The Debt Crisis, Volatility and Long-Term Investors

Let’s face it, there’s little you can do after uncertainty already has arrived. As in the face of a real-life twister, you’re best doing all you can to prepare in advance by taking care of matters that are within your control. Then, once the winds are howling at your door, it’s time to hunker down, remain calm and hope for the best.

Let’s apply this lesson to our market’s current turbulence — first by taking stock of the conditions, and then by offering some firm handholds to help you stay the course.

Last month’s political clash over increasing the debt ceiling and the subsequent downgrade of US Treasuries by Standard & Poor’s delivered nearly as much volatility as the financial crisis of 2008. But these events were unlike 2008 in one significant respect. Then, we were seeing a number of unknowns come to the surface, most notably the extent of the housing crisis and the degree to which the financial system was exposed to it.

Today, we are still suffering through a hangover from all that, but it’s hardly in the form of startling revelations. Many banks, both in the US and in Europe, remain in tenuous capital positions. Hundreds of thousands of homeowners remain under water on their mortgages. Unemployment remains stubbornly high. The economy is growing slowly, if at all. We may still be heading toward a double-dip recession and the Fed may have run out of ammunition to effect meaningful monetary policy. No new news, in this case, is mostly bad news.

The Phantom Downgrade

Still, to paraphrase Mark Twain when he dryly responded to an inaccurate news column that, “the report of my death was an exaggeration,” it would seem that rumors of the death of Modern Portfolio Theory seem premature, despite the downgrade of our hitherto risk-free Treasuries. While this mostly symbolic downgrade does foretell some difficult policy choices ahead for our long-term fiscal condition, the market has remained relatively resilient to the onslaught. Immediately following their downgrade, Treasuries perversely rallied. Interest rates went down rather than up.  That meant the security was in higher demand, so it did not need to offer increased returns to attract investors.

It is dripping with irony that a bureaucratic attack on our risk-free investment would prompt investors to flee stocks in favor of the asset class that is under attack. The market — which thunders more loudly than any “expert’s” opinion — still views US Treasuries as the quintessential safe-harbor investment when embarking on a flight to quality. The US still has the deepest and most liquid bond market in the world. (Equally ironic is the fact that the ratings agencies had such a big hand in causing the 2008 crisis to begin with by rating as top-notch AAA more than 30,000 collateralized debt obligations, or CDOs, masking millions of high-risk mortgages that subsequently went into default.)

Wild Swings

“Risk on, risk off” pervades the market. Whether by ordinary investors acting on emotion, professionals engaged in market timing, or computerized high-frequency trading, volatility is magnified by advances in technology. Exchange Traded Funds (ETFs) — including leveraged ETFs that magnify investors’ exposure to gains and losses — enable investors to move billions of dollars in and out of the market in fractions of a second. Such trading now accounts for half of the trading volume on the exchanges. In August, the Dow swung by at least 400 points on four consecutive days for the first time in history. That’s normally the kind of swings we see across multiple quarters. It remains to be seen whether this frenetic activity will affect the long-term volatility of equities — which is one way we measure market risk — or whether it turns out simply to be short-term noise.

Confronting Fear

The point here is not to determine whether the ongoing turmoil  will result in a market drop as deep as we experienced in 2008. Or whether the crisis will dissipate with relatively little harm done. Nobody knows. It’s beyond our control. The point is to deal realistically with ourselves in the face of the unknowable future.

Our brain is at war with itself. The instinctive (fight, flight or freeze) reptilian part of the brain naturally takes over from the rational part when the CNBC ticker shows nothing but red. Our active imaginations are marvelous at conjuring any number of stomach-clenching, worst-case-scenario possibilities. We could worry about whether the market will plummet to zero, as it eventually will when climate change renders the planet uninhabitable, an asteroid knocks the earth out of orbit, or our sun implodes. Or, wouldn’t it be ironic if a United States debt default — egged on by the Tea Party — set off the chain of events that undid the very capitalist system they so fervently wish to preserve? (Although a look at Ron Paul’s portfolio, invested entirely in gold and gold mining stocks, reveals that he would make a killing, at least for a while, in such an event.)

