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Smart Advice for the HuffPost Investor

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At last, a definitive answer to the question troubling so many investors: Is a market meltdown on the horizon?

Since nothing could be more important to my readers, I devote my entire column to this issue. After all, if a financial Armageddon is just around the corner, as so many of you believe, what else could possibly matter?

Your questions are thought provoking and stimulating. Please continue to add them as comments to this blog.

Question From opines:

Over the past 60 years individual stocks have been a sound investment. Prior to WWII, market crashes occurred about every 15 years and small time investors were cyclically wiped out.

It has become an axiom of current day pundits to preface their buying advice with a disclaimer to the effect of "barring a market crash".

It would be welcome if Mr. Solin would address the possibility of a near term market crash. The enormous overhang of housing debt and falling home prices warrant more than the dismissive "barring a market crash" disclaimer.

If, say, he believed a market crash was a 15% possibility, perhaps the best option for the small investor would be to take a 'wait and see' attitude for the moment. For that reason, it would be helpful to Mr. Solin's Huffpo audience if he would devote at least part of a column to whether he foresees a major downturn in the immediate future.

It is a scary thought that anyone would rely on my opinion of whether there is a market crash on the horizon and make an investment decision based on my views.

My concern is not shared by most "investment professionals" licensed to sell you stocks and bonds. Predicting where the market is headed is the daily grist for their mill.

And it is not just individuals who rely on these predictions. Thousands of investment advisors provide predictive advice to trillions of dollars of pension plans and mutual funds. And they make a darn good living doing so.

Unfortunately, most of their predictions are dead wrong.

They are wrong so often that, when one of them happens to be right, it is big news. Remember Elaine Garzarelli? She was credited with predicting the 1987 market crash and won great acclaim as a market guru for doing so.

This superb call apparently used up most of her predictive powers. In the ensuing seven year period, the mutual fund she ran consistently underperformed the S & P 500 index.

Nevertheless, I promised you a definitive answer, so here it is:

I don't know.

No one does. But financial advisors make a lot of money pretending they do. When they are right, it is due to the laws of chance and not to any measurable skill.

Not only do they not know, but no one understands why markets crash, much less how to predict them.

For those of you who want to delve deeper into the complexities of this issue, I recommend a study entitled: A Theory of Large Fluctuations in Stock Market Activity, by Xavier Gabaix, Parameswaran Gopikrishnan, Vasiliki Plerou and H. Eugene Stanley. It is available for a free download here.

Even a cursory review of this impressive study will demonstrate the complexity of this subject and the folly of trying to predict the next market meltdown.

Events that you think would trigger a market crash do not have that effect. After the attacks on the World Trade Towers, the Dow fell by only 7%.

Instead of engaging in the fruitless search for a financial psychic, here's the question that investors should be asking:

If there is a market crash, how long will it take the markets to recover?

This issue is critical to the determination by investors of their asset allocation--the division of their portfolio between stocks and bonds.

One study ran what is known as a "bootstrapping" analysis that took source data from July, 1926 through December 2002. Using this procedure, which is imperfect but probably more reliable that any other available statistical measurement, the author was able to simulate 250,000 years (that is not a typo!) of stock returns.

The study found that, if the markets lost 30% of their value (which certainly would qualify as a market meltdown), most asset classes would have about a 45% chance of a full recovery within 3 years. Over a ten year period, the probability of a full recovery increased to more than 80%.

Investors who cannot withstand short term market volatility--cataclysmic or otherwise-- should not be exposed to significant market risk. This should not be a market timing issue that changes with the latest doomsday prediction. Your asset allocation should remain static, unless your investment objectives or tolerance for risk change.

Finally, what about the strategy of assuming a market meltdown in the near term and taking a "wait and see" attitude?

The data on this approach is not encouraging.

One study looked at the performance of a broad index of domestic stocks from 1963 through 1993. During this extensive period, the average annual gain of this index was 11.83%. However, if investors missed only 1.2% of the total trading days that were the best trading days during this period, their annual returns plummeted to a pathetic 3.28%.

Sitting on the sidelines is a form of market timing. The odds are stacked against investors who engage in this practice.

Investors would be well advised to stick to the basics:

* Don't rely on the predictions of investment professionals who claim to have a crystal ball;
* Determine an asset allocation appropriate for your investment objectives and tolerance for risk;
* Use low cost index funds to implement your asset allocation.

I know it is hard to believe that an entire industry is made up of emperors with no clothes. But you owe it to yourself and to your families to view the data objectively and to be guided in your investment decisions accordingly.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.