Repeat After Me: Do NOT Panic!
In case you haven’t noticed, the stock market hasn’t been doing so well lately. And after another precipitous drop yesterday, a lot of people are very concerned. So what is the best course of action to take under these current conditions?
There are two ways to look at the current situation
1. This is the end: the US economy is crumbling, the market will never recover, everyone will lose his/her job, and no one will have any money.
2. This is a painful but temporary disruption: things will be hard for a while but the market will eventually recover. Start by looking at the history of the US stock market - it has always recovered in the past, right? Isn’t the market higher than before The Great Depression, or the Savings & Loan Crisis, or the tech-market crash of the early 2000’s?
If you think the economy and the stock market will recover (eventually), then you should not do anything rash. It’s time to take a deep breath (maybe even stop listening to all the talking heads screaming "PANIC!") and sit tight.
Remember, the goal is to buy low and sell high
If you were going to get out of the market, you should have already done it. It’s too late to take action now - all you’d be doing is following the strategy of buying high and selling low.
If you are a long-term, buy and hold investor and you believe that #2 above is the current reality, then the best course of action is to do nothing. Actually, you might want to consider buying more now that stocks are "on sale." As of this writing, the major US indices are all approximately 40% off of their recent highs of about a year ago. If you believe they will recover, that sounds like a good bargain to me.
For a buy and hold investor, having an appropriate asset allocation is the best strategy to ride through situations like this, not jumping into and out of the market in an emotional frenzy. In fact, if you still have a number of years before retirement, the current events might even be viewed as good for you. I believe it was Alan Greenspan who stated in his book, The Age of Turbulence , that a prolonged recession early in a working career was actually good for building a comfortable retirement nest egg. That person is able to purchase many more shares of stocks or mutual funds due to the lower prices and see them appreciate when the market finally recovers.
What is Warren Buffet doing?
Warren Buffet has a quote that I feel applies very well to the current situation:
"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." Warren Buffet
It certainly seems that now is a time when everyone is fearful…and as you would expect, Buffet seems to be out buying (He recently invested $3 billion in GE , for instance). Since his net worth exceeds most people’s by a few billion or so, I’d tend to follow his advice before that of all those on TV screaming about how bad everything is right now.
My disclaimer
Now, I certainly don’t know what the absolute best course of action is in the current economic climate (no one does). But I will tell you that I am following the advice I put forth here (I’m not like one of the professional mutual fund managers who have their own money investing in index funds). I have not removed any money from the market and, in fact, I just signed up to have Vanguard put a few hundred of my dollars into some of their index funds each month (and after reading about the 40% off sale…I’m very tempted to find some more money to put into mutual funds).
What about someone close to retirement?
Now, if you are close to retirement or in retirement and have all or most of your money in the stock market, then unfortunately I don’t have too much good advice for you. After a disaster strikes is not the best time to create a strategy to deal with the disaster - it would have been much better to plan for a possible economic meltdown beforehand by diversifying your assets among stocks, bonds, cash, etc.
What to do now is a much tougher question for someone who needs the money sooner. The real question is "what is the market going to do next?" Is it going to go down more? Are we at the bottom? Will it recover and, if so, how quickly? Unfortunately these are very difficult questions to answer (well, they’re easy to answer just not easy to answer correctly). Whatever course of action you decide to follow, be cautious - if you get out now, make sure you don’t miss the market as it starts to go back up or you’ll be worse off than if you did nothing now. It would be great if you could withdraw your money now and get back in at the bottom, but even the pros have a very, very hard time doing that. In fact, if you were a good enough investor to be able to do that, you would have taken your money out of the market about a year ago.
Emotion does not mix with investing
I’m really sorry that I don’t have a good answer for you. The one piece of advice I would give is do not panic or act out of emotion . If you decide to pull your money out of the stock market, do so because you have calmly and rationally decided that is the best course of action and not because all the TV personalities are screaming "panic! calamity! sell!"
As for me (someone with a number of years before retirement), I think it’s time to follow Buffet’s advice and get a little greedy.
