Expect Less, Pay More

Going into 2008, we seemed to have all decided this would be a year of expecting less. According to the predictions, investors would have to settle for lower returns and some very choppy markets. Analysts have lowered expectations for domestic stocks in general; the credit crisis, which has hammered the financial services sector, persists; and retailers seem headed for a very difficult year.

The question for today: So what?

At times like these—with consumer confidence way down, rampant talk about a recession, dislocation in markets everywhere—you have to choose between being a trader or an investor. An investor has a plan and sticks to it, whereas a trader is reactive and is more likely to be guided by emotion. An investor makes decisions based on rational thinking, but a trader is more likely to make ill-informed decisions.

But even the most steadfast investors can make mistakes when they panic. They lose sight of long-term objectives and may sell at the bottom. Or they could freeze up and decide against rebalancing their portfolios, which can result in buying out-of-favor assets.

What makes investing during a downturn in the market so unpredictable is that we don’t know how low it will go. Retail stocks are depressed right now, so they might be a good bargain. However, if consumer spending doesn’t pick up soon, your money could be dead in the water; you could lose money before you make money. But an investor with a long-term horizon might do all right.

On the other hand, oil, gold, and other commodities are hot right now. That’s what we were thinking six months ago, and since then, prices have gone nowhere but up. Will they keep rising in the near term, or tumble back to Earth?

Stocks are volatile over the short run, right? Of course they are. But never forget that the stock market is a discounting mechanism; in other words, prices today reflect anticipated future prices. In the year leading up to a recession, stocks decline in value by 4.3 percent on average. For the six months after a recession begins, stocks are down about 4.8 percent. However, a year after a recession begins, stocks are typically up 3.2 percent. In the year after a recession ends, they’ve increased in value to about 14.4 percent.

Talk about a rollercoaster! Ibbotson Associates, a division of investment research giant Morningstar, Inc., in Chicago, says that from 1966 through 2005, the Standard & Poor’s Index has returned an average of 10.53 percent. However, returns varied from negative 26 percent to a positive 37 percent over that period.

In only two years—2002 and 1974—was the market down more than 20 percent. It was down between 10 percent and 20 percent in three years, and flat to down 10 percent in five years. But the market was up more than 20 percent for 14 years during that period, and up 10 to 20 percent for nine years during that period. Those seem to be pretty good odds.