Smart Advice for the HuffPost Investor: Is This the Time to Dump Stocks and Sit On The Sidelines (Part 2)?

I received a spirited reaction to last week's column in which I advised investors to stay the course. Here is an example:

Mr. Solin, while your advice is "tried and true" one could also assert it is tired and trite. These are times much unlike any we have ever seen.

Is this reader right? The markets continue to fall. The economic news seems to be endlessly negative. Is there any light at the end of this dark tunnel? Are we really confronting times "much unlike any we have ever seen"?

I have one guiding principle when it comes to evaluating investment advice. I ask myself whether those giving the advice have an economic interest in their opinions.

The media loves bad news. It sells newspapers and increases ratings. A recent study by the Business and Media Institute noted that current financial coverage is more negative than coverage of the 1929 stock market crash. The study found that "[D]uring the week of the 1929 stock market crash, daily news stories reported positive news more often than negative by a 4-to-1 ratio. The week that the Bear Stearns fall occurred, coverage was the complete opposite. Negative stories on ABC, CBS and NBC outnumbered positive 6-to-1."

The securities industry is the real beneficiary of bad news. By some estimates it generates over $645 million a day from commissions and bid ask spreads. Activity is its closest ally. Investors who buy and hold are its financial enemy.

Financial pundits thrive in volatile markets. Their "expertise" is in great demand. After all, how will investors know what to do without guidance from these experts?

Let's take a look at their track record.

An article in the New York Times published October 17, 1974, at the end of a two year market decline, reported that the majority of Americans shared the views of prominent economists that we were headed for a major depression.

In the ensuing 5 years, a globally diversified portfolio of passively managed funds allocated only 60% to stocks and 40% to bonds had annualized returns of almost 19%.

In August, 1973, when the Dow was at 875, the cover story of Business Week proclaimed the "death" of equities. Investors in the same 60/40 portfolio realized annualized returns of 9.42% over the ensuing 5 year period.

In September, 1990, 58% of 50 prominent economists predicted an imminent recession. A 60/40 portfolio achieved annualized returns of 13.01% over the next 5 years.

Is this history applicable? Naysayers keep repeating the mantra that the current economic conditions are unique. Are they right?

The stock market crashed seven times in the 19th century. The panic was not limited to United States. Markets in Germany and France suffered similar fates.

The 20th century ushered in far more volatile markets. In addition to the Great Depression of 1929, the markets imploded at least 7 times. The markets in Japan tanked in 1990, markets in the United Kingdom crashed in 1992, the entire Asian markets collapsed in 1997, the Russian markets dropped dramatically in 1998 and the burgeoning markets in China had a major correction in 2007.

The markets have absorbed the Pearl Harbor attack, the Cuban missile crises, the assassination of John F. Kennedy, the invasion of Kuwait, and the September 11 attacks on the World Trade Center.

The lesson learned from this history could not be clearer: Investors who did not panic prospered.

I fully understand the anxiety and even panic of investors in these turbulent times. However, there are lessons to be learned from behavioral finance, which examines why investors behave the way they do.

These studies show that investors are more likely to regret taking affirmative action than not taking any action at all. This makes perfect sense. Acting rashly out of fear or panic is far more likely to cause harm than letting those feelings pass and reflecting carefully on an appropriate course of conduct.

Dumping stocks in bad times is probably the worst investment decision you can make. Eugene F. Fama and Kenneth R. French have had a greater influence on portfolio management than anyone. Their seminal paper, "The Cross-Section of Expected Stock Returns" (Journal of Finance, June 1992), changed the way we think about the real source of stock market returns.

Another study by Fama and French found that expected returns on bonds and stocks are higher when economic conditions are weak and lower when conditions are strong.

We have extensive data indicating that the markets reward those who determine the right asset allocation for their investment objectives and tolerance for risk, and who invest in a globally diversified portfolio of low cost index funds. These investors buy and hold. They do not try to time the markets. They understand that sitting on the sidelines for even a relatively small period of time can cost them a significant portion of their market returns.

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.

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Comments

[moAb]

Investment styles are very personal choices. Nobel laureates not withstanding one has to be able to feel comfortable with the investment method. Time has clearly proven that for many people for many reasons variations of buy and hold whether indexed or not run into several problems. Only one actually matters for most...PAI­N (anxiety, sleeplessness, depression, etc). due to losses on paper. There are alternatives which mitigate such risk by limiting exposure to the market. It is one of the many tradeoffs we are allowed to make in life.

