The value of global financial assets shrank $50 Trillion during the past two years, half due to the bronco-busting ride in the stock market. Those still standing or with the courage to consider getting back on that horse (or should I say bear?) might consider some of the lessons learned from the harrowing experience:
WE LIVE IN A GLOBAL ECONOMY WITH A GLOBAL STOCK MARKET. The U.S. is still the primary growth engine of the global economy. However, the European Union is today the world’s largest single economy and the BRIC economies (Brazil, Russia, India, China) along with other emerging markets will most likely drive global economic growth for the next several generations. Ten years ago the U.S. comprised half of the world’s stock market capitalization, but today its share represents about a quarter of the global stock market. U.S. investors will need to consider the risks and opportunities that will come from being inextricably connected to that global marketplace.
DIVERSIFICATION IS STILL THE ONLY “FREE LUNCH” IN INVESTING. Many believe that the recent downturn in all stock categories means that diversification does not work. However, diversification only promises to reduce portfolio risk by mitigating the specific risks attendant to individual investments; it never promises to insulate investors from overall market risk, which is exactly what we’ve experienced during the past two years. Diversification is still an important risk mitigation tool that arises from combining several asset categories (stocks, bonds, etc) or combining variety within a particular asset category, such as stocks. In fact, many experts believe that, for maximizing risk-adjusted returns, a portfolio mix of many types of assets is even more important than the mix of stocks in a portfolio. Therefore, first consideration should be given to allocating resources to stocks, bonds, gold, cash, etc. The stock allocation should be a secondary consideration. Within the stock category, investors traditionally seek to diversify according to industry sectors, geography, investment style (e.g., growth versus value) or market capitalization (e.g., nano, micro, small, medium, large, mega-cap) in order to minimize specific investment risks over the long term.
STOCKS SHOULD BE CONSIDERED LONG TERM INVESTMENTS.The dramatic increase in stock market volatility in recent years has created a professional trader’s paradise, but has also created a treacherous environment for other investors. Consequently, investors should have a long-term horizon of at least 5 years and preferably 7-10 years for their stock portfolios. Long time horizons provide flexibility to recover from protracted and dramatic market setbacks. Strict “buy-and-hold” strategies for individual stocks are not recommended, but needing to sell out of stock positions on short notice to raise cash for other purposes will not produce satisfactory investment results. Stocks may be “liquid” investments, but “fire” sales at steeply discounted prices provide little consolation to sellers.
INVESTING IN “BLUE CHIP” COMPANIES NO LONGER GUARANTEES INVESTMENT SUCCESS. During the last year, several venerable long-standing institutions disappeared or were saved from extinction by heroic government bailouts. AIG, Citigroup, Lehman, Fannie and Freddie and many other household names are on that list. An examination of the 30 stocks comprising the Dow-Jones Industrial Average shows that even major non-financial companies dramatically fell in value, some below $10 per share, during the past year. The past two years has proven that the idea of buying stock in today’s great companies and blindly holding them forever is a thing of the past.
Part 2 will highlight lessons specific to managing your money in these uncertain and turbulent times.