Understanding The Credit Crisis

Understanding The Credit Crisis… Through The One Eternal Truth of Investing

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
October 06, 2008: Issue # 866

The credit crisis has been with us for 14 months. But it is only now that it is turning into a full-fledged panic.

Mutual fund outflow numbers show that shareholders are yanking money out of both stock and bond funds. So many investors have jumped into T-bills that the yield has dropped below one half of one per cent. (In their rush to safety, they are guaranteeing themselves a substantial negative return after taxes and inflation.)

When I was interviewed on Oprah & Friends last week, one caller asked whether I agreed with this theory that the economy and stock market are going into a 15-year decline.

Please. The Great Depression didn’t last that long. And that was with the government decreasing the money supply, raising taxes and destroying international trade with protectionist legislation.

The Credit Crisis - Past & Present

Look, it’s not my job to be a professional hand-holder, but I will point out a few key facts about past credit crisis’:

The S&P 500 is now down 35% from its all-time high one year ago.
Since World War II, the average bear market has taken the average down 31%.
The two worst declines were the 1973-1974 bear market when the market dropped 48%, and the 2000-2002 plunge when the market slumped 49%.

Yes, the market can fall further. And given that this credit crisis is far from over, it probably will.

But as Soleil Securities Chief Investment Officer Vince Farrell said in a research note to clients this morning, “Bear markets end when the news is at its worse, and long before the statistics and the numbers turn to the positive. We need to keep that in mind.”

The first question every equity investor should ask himself is this: When had I planned to cash in my stock market investments?

If you are selling your stocks because you need the money for next week’s real estate closing or because your daughter’s college tuition is due, that’s one thing. (Although my rule of thumb is that you should never have money in the stock market that you need in less than five years.)

But if you are investing in stocks to meet your long-term investment objectives, a decision to sell now is almost certainly emotional not logical.

Yet many investors are unaware of this…

Don’t Justify Investments With Emotions

That’s because these investors justify their emotional behavior with all sorts of rationalizations.

If you visit an automobile dealer, for instance, and fall in love with a new car that you don’t need, you will find your mind saying things like, “gee, this car gets better mileage than my old car.” Or, “I’ll bet I can get a great deal on a convertible when winter is just around the corner.”

Your mind searches for reasons to justify your emotional decision to buy the car.

The same thing happens in the stock market. Investors say, “I’ll get out now and then get back in later at a lower level. That way I’ll avoid the pain of a further decline and enjoy the next run-up when it comes.”

Except it doesn’t work that way:

Before long you start feeling so pleased with yourself that you’re sitting safely in cash - while your fellow investors are suffering - that you stay in cash too long.
Eventually, the market starts to rally again, just as it has after every market break for the past 200 years. Often these upswings are sudden and violent.
When you miss the rally, you’re likely to tell yourself that you’ll get in as soon as the market comes back down again.
But what if it doesn’t? You get left at the station - earning a less-than-mouth-watering .4% - while the equity train rumbles on.

Bear Markets Compensate Long-Term Investors

History shows that investors who buy into a bear market at this stage - or at least hang on - are well compensated in the years that follow.

I don’t expect the majority of investors to agree with me. Even among the ones who do, few will step up to buy much (if anything) really cheap while the merchandise is on sale.

This story is as old as the markets themselves.

William Bernstein, author of “The Four Pillars of Investing,” once wrote that when it comes to investing there is only one eternal verity:

“Investing has always been, and will remain, an operation in which wealth is transferred from those without a working knowledge of financial history to those who have none.”

Govern yourself accordingly…

Good Investing,

Alex

Today’s Investment U Crib Sheet

The Four Pillars of Investing is the foundation of our investment philosophy because it gives us a proven strategy for building wealth. To achieve this long-lasting investment success, you need to make sure you’re asking the right questions.

How can I get the highest return with the least amount of risk?
How can I protect both profits and principal?
What can I do to guarantee my investment portfolio will be worth more in the future?

These questions are the quickest way to true wealth, and the answers aren’t as difficult as you would imagine with these four simple principles. Learn more in Investment U Issue #812, The 4 Pillars of Investing: Don’t End Up as Stock Market Road Kill

For a refresher course on financial history, take a look at one of our Investment U textbooks, Secrets of the Masters. Learn how investing greats like John Templeton, Jim Rogers, Bill Gross and Warren Buffett have used “hyper-profit strategies” to profit in all kinds of market conditions.

If you’d like to be one of the investors with a working knowledge of financials, we recommend you take a look at the Investment U archives. Its wealth of information can be searched by topic. You’ll get instant access to our backlog of investment reports and letters.