What you need to know (and do) during troubling times

What is happening to our economy? This is a question many of us may have on our minds these days. There are some strategies to help us work through these frightening times. First of all, WHY is this happening? The current economic situation is due, in large part, to the housing bubble. This bubble was fueled by easy to obtain subprime mortgages, lax regulation of mortgage brokers, housing speculation and exotic investments based on securitization of mortgages. Experts called it “financial innovation gone wrong”, and it led to a credit crunch, bank losses in the United States and abroad, and worldwide credit turmoil. So far, the 2008 bear market most resembles the downturn of 1990, when thousands of savings and loans (S&Ls) failed. The 1990 bear market also had its origins in financial innovation and lax regulation. In the late 1980’s Congress substantially loosened S&L lending standards and let S&Ls diversify into riskier and more profitable real estate lending. Between 1987 and 1993 more than 2000 S&L’s failed. We still don’t know how long this bear market will last. A long term history of the Dow Jones Industrial Average shows that the stock market has come back after bear markets, but not before investors had to suffer substantial pain. After the 1929 crash, it took investors 16 years to restore their investments if they invested at the market high. In 2000, it took five years. But after the 1990 crash, it took only eight months. Since 1900, a bear market has occurred once every 3 ½ years on average and has lasted about 329 days. Recessions, as well, have been recorded on a frequent basis. A recession is a contraction phase of a business cycle. The U.S. based National Bureau of Economic Research (NBER) defines a recession more broadly as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." A sustained recession may become a depression. According to economists, since 1854 the United States has encountered 32 contractions and expansions, with an average of 17 months of contractions and 32 months of expansions. Since 1980 there have been three periods of contractions, including 1980-82, 1990-91, and 2001-02. There are three lessons that investors can derive from 2008’s volatile market environment. 1. No asset class will continue to rise forever. When many homeowner’s first purchased their homes, they were so certain that housing prices would continue to rise that they signed up for adjustable mortgages with low “teaser” rates and – in some cases – chose a “no down payment” option. Unfortunately, when home prices fell in 2007 and mortgage rates were reset, “teaser” rates were no longer available. As a result, homeowner’s with little collateral couldn’t meet their inflated mortgage payments and were forced to forfeit their property. Investors who lost money when technology stocks crashed in 2000 had, sadly, made a similar assumption during the Internet boom of the late 1990’s. The bottom line: Don’t take on more risk than you can handle. Be prepared for the time when assets will decline. 2. Don’t try to time the market. The first six months of 2008 were a volatile period during which the unmanaged Standard and Poor’s 500 Composite Index, a broad measure of the stock market, lost 12.8%. For many investors, jumping in and out of the market to take advantage of the fluctuations can be a mistake. A hypothetical $10,000 investment in the S&P 500 made on January 1st that missed the five best market days would have been worth $7,433 as of June 30th – a loss of 25.7%. If the investment covered the period without missing the five best days, it would have dropped to $8,717 for a much smaller 12.8%. The problem with timing the market is that you have to make TWO perfect decisions: to get out at the right time and to get back in at the right time. In light of the housing slump, credit crunch, and rising commodity prices, the market is likely to remain unsteady, which, in turn, makes it very difficult to time the market. 3. Diversification can help smooth volatile periods. Many investors have been hurt because their portfolios were not diversified; others, craving the fast money they thought could be made, flipped their homes or invested in high-flying speculative stocks. In any market, spread your risk by selecting a mix of mutual funds invested in stocks, bonds and money market instruments – as well as those that invest outside the United States. Also, make sure that you have adequate liquidity. The Social Security Administration recommends three to six months of an annual income put aside in an emergency fund. Work with your Financial Advisor to develop a plan that will work with your lifestyle. Remember the hard lessons of 2008 as you look forward to the new year. Remember these key concepts:Market declines are natural. They are a natural part of the business cycle. History has shown us that the market, and the economy, are resilient and come back, usually within a few years. Focus on the positive. Since this is an event which we have been through before, use it as an exercise in prudent money management. Seek the advice of a Financial Planner if you need assistance in setting priorities.Holding, just like buying and selling, should be an active decision. Today, holding on, rather than cashing out, is an affirmation that the investor believes in the long term future on the economy. We have weathered market dislocations before and those maintaining a long term perspective have survived the experience. Stay invested. Missing out on the best days of the market by cashing out can deeply affect the long term success of your portfolio.Stay diversified. Diversification has never been more important. We can’t tell you what the next ten years will bring, except that they won’t be like the last ten. But if you stay committed to your plan you should be well positioned to weather market volatility.