Mr. Solin is a well intentioned person from what I see in his bio. He has represented people who have been abused by the investment community. That he sees no fundamental or significant change in what is going on in our world/nati­on/society is his seasoned opinion. I still believe there are such changes under way and that they have tremendous potential impact on our financial as well as our general well being. In fact some of these changes are in fact impounded into market prices and are increasing volatiity as well (early or not so early symptoms if you well). Two books come to mind as starters: Bad Money by Kevin Phillips and The Black Swan.

My views are those of a non-professional investor (retired in fact) who has been a market watcher and a lifelong egghead. Currently 76% cash holdings and a positive nominal return YTD.

[Idytme]

It is more than a little frustrating to have someone compare anything about the 1970's to today, especially media. A little reminder here, there were not 24 hour news stations or the internet.
There was also high interest rates in bond funds, no financial crisis, all the banking rules from the depression that have been removed in the last ten years were still in place, no hedge funds, no day traders, a much stronger industrial base, no global food shortages, no mortgage crisis.... should I go on?
In July of 1999 the stock market closed at 10,972, we closed below that two days ago. Chose your inflation rate - it doesn't matter, you have lost money, most likely with dividends included. (Yes I chose this data point carefully, but so do the people who are giving positive spin).

[montemalone]

the smart thing to do is the opposite of whatever the pundit/bro­ker/street says to do.

[knowhelpnow]

I over heard someone talking that said that the Dow could go below 7,000. I've heard now is the best time to buy. I've heard that we are heading for a major collapse of the market. I don't know what to believe anymore. I'm staying in cash for awhile but maybe I will check out the Vanguard Inflation Protected fund that Captain Video talks about to see what has been happening there.
I just don't believe that this is the time to be doing any kind of buy stocks or stock funds.

[Unrepentantliberal]

All the people who would of sold everything yesterday because 'it's the end of the world as we know it', on Tuesday, would of missed out the rally today. Did anyone see this coming on Tuesday? No. That's why you are better off holding a diversified investment mix you are comfortable with and riding things out rather than following the stampede of sheep in the investment community.

Just because the news is bad does not mean the market will go down. Sometimes, in fact, it seems to love bad news. You can't out guess the market so the only sane thing to do is to be diversified with a mix of index funds and stay invested for the long haul.

[Raymondf]

Don't dump stocks but cash in your 401k's now.

[MagisterLudi]

Buy low, sell high.... Duh

People who understand this childishly powerful principle make money.

Those who are given to panic and irrational fears don't.

I bought Southwest Air stock right after 9/11/2001. Sold in 2003. Made out pretty well, thank you.

Planning to buy B of A and JPMorgan/Chase now.

I expect to make some serious $$$ in 4-5 years.

You?

[TrollDiddy]

I also bought LUV...exce­pt I bought it the day after Katrina hit. I also bought IGT, which makes slot machines. It only took me a couple months to rake in substantial gains from those.

Bad times are a buying opportunity.

[Pdubya]

I would typically agree with you regarding what Warren Buffet likes to say: "When people are greedy I panic....w­hen people panic I get greedy". Staying the course is usually sound advice.

But, I do think we're facing unimaginable times. Stay the course? O.K. But I wouldn't have one U.S. dollar in your portfolio and it would be spread with physical holdings of gold, silver, and mining stocks and Asian currency.

Of course, one could stay the course in U.S. dollars and hedge on the pending Amero.

How very American.

[Cathexis]

Generally speaking, I believe Mr Solin is correct. Conversely, I almost doubled my investments by moving against the reactions to Bush's ill-advised Iraq war situation: When teh stock market started reacting to war events (e.g., invasion, set-backs, Saddam capture, Mission accomplished, etc.) I took a contrarian view. Why? Because the actions were obviously not at all related to the market, but instead based on Nationlistic emotion. Sure, I could have held during this time and done OK. But sometimes, the signs are obvious.

I still believe these are obvious times. I disagree that the charges are hyped: A weak dollar, high national debt, record high energy prices, a melt-down in housing, increasing inflation ... and a president/party in power who can't spell "economics," much less employ the principles.

The best time to get out was actually several months ago, before the herd pricked up its ears. That's when I got out. If I go back in TODAY, I'll still have made out MUCH better than if I'd passively held, because I have successfully preserved principle.

