“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years,” said the accomplished investor, Warren Buffet.
Although the stock market isn’t likely to close without reopening for any length of time, when it comes to the current environment and the impact of the credit crisis, it is very important to manage risk. The most important thing a financial planner can do for them is help them avoid making big mistakes. When volatility rears its head and the stakes rise, it is time to control that aspect first and foremost. The second objective is to find opportunities.
In the current environment, risk can be controlled primarily through two methods: diversification and paying the right price.
The first is an easy one. Diversification does work and good returns often come from unexpected places. Through properly spreading out a portfolio among different asset classes (stocks, bonds, commodities, real estate, etc.), investors can keep from getting damaged by bad returns in a single holding or asset class.
Paying the right price is why the world’s top money managers get paid the big bucks. Valuations matter. The key is to understand how much risk is already built into current market prices. When fear is running high and solid companies are being sold without reason, good buying opportunities are created. Since 1939, January has seen five occasions where the S&P (Standard & Poor’s) 500 declined at least 6 percent. In all five instances, stocks finished higher one year after the dismal January, averaging a 12 percent gain over the next 12 months (the Market Analysis, Research and Education MARE group, a unit of Fidelity Management and Research Co.). January, 2008 saw a 6.1 percent decline.
It is fair to say that once risk is in check, it is time to make some money. Opportunities abound during bad times. The tech bubble of the late-1990s led to huge stock market declines through most of 2002. While this was going on, U.S. housing stocks were quietly amassing large gains when most investors were not paying any attention to the stock market. Ryland gained more than 2,000 percent from early 2000 to its peak in 2005.
While the United States was experiencing a recession in 1990, good companies that had proven business models began trading at very inexpensive levels. For example, Citigroup declined about 45 percent from February to December of 1991. When the recession ended and strong companies displayed their merit, the market took Citigroup from a price of just under $9 in late 1991 to more than $170 in mid-1998.
Right now, similar situations are unfolding. Good companies are getting caught up with those that truly have problems. When one considers the fixed income markets, municipal bonds have rarely, if ever, traded at current low levels. Does it make sense to load one’s portfolio with any one or two of these investments? Absolutely not, although it may make sense using proper diversification to allocate some of these instruments into the mix.
Notable portfolio manager, Martin J. Whitman, co-chief investment officer and portfolio manager of Third Avenue Value Fund, stated that the mortgage meltdown/housing collapse seems nothing new for the U.S. economy. During the last 60 years, virtually every sector has gone through depressions as bad as anything that occurred in the 1930s.
Similar to every crisis, there will be casualties and companies that are no longer around. On the other hand, with thorough research, discipline and a little patience, there will also be those names that emerge at the top of the group and produce strong profits. To quote Mr. Buffet again, “Time is the friend of the wonderful company, the enemy of the mediocre.”