This is an old article that I like to re-post on threads like this one:
[i]This Time It’s Different?
No way. Don’t let the fear-mongerers fool you.
By James K. Glassman
“I am in a PANIC over this article, telling people to get out of stocks,” said an impassioned e-mail I received last week from a nice, intelligent professional woman who is a friend of a friend. “Is he right??? I am 52 years old, and I really hope to retire SOME day.” What upset her can be gleaned from this excerpt from the CBS MarketWatch website on March 24: “Listen closely: The next crash is coming. . . . It is coming! . . . Read my lips: The next crash is coming, and it could kill your retirement if you don’t start planning ahead now.” The main point of the author, Paul B. Farrell, is that there will be another big terrorist attack, which will not only kill lots of people but also have an adverse effect on stock prices. “The likely timing will coincide with a significant political event this year: the Fourth of July, a political convention, the 9/11 anniversary or the November presidential election.”
Farrell has other reasons for predicting a market collapse. He approvingly cites Richard Russell, a newsletter editor, who recently predicted, “We are coming into one of the worst bear markets in history,” plus Robert Prechter, who expounds a weird theory about Fibonacci cycles and says bluntly: “Get out of stocks and funds and park all your money in Treasurys and money markets. Cash out insurance policies.”
I do not know Farrell, but I do not like him. He scared this nice woman - and probably many others. Farrell claims to have predicted the market peak in March 2000. Let’s accept that. Maybe he is a genius or is psychic.
Still, he should be ignored.
Fear-mongers abound, as do stock touts and charlatans of all varieties. What investors need is a context in which to judge their proclamations, which are always made with the extreme confidence that the rest of us mortals lack. Context requires investor education, a buzz-phrase that was the subject of a Senate hearing last week. My view is that investor education doesn’t need to be complicated. It should be simple - and brief. If I were designing a curriculum, the course would last for five days, with each session running three hours. It would look like this:
Day 1. Lesson to learn: Your goals determine your investments.
To decide what to include in your portfolio (a process known as asset allocation), you need to decide why you are investing. A strategy for retirement is different from a strategy to save enough to buy a house in two years. Far-off goals (five years or more) require stocks. Medium-term goals (one to five years) are more appropriate for bonds, which are loans you make to businesses and government agencies. And for short-term needs, stick to cash, meaning money-market funds, savings accounts, or certificates of deposit.
History shows that stocks return far more than bonds: an annual average of about 10 percent, compared with a little over 5 percent for long-term Treasury bonds. But stocks are more volatile. They lose money in one out of every three or four years. Over the long term, however, that volatility evens out. U.S. stocks have lost money in only one out of every 10 five-year periods, and they have been profitable in every fifteen-year stretch in history.
Day 2. Lesson to learn: Markets are (mostly) efficient.
The price of a stock reflects the considered judgment of millions of investors who have their own hard-earned money at stake. These investors use all available knowledge about a company, the economy, the political situation, the weather - you name it - to reach their conclusions about the “right” price for a stock today. From today’s perspective, a stock price moves in what economists call a “random walk,” that is, a completely unpredictable pattern. Of course, as Warren Buffett points out, to say that markets are efficient
most of the time is not to say that markets are efficient all of the time. Sometimes stocks become expensive or cheap, and occasionally small investors can capitalize on such anomalies.
But it is a gigantic error of hubris to believe that you are smarter than the market as a whole. This is the error that Paul B. Farrell commits.
He says, first, that an attack is coming. Well, so do most Americans. They’ve believed, for the past 2 ? years, that a terrorist attack was imminent inthe United States. The most recent survey I could find on the subject, taken by the Harris Poll on Feb. 6, well before the Madrid bombing, found that 62 percent of respondents believe “a major terrorist attack [is] likely” in the next 12 months.
When that many people expect a calamity, their expectations tend to be reflected in the price of stocks - just as, for example, the price of Johnson & Johnson (JNJ) stock reflects the expectation that the company’s dividend will rise in 2004, as it has for the previous 42 years in a row. In fact, you might argue that the belief that terrorists will strike here has depressed stock prices severely since Sept. 11, 2001. At any rate, it’shard to credit Farrell with a profitable insight if his view on terrorism is shared by nearly two-thirds of the public. It is likely that such an attack is already “discounted” in stock prices. In other words, an attack may come, but that doesn’t mean that a stock market crash - or, more important toinvestors, a prolonged downturn - will result.
There are other conclusions to draw from the lesson of efficient markets. One is that, as a long-term investor, you shouldn’t worry too much about whether the stocks you pick are cheap or expensive. The market has determined that their prices are “right” at any given moment. The market may be wrong, but the default position is that it is correct.
Had a big winner lately? Don’t flatter yourself. It was probably just luck. Searching for undervalued stocks is great sport, and you should never deprive yourself of the pleasure, but it’s a mistake to believe you can make brilliant selections with any consistency.
Day 3. Lesson to learn: Diversify for protection.
