Saturday, December 6, 2008

Is This the Opportunity of a Lifetime?

Does the current crisis pose the opportunity of a lifetime?

Lately I've noticed a change in attitude. It just might be my wishful thinking, and I certainly don't have any objective data to support this feeling but I think something is shifting.

Considerably more articles are concentrating on the opportunity part of the current crisis rather than the massive losses we've all experienced. Many columnists are carefully discussing the relative sanity of current stock prices and the high risk premium they're trading in.

Opportunities are everywhere

Diversification didn't help much during this crisis. It rained, and we all got wet. The economic environment that preceded this crisis had hypothesized emerging markets like China, Brazil, Russia and others are strong enough to keep world economic growth going even should the US economy weaken considerably.

It seems we can lay that hypothesis to rest, at least for the upcoming decade or two. Globalization, for good or bad, has created many co-dependencies, one of which is the innate inability to actually properly diversify ourselves.

As I've discussed in the past the goal of diversification is to lower specific risks in investment leaving only the systematic risk which cannot be diversified. It seems that due to the co-dependencies of economies worldwide the systematic risk has actually risen.

This will work the other way around as well. In times of economic growth investments everywhere will show growth. Whether in real-estate, stocks, commodities or others, eventually growth will get there as well.

It is more probable than not, in my opinion, that every dollar invested today will grow considerably in 5 years time. The economy is cyclical and what goes up eventually goes down, and vice versa.

The more pressing question is: Would better opportunities present themselves in two months time?

No one can really answer this question but I certainly feel the tide changing. If you remember previous discussion I've always thought that reduced volatility in trading will be one of the predicators to the first steps out of this crisis. We're not there yet.

The good news is the stock market is a lot more like a speeding bus and a lot less like a light bulb. It's not an on/off, 1 or 0 thing. If you see the bus begin to speed away you can still catch it. Losing the first 10% (or more likely 30%) of price shifts is a relatively small price to pay for more quiet and peace of mind.

The problem: Most of us don't have the privilege or investing the Warren Buffet way

Attempting to be fearful when others are greedy is relatively easy. Being greedy when others are fearful is the tricky part.

I believe any investment made today will very probably generate generous returns in 5 years time. The problem is I don't have enough money to commit myself for such an investment term.
Furthermore, and much more frustrating, had I had $100,000 more I still wouldn't feel secure enough to risk more than 30% of that sum. Being greedy when others are fearful is a privilege for individuals and companies with very deep pockets.

It kind of reminds me of that statistical "trick" played in casinos, for examples, where you simply double your previous bet to earn the initial sum you'd bet on. For example, you bet $1, lose it, then bet $2, lose those and then bet $4 to win another $4. You net gain is $1. The problem is that this geometric column advances in a scary pace (2 in the power of …). Try to deploy this strategy and you'll find yourself betting $256 in 8 turns or $1,024 in ten.

What can we hope for as household investors?

Household investors should stick to basic principles when it comes to stock investments (I guess you've read these before so I'll try and emphasize the more important aspects. If you'd like to explore more please browse my investing section or top posts):

#1 Stock investing is a long term commitment

Even though prices seem relatively inviting the market can quickly turn around again. For long term investors the economic environment is relatively enticing. Prices have reached a level which prices the risk far better than a year ago; some might say pricing too much risk.

Keep in mind you'll probably face more crisis along the way. The clean-tech bubble, the Chinese bubble, or what not (who knows). It takes quite a stomach to being a long term investor.

#2 Dollar cost averaging can really help off-set some of the risk

Although academic researchers and finance professors disagree on this somewhat it seems spreading your investments over a certain period helps off set the risks associated while also lowering potential return (this should be clear).

I've written a more detailed post on dollar cost averaging which shows how it helped even out returns for investors in the US and Japan (where the market has been performing poorly for 20 years).

The market environment is currently very interesting for those who seek to start investing slowly, a certain amount each time. Prices are relatively low and should they drop more you've got yourself a better price for you next investment.

#3 Diversification and asset allocation

As mentioned diversification can't help much when it comes to a crisis such as this. Still it's far better to lose the average market loss than lose 90% in any given stock. Diversification, together with asset allocation helps in building a more robust portfolio to better withstand shocks.

Avoiding risk altogether is not an option

Extreme risk aversion is not the answer. In Extreme Risk Aversion Paradoxically Leads to Another Huge Risk I discussed why avoiding stock investments altogether creates another significant risk, that of failing to meet our financial goals, especially our retirement goal.
Stock investments are the only tool which can really provide the added value much needed in long-term savings. A 2% difference in the average yearly return is most significant and practically dictates a whole other lifestyle in retirement.

I promised to keep you updated when I make my move back in the market. I'm usually a terrible proxy and would advise you to sell the moment I buy but it'll make for an interesting, and more importantly long term experiment.

Related posts:

Image by: Justneal


Mr. GoTo said...

Isn't it also true that shifting cash from the market to paying down debt is a form of investment in your future? I think that it is so worried investors should feel no shame in shifting course in that direction during this economic cycle.

Aman said...

i think that this can be looked as a buying opportunity ONLY if you were one of the few people that actually saved for a time like this.

it amazes me how many people did not see this collapse coming and are in over their heads with mortgages on half million dollar homes while working a blue collar job. I"m not hating, but with some budget planning, you would know this dream could not be lived without longterm hardship.

those that have saved, are now buying stocks at prices that probably will never come to this level again and are easily about to make a 25-50% return. Housing price are dirt cheap to invest in and so is commercial properties.

Bill M said...

Paying down Debt is the biggest investment return you can make, at 18% a year in finance charge, it can get very expensive. Now is the time to invest in the stock market if.
1. You are debt free from Credit cards
2. You have an emergency fund.

Mark said...

I think that this crisis is the opportunity of a lifetime. You have a market selling at depressed prices that people are terrified of. This strikes me as an opportunity.