But let’s get real. To what end are these sorts of exercises? The far, far more realistic odds are that the Dow will double countless times long before civilization ends. After all, we only need a net return of an average 7 percent per year for our investments to double in a decade. As Vanguard founder John C. Bogle recently quipped in The Wall Street Journal (when explaining why he has not personally invested in gold), “Of course, I’m assuming there will be no apocalypse. And that’s almost always, if not quite always, a good assumption.”

We agree. As an investor, you can’t invest — or even rationally hedge — for economic Armageddon and still participate and prosper in the capitalist system.

The ultimate dilemma for investors is that macroeconomic environments that feel the safest (think the “great moderation” and the Tech bubble of the late 90s) actually present the greatest investment risk. Because that’s when investors flock into the market, bidding up prices through demand and reducing future expected returns. Paradoxically, the scariest moments offer the opportunity for the greatest future expected investment returns due to the opposite effect. For example, during the period 1972–2010, the S&P 500 index returned a compound annual 10.0 percent. But the period from 1975–2010 (following the 1973–1974 bear market) returned a compound annual 11.8 percent. Those who were frightened into abandoning the market as a result of the downturn missed out on the higher returns that followed. Mean reversion is a most persistent force in investing.

Planning, Policy and Patience

So, now that we’ve examined our conditions, let’s offer those handholds we mentioned earlier. Equity investors, even those with moderate allocations to stocks, like 50–60 percent of their portfolios, need a long time horizon and patience. So we need some techniques, tools and devices to get us through the difficult times.

First and foremost, have a plan. Have it well in advance. Having a predetermined asset allocation tied to your financial goals provides an anchor to windward during turbulent markets. If nothing else, by knowing you’ve got financial and investment strategy goals, you improve your brain’s ability to handle financial stress.

Second, manage the manageable:

• Maintain an appropriate cash cushion. If you’re still working, hold six months or even a year’s worth of spending needs in cash or short-term bonds. If you’re retired, keep two to five years in such instruments.
• Enhance the human capital of yourself and family. Take some classes.
• Make sure your spending and saving rate are aligned with your goals.
• Try to manage your debt. Pay off high interest loans. Make an extra principal payment on your mortgage.
• The primacy of the instinctive brain over our rational brain makes decision-making under stress very difficult. Maintain your physical and spiritual health. Training like an athlete, pilot or emergency responder will help you avoid panic when the feathers hit the fan.
• Taking up a mindfulness practice like yoga, meditation or Tai Chi works wonders in markets like these.
• Step outside yourself. Estate, legacy and philanthropic planning, activities you may have been putting off, are powerful tools to get your mind out of the present maelstrom and thinking about the future.

Questionable Strategies to Avoid

Investors WANT to earn the returns the market makes available over time while avoiding the volatility and risks involved. But this sets us up for potential trouble if we don’t have a deep understanding of the way markets work, and we’ve not adopted some of my preceding damage-control policies and procedures.

In a void, it’s too easy to be tempted by those who recommend strategies and products that purport to spare you entirely from the vicissitudes of the market. In some cases, the advice is well-intended if misguided. Then there are financial predators peddling products and preying on unsuspecting investors, capitalizing on the volatility and fear. There are hedging strategies (like options) and structured products (like variable annuities and indexed notes). Finally we have various “alternative investments,” whose moving parts are so opaque and inscrutable that not even the sales force who markets them fully understands them. The latest variation on this theme are “macro risk models” that claim to have predictive powers, enabling investors to be in market sectors when they are rising and out when they are falling. It is even possible to invest in fear itself by buying into a product that captures the VIX (volatility index).

These strategies are subject to one or more of several characteristics:  hidden costs, asymmetrical gains and losses, and the possibility of counter-party credit risk exposure.  In general, this means that you stand to lose a lot more than you can expect to gain, and the product provider will collect his or her generous fees — from you either way.  Most importantly, they all share an additional characteristic that should raise an unmistakable red flag: they sound too good to be true.

Where To Next?

Instead of relying on false hopes, we encourage you to anchor your investments to more realistic principles, based on the solid body of academic evidence indicating how the markets deliver their long-term returns.

Keeping your costs clear and minimal remains key. Diversifying your investments across varied asset classes in accordance with your personal goals and risk tolerance still counts. And planning — early, often, ongoing — remains your strongest pillar in the face of the uncertain future.

These are the foundations upon which to build and maintain your wealth. And, if nothing else, take away this reminder: in the broad scheme of things, remember to keep your investments in perspective. While important and impactful, they represent only a portion of your life.