Stocks — Part 1: There’s a major market crash coming!!!! and Dr. Lo can’t save you.

Posted: April 15, 2012 in Stock Investing Series

I’m feeling testy today.  I just finished an article in Money Magazine and reading this magazine is, in and of itself, enough to make me testy.

This particular piece is an article on page 87 of the March 2012 edition interviewing Dr. Andrew Lo.  Dr. Lo is an economist and finance professor at MIT’s Sloan School of Management.  There are a couple of impressive photos of Dr. Lo looking serious and imposing.  Here’s one:

Dr. Andrew Lo

I’m going to tell you what he says and why he’s wrong.  You can see the article here if you’d like:  http://money.cnn.com/2012/03/02/pf/efficient_market.moneymag/index.htm

Oh, and that major market crash that’s coming?  Don’t worry.  I’m also going to tell you why it doesn’t matter.

First, in fairness to Dr. Lo, I have no quarrel with most of his ideas.  In fact, it is very possible the good folks at Money didn’t quite get it right.  Perhaps they simply didn’t put the emphasis correctly.  Maybe someday Dr. Lo and I will have a few laughs over a cup of coffee on this.  Or not.

Basically Dr. Lo contends that the long-held theory of efficient markets is morphing into what he calls the”‘adaptive markets hypothesis.”  The idea is that with new trading technologies the market has become faster moving and more volatile.  That means greater risk.  So far so good.

But he goes on to say this means “buy and hold investing doesn’t work anymore.” Money then points out, and good for them, that even during the “lost decade” of the 2000s buy and hold would have returned 4%.

Dr. Lo responds:  “Think about how that person earned 4%.  He lost 30%, saw a big bounce back, and so on, and the compound rate of return….was 4%.  But most investors did not wait for the dust to settle.  After the first 25% loss, they probably reduced their holdings, and  only got part way back in after the market somewhat recovered.  It’s human behavior.”

Hold the bloody phone!  Correct premise, wrong conclusion.  We’ll come back to this in a moment.

Money:  So what choice do I have instead?

Dr. Lo:  “We’re in an awkward period of our industry where we haven’t developed good alternatives. Your best bet is to hold a variety of mutual funds that have relatively low fees and try to manage the volatility within a reasonable range. You should be diversified not just with stocks and bonds but across the entire spectrum of investment opportunities: stocks, bonds, currencies, commodities, and domestically and internationally.”

Money:  Does the government have a role in preventing these crises?

Dr. Lo:  “It’s not possible to prevent financial crises.”

In the on-line comments a guy named Patrick McGuinness nails it:  “So, markets are efficient except when they’re not. And buy and hold doesn’t work because most people don’t stick to it at the wrong time.  OK wisdom, but is this news?”  Gold star, Mr. McGuinness.

Let me add, Dr. Lo’s recommendation (since he contends “buy and hold” no longer works) is to buy and hold lots of different stuff.  Huh?

Let’s accept Dr. Lo’s premise that markets have gotten more volatile and will likely stay that way.  I’m not sure I buy it, but OK, he’s the credentialed economist.  We can also agree that the typical investor is prone to panic and poor decision-making, especially when all the cable news gurus are lining up on window ledges.  We certainly agree that it is not possible to prevent financial crises.  More are headed our way.

So the question that matters is, how do we best deal with it?

Dr. Lo says:

Treat the symptoms.

He defaults to the all too common canard of Asset Allocation (later in this series we’ll discuss how and when AA can be useful).  He would have us invest in everything and hope a couple of those puppies pull thru. To do this properly is going to require a ton of work understanding the asset classes, deciding on percents for each, choosing how to own them, rebalancing and  tracking.  All this to guarantee sub-par performance over time while offering the hope of increased security.  I am reminded of the quote:  “Those who would trade liberty for security deserve neither.”

jlcollinsnh says:

Toughen up bucko and cure your bad behavior.

Take the cure.  Recognize the counterproductive psychology that causes bad investment decisions and correct it in yourself.