Photo Credits: nate steinerBook Review: The Bogleheads’ Guide to Investing - Part 1
By Taylor Larimore, Mel Lindauer, and Michael LeBoeuf
BFN Book Reviews
Here at BFN, I have been periodically reviewing personal finance books. In each review, I provide a brief overview of the book and the author(s), touch on the good and bad in the book, and give you my personal recommendation for whether you should borrow the book, buy the book, or neither. This is a fairly thick book with a lot of useful information so I am not going to be able to cover it in a single post. This will be Part 1 and Part 2 will follow soon after.
What is this book about?
Don’t be fooled by the title, though this is a book about investing, it contains much more than just investment advice. The authors do spend the bulk of their time discussing and educating the reader on the various aspects of investing. However, they also touch on other related topics such as financial lifestyle, insurance, estate planning, etc.
Who are the authors?
Not only are the authors "Bogleheads," but Taylor Larimore is actually the founder of the Bogleheads. Co-authors Mel Lindauer and Michael LeBoeuf also spend a lot of time reading and responding to posts on the Bogleheads forum hosted at bogleheads.org . At this point, you might be asking, "What is a Boglehead? " (good question!) A Boglehead is a person who shares the investment philoshophy espoused by John Bogle, the founder of The Vanguard Group. In a nutshell, that philosophy is based on investing in a diversified manner with very low cost investments. (yes, that picture on the cover is John Bogle’s head)
What are the best parts of the book?
There is a great deal of useful and interesting information in this book. I really enjoyed reading it. I felt like I learned much about the stock market and especially mutual funds as a result. I’d heard how important mutual fund costs were to a portfolio, but really learned the "why" in this book. I can’t really go into too much detail on all of what they wrote in the book (it is going to take multiple posts as it is!), so I will present the information and you can check out the book if you want a more detailed treatment of each topic.
The authors start out by pointing out why investing is different than the rest of life by claiming that the following statements are NOT true for investing:
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If you don’t know how to do something, hire an expert
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You get what you pay for
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If there’s a crisis, take action!
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The best predictor of future performance is past performance
These are the investment principles that do work:
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Choose a sound financial lifestyle - I covered their three financial lifestyles in a recent post.
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Start early and invest regularly
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Know what you’re buying
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Preserve your buying power
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Keep costs and taxes low
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Diversify your stock portfolio
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Diversify your stock risk with a bond portfolio
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I thought it was a good idea for the authors to spend time discussing the importance of the extra-investing topics. Basically, the fundamental point is that the more you can do to free up money to invest, the more investment success you will have.
Chapters 1 & 2 focus on financial lifestyle and ways to spend less or make more money so you have more to invest. The following few chapters go into detail explaining what some of the common investments types are and how they work. These include various bonds (with an entire chapter on inflation protected bonds), mutual funds, ETFs, annuities, etc.
The investment part of the book starts in chapter 7. The authors, as you might expect, recommend using index funds as the core, if not the entirety, of your portfolio. The authors present the following list of why index funds are a great choice:
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No sales commissions
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Low operating expenses
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A 1% difference makes an 18% difference in returns when compounded over 20 years
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Many index funds are tax efficient
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You don’t have to hire a money manager
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Index funds are highly diversified and less risky than individual stocks
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It doesn’t matter who manages the fund
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Style drift and tracking errors aren’t a problem
Asset Allocation
Asset allocation is portrayed in this book as the cornerstone of successful investing. Some of the same theory is discussed in another book recently reviewed at BFN, The Intelligent Asset Allocator . The authors reference a 1986 study of pension plans by Brinson, Hood, & Beebower that found the following:
- Allocation between stocks, bonds, and cash determined 93.6% of the variability of the studied pension plans’ returns
- Manager’s attempts to actively manage their fund cost the average fund a 1.1% reduction in return compared to the indexes
Costs Matter
How is it possible that professional money managers actually cost their funds money, you ask? To borrow (and alter) a phrase, "It’s the costs, stupid!" The authors reference another study that found the expense ratio is the only reliable predictor of future mutual fund performance. Also, there are a number of hidden costs that investors never hear about in a mutual funds’ prospectus:
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Hidden Transaction costs
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Brokerage commissions
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Soft dollar arrangements
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Spread costs
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Market impact costs
The investing takeaway from these chapters: buy a diversified mix of low-cost index funds in the context of an appropriate asset allocation. (you have to figure out your exact "appropriate" asset allocation yourself though there are some very general guidelines in the book)
That’s enough for one post
Ok, I’m stopping here for this post. I appreciate you sticking around as long as you did - and I’m only half way through the book! Update - please check out part 2 of the review .
