Wednesday, July 15, 2009

What Have We Learned?

Bert Whitehead, M.B.A., J.D.

Who knows what will happen in the next few weeks, but the markets have bounced off their lows from March (except real estate…). Some say we are in recovery mode, but I’m not so sure. Maybe it’s time we take a deep breath and ask ourselves what we have learned from this experience. Here are 5 lessons most of use should have learned before, but had to re-learn.

1) This recession caught everyone off guard. Most economists didn’t see it coming, nor the government, not even the money managers who are always bragging about their superior market timing. There were a couple of experts who now are claiming that they did indeed predict this, and it is inevitable that some did accurately predict this.

So can we conclude that we should find out who these prescient money mavens were, and start doing what they tell us to do?

I think not. To begin with, market predictions are a lot like fortune cookies: usually they are a bit vague and so, after the fact, can be construed to be ‘right on the money.’ For example, a forecast in 2007 noted that “the market near-term can be expected to be very volatile and the winners will be not the stocks you would generally predict.” Looking back, that seems to be what happened…but it is hardly specific (or maybe you have to subscribe to the newsletter to get the specifics!).

It is obvious that if a newsletter publisher could predict the market, they wouldn’t be spreading their secrets – they would be making a killing trading stocks. “There is no ‘guru’ and many false prophets.”

2) When we think back to the earlier part of this decade, we all knew that the government was stretching to make mortgages affordable to increase the percentage of homeowners, a noble social goal. Maybe we shook our heads at how much the standards had changed, and how easy credit was to obtain. Of course the banks certainly knew what they were doing.

Now it is easy to see how this house of cards couldn’t last. But few could see the huge impact it would have in the financial markets. Most stock brokerages and financial advisors don’t even advise their clients on real estate. To them, the world of finance was all about stocks and bonds. Most consumers have to rely on commission-driven mortgage brokers. So that’s one thing we have learned: “Real estate is an important financial asset and people need good independent advice to make sound decisions.”

3) When interest rates started to rise, especially ‘safe bonds’ like municipal bonds, or GM bonds, it seemed to be very savvy to start chasing yields. Then we find out that these high-flying securities are much more risky than they used to be. This shouldn’t be a new lesson: “Higher returns always mean higher risks.” Often we just have to learn it again every ten years or so (remember dot-coms?).

4) Everywhere we turned frantic financial advice abounded: “Get out now, the market is going to tank!” “Now’s the time to buy – stocks are very undervalued!” When people ask me where the market is going, I review last week’s survey results of the 5% of the money managers who do 95% of the trading. Exactly half of them were convinced the market was headed up, and half were sure the market was going to drop.

The survey is run every day, and the results are always the same. Why? Because for every buyer there always has to be a seller…and one of them is wrong! It’s not the smart people selling to stupid people, because these 5% of the traders do 95% of the trades. The media is like financial pornography. They get you excited, and encourage you to act on impulse; you act on your ‘gut instincts.’ Then you are inevitably disappointed and discouraged with the result. Another lesson re-learned: “To be a successful long-term investor, you must ignore the investment media hype.”

5) If you were a prudent investor, you would analyze every investment or have your advisor do it professionally. There is historical data going back decades, and it is much easier to see the trends when the data is displayed in colorful charts and graphs. Alas, none of those trends forecast what would happen in the past 2-3 years. Could this be a new lesson learned(?):
“Past performance does not guarantee future results.”

Many investment models, including many derived from Modern Portfolio Theory, proved useless in this market. In our next blog we will review the defeats and successes of current investment theories…unless a more critical development arises which requires comment.

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