To start you need to understand a few things about the stock market:

1.  Market crashes are to be expected. What happened in 2008 was not something unheard.  It has happened before and it will happen again.  And again.  I’ve been investing for almost 40 years.  In that time we’ve had:

  • The great recession of 1974-75.
  • The massive inflation of the late 1970s & early 1980.  Raise your hand if you remember WIN buttons (Whip Inflation Now).  Mortgage rates were pushing 20%.  You could buy 10-year Treasuries paying 15%+.
  • The now infamous 1982 Business Week cover:  “The Death of Equities,” which, as it turned out marked the beginning of the greatest bull market of all time.
  • The Crash of 1987.  Biggest one day drop in history.  Brokers were, literally, on the window ledges and more than a couple took the leap.
  • The recession of the  early ’90s.
  • The  Tech Crash of the late ’90s.
  • 9/11.
  • And that little dust-up in 2008.

2.  The market always recovers.  Always.  And, if someday it really doesn’t, no investment will be safe and none of this financial stuff will matter anyway.

In 1974 the Dow closed  at 616.  In 2011, 12,217.  If you had invested $1,000 then, it would be $66,892 by this past New Year’s Eve.  That is a 12% annual return thru all those disasters above.

All you would have had to do is Toughen up and let it ride.  Take a moment and let that sink in.  This is the most important point I’ll be making today.

3.  The market always goes up.  Always.  Bet no one’s told you that before.  But it’s true.  Understand this is not to say it is a smooth ride.  It’s not.  It is most often a wild and rocky road. But it always, and I mean always, goes up.  Not each year.  Not each month.  Not each week and certainly not each day. But take a moment and look at any chart of the stock market over time.  The trend is relentlessly, thru disaster after disaster, up.

4.  The market is the single best performing investment class over time.  Bar none.

5.  The next 10, 20, 30, 40 years will have just as many collapses, recessions and disasters as in the past.  Like the good Dr. Lo says, it’s not possible to prevent them.  No question, every time your investments will take a hit.  Every time it will be scary as hell.  Every time all the smart guys will be screaming:  Sell!!  And every time the guys with enough nerve will prosper.

6.  This is why you have to toughen up and learn to ignore the noise, stay the course and ride out the storm.  Oh, and Buy!

7.  To do this, you need to know these bad things are coming.  They will happen.  They will hurt.  But like blizzards in winter they should never be a surprise.  And, unless you panic they won’t matter.

8.  There’s a major market crash coming!!  And there’ll be another after that!!  What wonderful buying opportunities they’ll be.

The world isn’t going to end on our watch.

I tell my 20-year-old that during her 60-70 odd years of being an investor she can expect to see 2008 level financial meltdowns every 15-20 years or so.  That’s 3-4 of these economic “end of the world” events coming her, and your, way.  Smaller versions even more often.

Thing is, they are never the end of the world.  They are part of the process.  So is all the panic that surrounds them. So, of course, is all the hype that will surround the 3-4-5 mega bull markets she’ll see over those same years.

About those the financial media will be confidently saying “this time it’s different.”  In this too they will be wrong.

In the next few posts in this series we’ll discuss why the market always goes up, and I’ll tell you exactly how to invest at each stage of your life, wind up rich and stay that way.  You won’t believe how simple it is.  But yer gonna have to be tough.

Disclaimer:  Like everything on this blog, this is only sharing ideas.  You are solely responsible for your own choices.

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Comments
  1. […] like (I’ll say it again) Mr. Money Mustache, jlcollinsnh.wordpress.com (You have to read his series on stocks and investing), The Mad Fientist (great podcasts featuring both of these prior bloggers) and a book, recommended […]

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  7. […] Stocks Part 1: There’s a major market crash coming!!!! and Dr. Lo can’t save you. […]

  8. matt76allen says:

    Oh.. I also get extremely agitated when I read Money magazine. So much so, that I didn’t even renew my subscription. The thing with reading a printed magazine is that there is no comment section for you to yell at the author when they are blatantly wrong, ignorant, stupid, etc! Reading money blogs is way better and more real. Real advice from real people.

