  Bear markets are just as irrational as bull markets.  All those mathematicians who try to tell us the markets are perfectly rational are simply wrong, the markets have always been more emotional than based on fundamentals in the short run.  The long run they are correlated with profits, but bounce around irrationally on a day to day basis.

Here is a chart of the S & P 500 Index going back to 1950.  Looks pretty scary at the end, but that is a function of the scale.  In other words because of the growth the absolute numbers are much larger making it appear to be larger percentage drops at the end.  Changing it to a log base 2 scale (don’t worry about the math) allows our minds to make better sense of the proportion.

Now we see, that there are no unusual variations from this weeks drops!

However, the media does what it always does and makes it seem like the end of the world.

Here is a couple of sentence from my forthcoming book.

The truth is that several times a decade mutual funds drop over 20%. It was only 20
years between times that the S&P 500 dropped 50%. So we see big drops aren’t unusual for stock funds. Wall Street has sold mutual funds as a way to not have risk or at least avoid most of it. Now the truth is you must assume some risk in order to build wealth. Instead of that message, the message is that mutual funds diversification makes risk disappear. So is it surprising when individuals who are sold on an investment that has little risk, react badly when their funds lose value?

Yesterday, I pointed out that mutual fund outflows forces selling. Add in investor panic and you have the recipe for what has been happening! My best advice, build a plan that suits your personality and does not require unrealistic returns to find success.

Turmoil, Schmurmoil; What Turmoil? September 16, 2008

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The newspaper headlines scream it.  Blood on the street.  Wall Street that is.  Truth is, even though this is a risky time, it is not that unusual.  The Dow Jones dropping?  S & P 500 dropping?  Yea, so what?  Companies that made mistakes are being bought or going bankrupt. So what?  I can imagine folks are looking at their mutual funds dropping over 4% in one day, taking a look at their portfolio values and spitting out their coffee.  S & P 500 down over 8% in a month!  Now hear this, many big companies have done poorly for the last 30 years, some going out of business.  This has been a common occurrence, although a bit slower than the last few months.  Banks failing?  Well some, but others are doing quite well, like Bank of America which is on a buying spree (Countrywide, Merrill Lynch).

While those in mutual funds were losing over 4% yesterday, Berkshire Hathaway went up almost 1%. The REIT I own is up 15% in the last year plus 6% dividends.  There are many more examples of companies doing well.

What’s the point?  Become an active investor.  Take control of your finances from Wall Street.  Stop betting on mutual funds (hasn’t your brain told you this yet). Stop reading the headlines and start doing your research.  If you invested $10,000 in the ultra low expense Vanguard S & P 500 mutual fund the first trading day of 2000 you would be looking at a small loss now 8 3/4 years later!

VanguardS&P500-Invested $10K on Jan 2, 2000

VanguardS&P500-Invested $10K on Jan 2, 2000

Become an INVESTOR,with an INVESTOR MENTALITY! June 11, 2008

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One of the large problems for folks who have listened to the financial experts is that negative returns can really do damage to one’s retirement planning, especially if it occurs around the time one retires.  Let’s look at what would have happened if a person retired in the year 2000 at the age of 65.  For the sake of argument let’s pretend this person did very well and had $500,000 in his retirement accounts (6 times what the average person had).  This person followed the current wisdom of taking our 5% from the initial account value as income, thinking this would last him throughout retirement.  Let’s pretend this person had his money in a S&P 500 Index Fund with a total expense of .3%.  So this is a best case scenario.

Year                    Income                     Account Value (End of Year)

2000                  $25,000                            $430,350 

2001                   $25,000                           $355,897  

2002                   $25,000                           $256,000

2003                   $25,000                           $297,601

2004                   $25,000                           $301,496

2005                   $25,000                           $289,215

2006                   $25,000                           $305,168

2007                   $25,000                           $294,737

In eight years our 73 year old has an retirement account value which has decreased 41%!  Accounting for official inflation rates the $25,000 now has the buying power of $19,594. With a life expectancy of 17 years for a man and 20 years for a woman, this person is in serious threat of running out of money.  Note, this person has already seen 20% of his/her buying power disappear from the ravages of inflation.  Five out of eight years were positive for the index.  Negative returns hurt!

Now, what do you think the person who was retired would do after a year or two of negative returns?  Might they buckle and decide to get out of the market?  It is a fact that negative return years yield outflows from mutual funds.  This year is no exception.  People who have been taught to think of investing as a risk free endeavor are not emotionally prepared for market downturns, especially when they are close to or are in retirement mode.  It is a psychological fact that we fear pain more than we appreciate pleasure.  So in very real terms we are all risk adverse.  That is why the financial experts have to downplay market risk in order to sell their wares.  So ironically, after they have convinced you to buy those mutual funds, they then need to change the game for you and attempt to have you forget about the pain of market downturns.

Now, to accomplish this the financial expert industry has turned to another dubious fix; amatuer psychoanalysis!  Yes, they are having their clients take tests designed to examine their childhood memories about money in order to get people to stop reacting to market downturns.  You think it will work?

My experience tells me it will take a little more than amatuer psychoanalysis to reorient folks thinking to stop this detrimental behavior.  The buzzword in the industry is “trusted advisor status.”  But, if you are selling the same old snake oil, you are making a mockery of the word “trust.”  Folks, take the time to turn yourself into an investor with an investor mentality then you won’t need to trust anyone else with your money.  Investors know that risk is always there.  Investors have a plan that takes into account market downturns or other bad situations that can occur.  Because it is part of their plan, they don’t feel the need to react to every negative feeling.  Stay the course is more than a mantra with investors, it is the direct result of having a plan that they designed to fit their needs and account for their proclivities.  They own their plan intellectually and most importantly emotionally.