Panic? What Panic?

by | Aug 24, 2007 | Cash Flow, Weekly Column

angry.jpgLast week I received an inquiry from a reporter who writes for a well-known national news magazine. It read, “I am trying to find individual investors from all walks of life (blue collar, immigrants, retirees, etc.) who are ANGRY and would be willing to talk about it. Who do they blame for this mess and why?”

My response was, “When you have found and interviewed those ANGRY investors, would you give them my contact information? Investment advisors doing their jobs properly have prepared their clients for times like these. I haven’t received ONE phone call from a client who is panicking or angry!”

While the rest of the investment world had a frenzy over the stock market decline last week, investors with solid, diversified portfolios took the decline in stride….maybe with a yawn. We’ve “been there and done that.”

Indeed, the Dow’s decline from its all-time high on July 19th to August 20th was about 6.5%. However, a diversify.jpgportfolio with good asset class diversification (in this case nine asset classes) was down around 4.8%. That is 26% less of a decline than the Dow. This decline is a little more than the decline a diversified portfolio experienced back in February, when the Dow was down about 4% in one week. The difference is that the decline of the past month is much broader than just the Dow Jones or the S&P 500. The current decline has hit almost every asset class, with only cash having a positive return. Of the remaining asset classes, the two that are down the least are bonds and market neutral funds. The balance of the asset classes are down 5% to 8%.

Readers of this column know I’ve written repeatedly that the markets of the past four years were doing far better than what my models show is sustainable over a long period of time. Savvy investors know that what goes up will not continue to go up forever. Indeed, my experience is that about every five years we experience a market where almost nothing in our portfolios increases. This is the nature of investing.

Personally, I think another 5% to 10% fall in the Dow would be a good thing, washing a lot of optimism out of the market and building a solid foundation for another advance. But it really doesn’t matter what I think, does it? The market will do what the market is going to do. We just need to have well-diversified portfolios and hang on for the long run.

Long-time readers also know that most investors know very little about asset class diversification. Heck, most advisors don’t practice it, either. Polls show that three-fourths of financial planners don’t practice asset class diversification with their clients.

What is asset class diversification? In addition to the usual asset classes of US and international stocks and bonds, a diversified portfolio will also include real estate, commodities and natural resources, market neutral funds, junk bonds, and Treasury Inflation Protected Securities (TIPS).

key.jpgThe key to investment success is having reasonable expectations. It is normal for a diversified portfolio to have annual returns anywhere between -10% and +25%. The last five years have seen diversified portfolios produce average returns of 12% to 18%, well above our expected long-term returns of around 7%. When you know that a -10% return one year is as normal as a 25% return the next year, you don’t panic. You don’t make “the big mistake,” which is selling low and buying high.

If a portfolio is well-diversified, about 50% of the roller-coaster volatility is eliminated. Investors don’t panic, because they have no reason to.

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