    • jlcollinsnh says:

      glad I’m not the only one! by the end of a year’s worth I’m so irritated I tend to let my subscription expire. Then I get curious and sign up again.

      the trouble with Money Mag is that sometimes they get it right but too often they are writing things to tout their advertisers.

      So you get conflicting info that can be very tough for the typical readers to sort out. That makes it worse than useless.

      thanks for your comments!

  9. matt76allen says:

    Awesome insight here from somebody who’s actually been investing for a long period of time. I just don’t know how all the nay-sayers about the stock market can’t understand this simple logic. The proof is in the numbers. Great post. Now I gotta read the next one.

  10. […] Stocks Part 1: There’s a major market crash coming!!!! and Dr. Lo can’t save you. […]

  11. bluecollarworkman says:

    This post is absolutely AWESOME! Can’t say I disagree with anything you said. Doesn’t W. Buffett have a similar thought? Buy when everyone is selling and sell when everyone is buying (i.e., when the market crashes and people freak out, that’s the time to buy buy buy [and not freak out]; and when everyone is living high on the hog and selling, you hold hold hold). This is my first time here actually– I’ll be back!

    • jlcollinsnh says:

      Hey BWC….

      …great to see you over here and thanks for the very kind words! Glad the post struck a cord. Hope you subscribe and add your comments to other posts.

  12. 101 Centavos says:

    Just keep some powder dry for those buying opportunities… To expect an endless ride up is to deal in self-delusion.

    • jlcollinsnh says:

      Hi 101C…

      Amen to keeping some cash for buying on the pull-backs and/or crashes. The bigger challenge is to have the courage to deploy it when everybody else is in a selling panic.

      In fact the ride is endlessly, relentlessly up. Always. More on this next time.

  13. Jan says:

    I agree with the theory you posited about the stock market. In fact, I often advise my son, an M.D. in his early 30’s, married to an M.D., to each consider maxing out their respective 401k contributions and then investing the rest of their disposable income. That being said, every once in a while, I get this sickening feeling that the stock market is really just some some sort of publicly sanctioned Ponzi scheme!

    • jlcollinsnh says:

      Hi Jan….

      ….glad you are reading this and took the time to comment.

      With their “double doc” income you son and his wife should do very well following your advice.

      the biggest risk high income earners face, especially doctors who go from poor interns to mega earners overnight, is lifestyle inflation. If their lifestyle matches or, god forbid exceeds, their income they become no more than a gilded slaves.

      Next time, I’ll be talking about why the market always goes up and why it’s always a wild ride on the way.

  14. Shilpan says:

    Jim, I enjoyed this article. I agree with your reasoning for most part, but I also agree with Dr. Lo somewhat on the fact that market is much more volatile and dynamic due to ease of trading and lower cost of trading. I’ve come up with my box theory to buy and sell top quality stocks with strong fundamental and technical measures. I’ve been generating on average 32% return for past several years. This year is off to a good start as well.

    http://www.streetsmartfinance.org/2012/01/14/how-to-grow-your-retirement-account-fast/

    • jlcollinsnh says:

      Thanks Shilpan….

      glad you liked it. And you and I agree on that point of Dr. Lo’s. But, for the long-term case I’m making whether he is correct or not doesn’t matter. Market’s have always been volatile, and if this new technology has made them more so we’ll tough our way thru that as well.

      Thanks for linking to your post on your “box theory.” I encourage my readers to click over and give it a read. For those readers, let me make a few points first:

      1. Shilpan is one of my very favorite bloggers. He brings great insight and wisdom to his posts and I always benefit from reading them.

      2. His “box theory” is a strategy for picking individual stocks with the goal of out-performing the market as represented by Index Funds like VTSAX which I’ll be discussing next time.

      3. An average 32% return is spectacular. I have no idea if he can maintain this pace, but if he does it will put him in a league with Peter Lynch (who he mentions), Michael Price, Warren Buffet and other rarified investment names.