If you’re already sold on the book….
Want to borrow this book? Search your local library
Want your own copy? Buy this book now at Amazon.com
Check out the books I’ve chosen for my virtual bookshelf
Book Review: The Intelligent Asset Allocator
How to Build Your Portfolio to Maximize Returns and Minimize Risk
by William Bernstein, PhD, MD
BFN Book Reviews
Every Thursday I have been reviewing a personal finance book. I provide a brief overview of the book and the author, touch on the good and bad in the book, and finally, give you my personal recommendation for whether you should borrow the book, buy the book, or neither.
What is this book about?
As you probably have already figured out, this book is about investing and, specifically, asset allocation. The author discusses numerous investment concepts covering both theory and practical advice. Be warned, however, the information you read here will not be what you would hear from a typical financial advisor (well, maybe a fee-only one). The author presents this book as a guide to enable a normal person to construct and manage his/her own investment portfolio.
Who is the author?
William Bernstein is not a financial advisor or a wall street analyst. Instead, he is a neurologist. So, I’m not sure if that makes him less qualified or more qualified to write this book. He writes the book not as an expert in the field but as a person, probably like you and me, who desires to figure this investing stuff out for himself. Dismissing the typical wall-street wisdom and advice from self-serving brokers, his philosophy is that a normal person can do a good job of managing his/her own portfolio. Bernstein also maintains efficientfrontier.com which provides investing and asset allocation resources.
What are the best parts of the book?
There is a great deal of theory in this book but it is also packed with really practical, useful information. Bernstein gives practical information and backs it up with statistical analysis. Here are some of the really valuable concepts that the author provided in this book (don’t worry - I won’t bother you with the statistics - you can read the book for that information)
- Effective portfolio diversification can increase return while reducing risk (diversification means creating a portfolio of multiple non-correlated or weakly correlated assets)
- Adding a small amount of stock to a bond portfolio increases return and reduces risk
- Adding a small amount of bonds to a stock portfolio significantly reduces risk while reducing return only slightly
- Favor short-term bonds (6 months to 5 years) rather than long term bonds
- Indexing is the best way to invest
- One possible exception: Small-cap growth stocks
- Periodically re-balance your portfolio back to your target allocation
- Sticking to your target asset allocation through thick and thin is much more important than picking the right asset allocation
- Value investing typically returns more than growth investing (good companies make
- The market is not exactly a "random walk" – a good return this months means a slightly better than average chance of a good return next month.
- Dynamic asset allocation – changes in allocation that are purely market valuation driven are likely to increase return. Changes in response to economic or political conditions are a very bad idea.
- There are more expenses to an actively managed mutual fund than just the management expense fee disclosed in the prospectus:
- Expense ratio
- Commission ratio
- Bid-Ask spread
- Market-impact costs
The author also provides these key pieces of knowledge and advice as a final summary:
- Risk and reward are inextricably intertwined
- Those who do not learn from history are condemned to repeat it
- Portfolios behave differently than their constituent parts
- For a given degree of risk, there is a portfolio that will deliver the most return; this portfolio occupies the "efficient frontier" of portfolio compositions
- Focus on the behavior of your portfolio, not on its constituent parts
- Recognize the benefits of rebalancing (but not too often)
- The markets are smarter than you are; they are also smarter than the experts
- Know how expensive the tomatoes are (investigate Price/Earnings, Price/Book Value, Dividend yield)
- Good companies are usually bad stocks; bad companies are usually good stocks (Lowest P/E stocks typically outperform highest P/E stocks)
- In the long run, it is very hard to beat a low-expense index mutual fund.
