Indexers are Human Too

Get an appropriate asset allocation and index.  This is a key to controlling emotions in volatile markets. And we are in a volatile market environment.

Indexers can make this look robotic. Many have conquered the emotional side of investing. They are like the soldier running up Mt. Suribachi lobbing grenades as machine gun fire is raining down the side of the mountain. Are they superhuman investors? Don't they have emotions? How are indexers able to hang in and ride out the market turbulence?

The Secret

I'm here to let out the secret. Yes, we have emotions. Yes, we get nervous when we hear tornado sirens go off. Yes, our minds try to play tricks with us. We are, in fact, human.

DIY Investor looks at today's market and cringes. The media is playing up many disaster scenarios. Brush fires are all over the place. What happens if the unrest in the Middle East spills over to Saudi Arabia? In fact, it appears that the Saudis are the key to us getting out of this alive. If they don't push up oil production closer to capacity, oil prices will spike further, pushing U.S. gasoline prices sharply higher and killing off the nascent U.S.economic recovery. Revolutions are nasty.

DIY Investor looks at the Middle East power struggles and is fearful for the simple reason that the U.S. isn't in control. It reminds him of late season drives by the Washington Redskins, who could only get into the playoffs with an improbable chain of events--requiring other teams winning and losing particular games. You could only sit there and wring your hands once your fate was out of your hands.

Then there are the budget fights with public unions taking place in a number of states--another contagion type development that has the potential to spread.

Add to this that the budget limit is close to being broached and that our politicians at the national level care more about vote getting, posturing, and playing to the cameras than taking courageous action that benefits the country.

All of of this and much more weighs on the minds of indexers as it does most investors. What, then, prevents the indexers from pitching all the cargo and jumping overboard?


Controlling Emotions

First,  indexers are probably a bit older than the average investor. In fact, I would like to see survey data on this, if anyone knows of some. It is hard not to get a sense of deja vu for those of a certain vintage. Secondly, indexers (even the younger ones) are knowledgeable about the history of markets. This is a real key. Take 9/11 as a fairly recent example. After the immediate horror sunk in, investors looked at markets and heard pundits proclaim people would never fly again.  Expectations were rampant that further attacks would occur, and economic forecasters predicted disaster.

The S&P 500 hit a new peak six years later.

The recent example, of course, is the housing crisis of 2008. It looked as if the whole banking structure of the U.S. was going under. The potential for massive money market fund liquidations brought to mind the bank runs of the Great Depression. The bond rating agencies were exposed as incompetents and, to boot, it became unnervingly obvious that the top people at the Federal Reserve were clueless on the economic economic impact of the housing crisis. On March 9, 2009 the S&P 500 stood at 676.53; today it is at 1319.88.

Out of 26 investment management clients, I had 2 who totally "freaked out" (to use an up-to-date expression)  and asked to put everything in money markets in early March 2009.  They said that all the news was negative and they didn't see anything that could be positive for stocks. This, of course, is the best time to invest, as Buffett et al. have long argued.

The bottom line for indexers is that we have been through this before, we understand that emotions will be high, but, importantly we know that these situations offer opportunities. But, again, investors have to be allocated appropriately. It is important to understand the difference between the stage where an investor is accumulating assets and where assets are being drawn down. The investor building up the nest egg can confidently say that, from the perspective of several years down the road, this period will be seen as an opportunity to have added funds to the portfolio.

The bottom line is very simple. For most people, if they have an appropriate asset allocation and forget trying to time the market or pick stocks or even pick the sectors of the market that will provide the best performance, they will find they can control their emotions and be well positioned for calmer markets. Otherwise, IMHO, they shouldn't be in stocks at all. And that's OK.

Coping With Emotions in a Volatile Market

Yesterday's post elicited a comment from Shawn in which he asked "...I do wonder how investors can deal with the emotions of the roller coaster ride we have been experiencing." This is the most important question facing do-it-yourself investors and the present environment is a great test. One day the market is falling off a cliff, all the news is negative, and doomsday commentary is everywhere. You feel like the character in Edvard Munch's painting. It makes a normal person want to cash it all in and sit on the sidelines.

The next day we get a piece of positive news: different commentators argue that the economy is in a recovery mode and that the worst possible scenario is a slowdown - not the dreaded double dip.

In the background, the news du jour is the sub-par long-term under performance of stocks. Over the last decade, investors were not rewarded for taking on risk which, of course, undercuts one of the main tenets, supposedly (actually investors can expect higher returns for incurring greater risk), of investment theory. Then there is the ongoing argument that a bond bubble is building.

All of this, as Shawn implies, is causing the arrow on the emotions meter to register in the danger zone. Again, how does the do-it-yourselfer cope?

Well (I'm taking a big breath here), we do know a couple of things. First, the average do-it-yourselfer is not going to do well in this environment. Simply, some who are completely out of stocks today will dive in aggressively if the S&P 500 rises 400 points. We know that there are diyers who capitulate every time the stock market drops by triple digits and then jump in when it's up a couple hundred points. DIYers like to buy high and sell low and tend to chase the best performing sector. Today that's bonds.

This behavior is the result of DIYers focusing on prices and not on the underlying businesses. Simply, if DIYers are not going to put in the time and resource-consuming effort they need to understand individual businesses, they need to index and capture market returns. Focusing on the erratic day-to-day price movements of individual stocks in a volatile market would even drive the Fonz to lose his cool.

Secondly, the last 10 years have been highly unusual. Ten years ago was near the end of the best 3 years in the history of the stock market! It was the most bullish environment ever experienced in the U.S. Valuations were skyrocketing, investors were convinced that old valuation metrics were irrelevant, and the bubble was wildly over inflated. We're not in a stock bubble today. In my view, it is a mistake to fixate on the last 10 years.

Thirdly, it is easy to emphasize what we can see; and it is impossible to see what is around the corner. Typically, on the business front, positives have been around the corner.

Some perspective: when I was the age of many of today's personal finance bloggers, I had to carry boxes of punch cards to the computer center at the university and get my results the next day. If I had a question about house prices over the past 20 years, I went the library; I didn't google "house prices." Businesses didn't have PCs on every desk. People had to actually answer their phones and, if you wanted to see a TV show, you had to be there when it aired.

Today's world is completely different. And it will be very different in 25 years. In terms of products produced by businesses (notice I'm steering clear of politics and the fiscal mess we are in!), it will likely be much better. We'll have completely different automobiles, medical technology will be much improved (and may actually lower medical costs), and, yes, today's computers will be like "pong" is to today's games.

Thus, for me, when I put all of this together, I go 100% with the advice offered by the school of thought that emphasizes low-cost indexed investing. Give a lot of thought to risk tolerance, how much you need to reach your retirement goals, and structure assets accordingly. Then live life - don't let the ups and downs of daily stock prices on the computer screen mesmerize you. To me this is how the DIYer copes.