      4. These names are legendary precisely because out pacing the market over time is vanishingly difficult.

      5. Only a fraction of investors that start down the stock picking path outperform. I certainly could not, and that’s not to say I didn’t have some pretty impressive up years along the way.

      6. This blog in general, and this series of posts in particular, are designed to give my readers a winning strategy that over time will outperform roughly 80% of active stock pickers and professional managers.

      7. If you want to try to be in that top 20%, read and absorb first the principles I share here. Then feel free to expand into other strategies. Shilpan’s are a great place to start. But know, the odds are steeply against you and you are signing up for a far more intensive investing experience.

      • Shilpan says:

        Jim, I am both humbled and honored for your kind words. I don’t know if I have your wisdom, but I am constantly reminding myself what I don’t know; Socrates was famous for being cognizant about things he didn’t know. And he was a genius of his time. I honestly try to learn what works in life, and avoid mistakes I’ve made in the past. My box theory is one of those life experiments. I will honestly share, in due course, if it works consistently or not.

  15. Post WW2 industry has relied on 1)finding new markets and 2) utilizing credit to allow purchases not otherwise affordable. the emergence of an interconnected global market and near capacity credit limits witnessed by universal default are new and not repeated events.

    In response governments have become the driving force by purchasing excess capacity and using social programs to prevent desperation. They can only do this by borrowing far in excess of credit limits imposed on non-governments coupled with printing the money to make minimum interest payments.

    At some point a global reset button needs to be pressed, all electronic debt erased and start the process over again. has this happened in history? I love the study of economics but not sure we can see the pattern or future in this one.

    Todd
    http://www.financialpeacecollege.com

    • jlcollinsnh says:

      Hi Todd….

      ….and welcome. Just took a look at your blog. Looks interesting and I am planning to spend some time over there checking it out.

      good points.

      “Reset buttons” have been throughout history and will continue to be routinely pressed. Individual stocks come and go. Companies come and go. Countries also come and go, but on a surprisingly slow scale.

      This is all part of the sometimes painful but always healthy process of creative destruction. We’ll take more about this later in this series.

      What won’t happen is a global reset all at once. Too many conflicting interests rise as others fall. We’re going to learn how to win regardless.

  16. Fuji says:

    Thank you for this comforting wisdom. I try not to flinch from all the scary headlines, but it is difficult not to freeze up. I have $10,000 cash available for each of my kids (19 and 20) and have been waiting to buy Vanguard Total Stock Mkt for them, but haven’t been able to make the leap. Do you think it matters when I make the purchase – should I do it at one go, or do it in chunks?

    • jlcollinsnh says:

      Hi Fuji….

      even the toughest of us flinch. That’s OK as long as we don’t let go. In Part III I’ll be sharing the story of my own nerve failing me.

      Your kids, if they are smart, will be holding that 10k for the next forty years. Take a moment at re-read point #1 above. Thru all the financial turmoil of the last 40 years, 10k would have grown to $668,920. Even if they had never added another dime.

      It is a very safe bet the next 40 years will see an equally rough ride, and yet will produce an equally spectacular return.

      So, I’d invest it tomorrow. I say that having no idea what the market will do on Monday, or next week, or next month, or next year. But with great certainty as to what it will do over 40 years.

      Your toughest problem: Convincing your kids to hold it all that time.

  17. JTH says:

    Very comforting to read. We’ve experienced exactly what you say. We’ve stayed the course, with a side-dish of panic. What is driving the market anyway? Can’t wait for the next Part. Yo to lobo! 😉

    • jlcollinsnh says:

      Hi JTH…

      Staying the course is always served with a side dish of panic (great phrase, BTW!) That’s why ya gotta be tough.

      Great question! and this is the subject of the next post in this series. We’ll look at what it is that drives the market relentlessly upwards over time and why it is such a rough ride along the way.

  18. Fritz Hahn says:

    Right On Mr. Collins!
    New Mexico Lobo

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