In the interest of brevity, I won’t go into the detailed explanations of these concepts or his advice right now (Don’t worry, though, I plan on doing numerous posts on these investing concepts in the future). If you’re intrigued by some of these concepts and more more information or you don’t believe the author and want the proof behind them, then you should grab a copy of the book and delve into it.
The three questions to ask yourself when determining asset allocation
The author shows you how to use your answers to these questions to determine a comfortable asset allocation:
- How many different asset classes do I want to own?
- How conventional of a portfolio do I want (how much difference from the S&P 500 can I tolerate?)
- How much risk do I want to take?
Besides the theory and concepts, there is also some very practical information
The author also describes various example asset allocations tailored to how many different types of asset classes you want to include in your portfolio. He also includes a table that lists actual mutual funds to use in your portfolios. He even divides this table into three sections describing which funds are best for tax-sheltered accounts, taxable accounts, and those that are acceptable for either type.
What is not-so-good about the book?
I did not find much bad information in this book. Actually, the biggest issue with the book is that there are a lot of statistics in it. That can be good or bad, depending on your perspective. If you don’t really enjoy reading a lot about the details of the numbers, then this book will be a tedious read for you. In fact, on Bernstein’s website, he notes that this book is "for the Sophisticated Investor" while his similar book, The Four Pillars of Investing 
So what is my recommendation?
If you are not concerned with the mathematical details of why asset allocation and low-cost investing is important, then you probably don’t really need to read this book. Instead, you might want to read Paul Farrell’s The Lazy Person’s Guide to Investing. That book ascribes to the same investment philosophy. It will provide you with some practical examples of actual investment portfolios without bogging you down with all the theory and math.
If you are really interested in understanding why asset allocation is so important, then I think this is a good book to read. As I mentioned, this book contains some really useful and informative information covering both theory and practical advice. I have repeatedly mentioned that the book contains a lot of statistics, but don’t let that scare you. It’s not like this is a statistics textbook (and you can always skip a section or two if you want).
I would say that this is a good candidate for checking out from your local library. Borrow it, read it (maybe renew it), digest it, and become much more knowledgeable about what is important when constructing your portfolio and get inspired that you can do it yourself and do it well!
Want to borrow this book? Search your local library
Want your own copy? Buy this book now at Amazon.com
Check out the books I’ve chosen for my virtual bookshelf
Book Review: The Lazy Person’s Guide to Investing
A Book for Procrastinators, the Financially Challenged, and Everyone Who Worries About Dealing with Their Money
by Paul B. Farrell, JD, PhD
BFN Book Reviews
Over the years, I have found it tremendously helpful to see what other people with similar interests have been reading on the topics of personal finance. That is why I am periodically publishing my own reviews - to hopefully be helpful to others. I will provide a brief overview of the book and the author, touch on the good and bad in the book, and finally, give you my personal recommendation for whether you should borrow the book, buy the book, or neither.
What is this book about?
Click here to continue reading…
Help! I’m Trying to Determine My Asset Allocation
I recently transferred a Rollover IRA and some mutual funds in a taxable account to new Vanguard accounts. Unfortunately, I have not actually done anything with either account yet. The taxable account currently consists of two funds - a S&P 500 Index fund and a global equity fund - and some cash. The IRA is completely in cash.
Asset allocation is key
After some mistakes over the past few years (more on those in a future post), I have decided to go the way of ultra-low expense index funds for these two accounts (that is why I transferred them to Vanguard). The most important component of any investing plan (other than doing something) is the asset allocation plan. That is not to say that there is one magical asset allocation that works for everyone in all situations. Rather, choosing a plan for your situation and sticking to it through thick and thin usually leads to good long-term investing results. Click here to continue reading…
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