Avoid Your Parent's Mistakes

When I first meet clients  one of the first things I point out is my experience.

Why does experience matter you ask?

Well, experience in a nutshell, means I have lived through many economic cycles. I have seen the highs and lows, and I know what they mean and what they don’t mean.

It means events of today are always placed in a historical context. I have purposely tried to avoid the Recency Bias that all of us have.

This bias can have profoundly negative consequences on building your wealth. Today, many people investing or advising on where and how to invest have a very short historical time frame.

History gives context to the present.

Many were being born in the late ’70′s/’80′s just when mortgage rates were peaking at 21.75%. I was an active adviser and I sold GIC’s at 17.75%. Do you remember that?

Do you remember Black Monday October 19th 1987 when the stock market lost 22.66% of it’s value in one day? Many at that time predicted financial Armageddon but it didn’t happen.

Some of us remember the tough financial situation Canada and Canadians faced in the early 90′s. We were facing a severe downgrade from the ratings agency.

At that time, Jean Chretien and Paul Martin along with the sacrifices of Canadians made sweeping cuts to expenses and increased revenues by maintaining the GST.

The Eurozone crisis of today isn’t much different than what Canada faced.

I am sure at the time Chretien and Martin were short-term focused but it had long-term consequences. Canada began running surpluses. Markets were absolutely buoyant.

Canadians began discovering the merits of investment funds and investing. For 5 years we had market returns like no other period in modern history. In cases you forget here are  the annual returns of the S&P 500.

YEAR	PRICE	PRICE	CHANGE	TOTAL
ENDING	CLOSE	CHANGE		RETURN
				CHANGE

31/12/1999	1469.25	240.02	19.53%	21.04%
31/12/1998	1229.23	258.80	26.67%	28.58%
31/12/1997	970.43	229.69	31.01%	33.36%
31/12/1996	740.74	124.81	20.26%	22.96%
29/12/1995	615.93	156.66	34.11%	37.58%

So what’s wrong with those positive years you ask?

Clients changed how they invested radically. They became greedy. They believed the good times would last forever.

Prior to that run, financial advisers such as myself were advising clients to build balanced, diversified portfolios involving all three main asset classes, equities, bonds and near cash items. It would be common for a client to say have 60% in equities and the rest in bonds or near cash, what I call the defense in a portfolio.

But when investors stared seeing the returns  noted above, they ditched the defensive part of their portfolios and went all in, in equities.

As long as returns stayed positive they were patting themselves on the back and cursing their conservative advisor who wanted a more conservative approach.

It was also at this time many internet companies arose, the beginning of the Dot.Com era. Some would succeed, many did not. However they were all viewed the same.

This was the beginning of the new economy, and investors flocked to invest in companies that had no history of earning one dime! Their price run-ups in the late 90′s and in early 2000, 2001 was nothing short of staggering in terms of the share prices.

On March 1st, 2000, the Nasdaq 100 which was where the new economy stocks traded had a value of 5132.52. Investors were experiencing what Alan Greenspan called Irrational Exuberance.

People literally went to their advisors and said I want out of the portfolio I am in and I want in on this new economy. Sadly too many advisors did exactly what their clients wanted without any discussion or counselling.

In turn what happened?

In 1999 and 2000 the price for these new economy companies was at their zenith. This was a classic case of buying too high and reacting to yesterday’s news.

Investors decisions were emotional even though many would say they were highly objective in their approach.

In March of 2001, the index had a value of 1840.26.  One year earlier its high value was 5132.52. An investor buying at the peak would have lost 66.15% of his/her equity value.

The news didn’t get better. There were many corporate scandals, Enron, Global Crossing, Worldcom, where employees and investors were defrauded of monies.

By the end of 2002, the index had dropped to 1320.91.

(Click to enlarge image)

Well dear loyal reader you are probably saying whew I hope those people sold out on the way down and minimized their losses. The fall was dramatic, almost like going over a cliff.

Those who choose to sell their holdings,  had seen their portfolio drop by numerous percentage points in a very short time frame.

If they had sold they would have been reacting out of fear and making a huge mistake.

You see people had gone from one emotional state  irrational exuberance and euphoria to another state of emotion, fear, absolute resignation and capitulation. They were screaming at their advisors, just get me out.

By doing so they had consolidated their loss. Remember a loss of 25% requires a higher return percentage going forward just to break even.

These points I make are examples of the boom and bust cycles of the market. Often 3 to 4 years of growth followed by 12 to 18 months of negative growth. Here is the actual history since 1942

I want to highlight one paragraph from that article:

Since 1945, the average bull market has been 1,625 days with an average rise of 149.53%. The average bear market has been 393 days with an average decline of 30.57%. So the typical bull is long and strong, while the typical bear is short and nasty.

I am sure in each bear market people were in fear, panic mode. But I am reminded of something I said to my son on the weekend as we discussed this type of scenario. For each seller that wants to get out of the market there is also a buyer on the other side.

One was acting on emotion, fear and selling, the other was seeing everything on sale and buying. They were buying at discounts and we all know despite the negative periods, markets they have always recovered and moved inexorably up.

What if we can counsel our clients to see market downturns as opportunities. This is where they can hit a home run. This is truly buying low and then later selling high.

Ok, why did I go back over 25 years of history?

To illustrate that my experience can remind people of the past, how it actually happened, how with the right mind set they can take advantage of  negative market opportunities when everything is on sale and that they should take a long-term approach.

The volatility of the present matters not when your plan is focused upon a future that is 15, 20 or 25 years down the road. I try to help clients understand this, how their emotions can hurt them, that investing is emotional as well as objective.

My role is to help client’s avoid the big mistakes that cannot seriously erode wealth.

These are stories I share with clients so they can become better investors by taking along term view, not overreacting to the news of the moment.

So the moral of this post is: If you want to be a good investor, be a student of financial history.

Related articles

• The Illusion of Safety
• Canada’s market gurus analyse the panic (opinion.financialpost.com)
• How to Maximize Long-Term Returns (dakotavoice.com)
• Their Own Worst Enemy (online.wsj.com)