Own one stock, and you are vulnerable to disaster. Own 40 stocks in different sectors, and your portfolio is more likely to perform about the same as the market as a whole. It’s the same with bonds. Own a single corporate or municipal bond, and you could lose everything you have in a default. U.S. Treasurys won’t default, but owning just one, with a single maturity date, is also risky. A sharp rise in interest rates could leave you with a bond you will have to sell at a loss.
The easiest way to diversify with stocks is through mutual funds or exchange-traded funds (ETFs, like mutual funds, are portfolios of stocks, but ETFs are pegged to indexes and trade as though they were individual companies). Because stocks are efficient, smart investors are not outsmarters, but partakers; instead of trying to beat the market, they join it. How? By owning index funds like Vanguard Index 500 (VFINX), which reflects the Standard & Poor’s 500-stock index, the largest listed U.S. companies, which together account for more than four-fifths of the value of the entire stock market.
But managed (or human-run) mutual funds can be an even better choice. On Thursday, I used a screening tool on the Morningstar website http://www.morningstar.com/ and specified that I wanted to find all U.S. domestic-stock large-cap growth funds that had a manager with at least a five-year tenure; required a minimum investment of no more than $2,000; had turnover of 100 percent or less (that is, the average stock was held for one year or more); had a rating of five stars (tops); and had beaten the S&Pover the past one-, three- and ten-year periods.
The computer spat out only two funds, and they are both terrific: SmithBarney Aggressive Growth (SHRAX), managed by Richie Freeman since its inception in 1983, and American Funds Growth Fund (AGTHX), run by a six-person team with an average of twenty-eight years of experience.
Day 4. Lesson to learn: The little things count.
The little things, in this case, mount up, thanks to the power of compounding over long periods. But the little things also include taxes, inflation, and expenses. Gross returns mean nothing. The question is how much you can put in your pocket at the end of the day.
Here are the high points:
Taxes: The recent cut in taxes on dividends to 15 percent means that income-producing stocks can be much more profitable than bonds, whose interest is still taxed at ordinary-income rates of as high as 35 percent. Also, remember that holding stocks for a year or more qualifies the gains for a much lower tax rate.
Inflation: The rate today is below 2 percent, but the average for the past thirty years has been 5 percent. At that pace, during a human lifetime, the purchasing power of a dollar will diminish to about 3 cents. Inflation is bad for nearly all investments. An exception is a new type of bond - Treasury Inflation-Protection Securities, or TIPS, introduced in 1997. The value of these bonds rises with the consumer price index. Stocks do better in inflationary times than conventional bonds, since companies can raise their prices while bond yields (interest payments) are fixed.
Expenses: The average expenses that investors pay to mutual funds amount to about 1.25 percent annually (not including the fund’s costs of buying and selling stocks, which can be another 0.3 percent or so). This may not sound like much, but, as the value of your holdings rises, the amount of dollars you pay in expenses soars. Assume an initial investment of $10,000 and an annual rate of return averaging 11 percent for thirty years. According to a calculator I used on the Securities and Exchange Commission website <“http://www.sec.gov/”>, total expenses over that time for a fund that charges 1.5 percent annually would come to $83,000; for a fund that charges 0.8 percent, $34,000. Among the 8,000 mutual funds on offer, expenses varywidely, so pay attention.
Day 5. Lesson to learn: Know what you don’t know.
It’s your money, so it’s understandable that you worry about the many
things that can affect it. The lesson here is: Don’t.
The economy, for example, has its ups and downs, but over long periods - and, if you are a stock investor you should be investing only for long periods - the trajectory has been up. After each bear market, for instance, stocks move to a new, higher level.
“In the last 50 years,” writes Peter Lynch, the former manager of the Fidelity Magellan fund and one of the greatest investors of all time, “we have had many periods of economic prosperity and many periods of uncertainty. Despite nine recessions, three wars, two Presidents shot (one died and one survived), one President resigned, one impeached, and the Cuban Missile crisis [I would add a period of runaway inflation, a one-day crash that depleted the market by 22 percent and an attack that killed nearly 3,000 Americans], . . . stocks have been a great place to be.”
Indeed, stocks have doubled in purchasing power roughly every 10 years.
Farrell, after quoting Lynch, writes, “This time it is different.”
Those are the five most dangerous words for investors. We could be hit by a meteor tomorrow. But the final lesson is that intelligent investors don’t jeopardize their nest eggs by making such guesses.
Again, Peter Lynch: “Betting against America was a bad bet in the past. It’ll be a bad bet in the future.”
Investing is hard, but it is not hard in the way that most people think.
Benjamin Graham, who was Buffett’s mentor, wrote more than sixty years ago, “The investor’s chief problem - even his worst enemy - is likely to be himself.”
In addition, of course, there are a lot of people encouraging the investor to be his own worst enemy by making him panic.
In the end, the best qualities for investors are the same ones Aristotle admired: moderation, common sense, restraint, modesty, and integrity.
Maybe, instead of five days of investor education, we should all sit down and read five days’ worth of the ancient Greeks.