• Financial & Investment Management Group
  • Tuesday, January 06, 2009

'Get Me Out' or 'Get Me In' – An Experience of Emotions

by Jeff Lokken
Posted October 14, 2008
FIM Group
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I've worked in the financial industry 25 years, and each day provides an incredibly interesting learning experience. My cumulative knowledge and experience serve as a reference for the financial advice I currently give my clients and are especially valuable during challenging times for the stock market.

Recently, most of the major stock markets of the world have lost over 20% in value. Bear markets like this tend to shake the confidence of investors and inject the powerful emotion of fear into decision-making.

I remember one such experience on Monday, October 19, 1987, or "Black Monday." The Dow Jones Industrial Average dropped 508 points that day, losing nearly 23% – the largest one-day percentage drop in market history. Many things were different in 1987 than today. In particular, we did not have "instant" access to news flow via the Internet, and prices of stocks were mostly unknown throughout the day. All we had were radio and television news reports, so it was virtually impossible to react quickly to this news flow. At about 9:30 p.m. that evening, I received a call at home from a client. He was obviously stressed by the day's events and really didn't want to chat; he simply repeated several times, "Get me out." Although I understood his concerns, I was faced with two problems. First, the markets were closed, and second he didn't own any stocks. His only two investments were a money market fund and an investment-grade bond fund. At his insistence, we redeemed his funds the next day. Interestingly, he earned a profit because bonds actually went up as investors moved to a "flight to safety." We sent him a check and he felt much better. Subsequently, the stock market entered one of the most significant and longest bull markets in history. The NASDAQ rose from 330 at the end of 1987 and reached a peak of over 5000 in 2000.

In 1999, the NASDAQ Composite returned over 80%. Stock investors were euphoric and daily conversations were filled with excitement citing the amazing returns available to investors via the stock market and the latest "hot" technology stocks. Many new investors entered the bull market demanding to "Get me in." I recall a conversation with a retired client early in 2000. As a risk-reduction technique I had sold several of his appreciated stocks and purchased some bonds with an annual coupon rate of 8%. Upon discovery of this portfolio change he asked me, "Why would you buy an investment at 8% when you can make 80% in the market?" Within that year the NASDAQ peaked at 5132 but by year's end fell over 50% as the speculative Internet bubble burst. As I write this article, in September of 2008, the NASDAQ sits at 2096, down 60% over the past eight years. This makes those 8% bonds look pretty good.(see NASDAQ graph on page 5).

Figure 2

Click to Enlarge

These two experiences illustrate the perilous power of fear and greed when making stock purchases or stock sale decisions. Research suggests that the stock market is mostly efficient in pricing stocks, referred to as the Efficient Market Hypothesis. However, at infrequent times of extreme market lows or highs, maximum pessimism (fear) or maximum optimism (greed) are prominent and causes stocks to become inefficiently priced. The study of behavioral finance, which explains how investors' emotions affect stock prices, have consistently shown that individual investors underperform market index averages. Unfortunately, individual investors are motivated too much by fear and greed and tend to buy high and sell low. Sadly, surrendering to these powerful emotions destroys their long-term investment performance.

In the near future, I will be able to characterize the current stock market experience and determine when we reached the point of maximum pessimism and low stock prices. This point will be the best time to buy stocks. Market bottoms are impossible to predict, but there are several tactics a wise investor should always implement:

  • Keep an emergency fund to cover at least six months of living expenses in safe assets like certificates of deposit or money market funds.
  • Aggressively pay down debt to reduce debt pressure, which may cloud decision-making.
  • Expand your time horizon to long-term performance of at least three to five years.
  • Invest a portion of your assets to generate income that will allow you to receive cash flow or continually reinvest in the down market.
  • Diversify assets across many companies, industries, countries and sizes (which we do for you at FIM Group).
  • Focus less on the daily news flow and more on critical valuation metrics of stocks such as price-to-earning ratios, price-to-book value or other fundamental valuation techniques to make buy and sell decisions.
  • Follow the smart money. These are investors and companies that will take advantage of market fear by giving one dollar to a scared investor to receive an asset worth significantly more.

Investors like Warren Buffet and companies that repurchase their own stock provide rational leadership.

Bear markets are emotionally painful in the short term, but historically they provide investors the opportunity to make big returns … but only if investors do not succumb to fear. Here's to the next bull market. I trust we won't get too greedy.

 
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