Market Overview, April 2009

A financial mania leads to a bubble. The bubble pops, asset prices fall to earth and, especially when that asset is bought on credit, the damage spreads to the economy as a whole. That is what happened recently with the residential housing market.

But the question is: aren’t such bubbles part of the record of the past, the market history we use as the basis of prediction?

Yes and no. Large bubbles – and other shocking dislocations, such as a terrible war – don’t happen often enough to have a major impact on data. The risk is real but hard to quantify because it is so rare.

However, the kind of risk we can “eliminate” – or prepare for – is the sort that takes place with a coin flip. We know the odds are that half the time heads will come up and half the time it’ll be tails. You can get a run of ten heads in a row, but on each new flip the odds are 50-50 that heads will appear, and over thousands of flips, heads and tails will each win about the same number of times.

So …you should have enough capital to withstand losses from, say, ten tails in a row. History assures us that stocks will lose money only a few times over ten-year periods and never over 20-year periods, and that on average they’ll deliver annual real returns of about 7%.

The future is, of course, unknowable since no one has ever been there. But our lives require forecasts about what it will be like, and we have to base those forecasts on something. Our choice, usually, is history. And so it is with investing.

When you invest, you forgo the immediate gratification your money could purchase and instead put your cash away, to be recovered later, when, you hope, it will be worth more.
The key word is hope, but the past teaches us that:

• Stocks have outperformed bonds by a wide margin.
• Stocks have been volatile over short periods but stable over long periods.
• A diversified portfolio provides extra stability.
• Therefore, the best strategy is to buy a diversified portfolio of stocks and hold for ten years or more.

Your choices. There are two ways to respond to uncertainties as an investor. The first is to take your chips off the table. If you can’t calculate the odds, refuse to play. The second is to ignore the risk and assume that a logical system, even if severely buffeted, will eventually prevail.