Most times, I'd agree with Mr Solin's advice.

However, these are not "most times," IMO.

[Bobrobert]

If all the fold and the stock market does another crash - would it not be better to be holding cash???

Many of my friends and their brokers have been steadily replacing 10-15% of their stock on a weekly basis for just over a month.

Most have cash on hand - in safe deposit boxes anyway - equal to 40 -60% of their net worth.

Guess we will see who does better - I am a poor guy that lives paycheck to paycheck so I don't really bother with getting rich.

Remember to vote all.

:-)

Pray for our troops.

[Unrepentantliberal]

Read the book. Dan's got all the data and research to prove he's right and you are, sadly wrong. Most people do more harm than good to their portfolio getting in and out of the market on what they think is sound economic grounds, but instead is just emotional panic.

[worldtraveller]

Dumping now, No Comment.

If you are an investor than focus long term, you can not outplay the averages, you are not good enough.

If you are going to play the market timing well then act like a pro in the first place and you should never enter into a position without stops placed on it to begin with.

[moAb]

Exactly...­stops and realizing that being out of the market is just fine at times.

[mightbesane]

It's not surprising that the comments to Dan's post are predominantly negative. Who wants to hold on to investments that not only have declined in value, but seem certain to continue to decline?

Well, I am.

As I was growing up, I had an uncle who was a real partyer - at age 80. One of those guys who did not mind at all having his picture taken wearing a lampshade with a woman on his lap and a s&*t eating grin on his face. After he died and his estate was being settled, I learned the source of his income. In 1930 he sold everything that he owned and invested in a basket of stocks - what might be called the DOW of its day. After hunkering down for a few years, working at hard labor to feed himself and his sister's family, he never worked another day in his life. Market timing? Maybe. But according to his rcords, he had held a well-diversified portfolio before the Crash. I prefer to think that it was faith in the system.

Certainly, investors are facing hard times these days. I recently had a conversation with the CFO of a well-known international firm who predicted that there was little hope for a market recovery to even begin until the first or second quarter of 2009. I asked him how that affected his personal investment strategy.

"Not one bit."

[CaptainVideo]

Robert Shiller has pointed out that in the 20 years after a stock market bubble collapses, stock do not do well. What is happening right now shows that he is right. For example, the Vanguard 500 stock index fund has a one year return of greater than -16% and a 10 year return of 2.81 %

Inflation indexed bond funds are the place to put one's money at the present time. For example, the Vanguard inflation protected fund has a 1 year return of over 15%.

I sat out the previous decline in the stock market in inflation indexed bond funds and am sitting this one out there too. My only mistake was in not getting out of stock funds quickly enough.

[Idytme]

Study what has happened in the bond market in the last few months. Do not think that you can have a guaranteed high return from any bond fund right now, even if it is rated AAA.
My advice to anyone from right now until the entire mortgage mess is behind us - don't get greedy with bond interest rates.
This is not the 1970's with high interest rates next to a declining stock market.

[veracity]

Dan, you do have a couple of points there - brokers and traders Do earn commissions with each trade (even in panic selling), and -
"The media loves bad news. It sells newspapers and increases ratings. A recent study by the Business and Media Institute noted that current financial coverage is more negative than coverage of the 1929 stock market crash."

BUT that is not always the case!

I have found, listening to "Liberal talk radio", that the perfect ENCAPSULATION of the corporate media bias can be found at their top-and-bottom of hour radio "news" reports, those 2 or 3 minute "news" items. Whether CNN, ABC, CBS (much less Fox noise), they all trumpet the corporate spin as the "Conventional Wisdom."

They will report "Today, Congress debated BAILOUTS for FreddieMac & GinaeMae" BUT INSTEAD OF DIGGING INTO THE STORY "why are Fmac & Gmae facing crisis?" they will sum up their 1 minute news blurb with "PRESIDENT BUSH SAYS..."

Network newscasts are scarcely better. They WILL NOT TELL YOU about the BUSH 2 DEFICITS, which of course are the source of the HYPER-INFLATED OIL and COMMODITY prices, and the DEFLATION of home values.

NO financial news reporting should ever start without mentioning the current state of the US Deficits
http://www.scribd.com/doc/3015540/US-Budget-Deficit-or-Surplus-1960present

But NONE EVER DO! The American press-media CENSORS the REALLY BAD NEWS, the Bush2 Deficits!