Wednesday, September 24, 2008
I am currently having trouble assessing what is really going on with sentiment over the last couple of days.
It is not crucial to the way I do the job at hand but it opens the door to an interesting line of thought that to some will seem insensitive but could be very constructive in terms of getting through the current bear market and could help with future bear markets.
The context will be for diversified portfolios.
For anyone feeling a sense of fear now at any point previously or at anytime before this bear ends, what exactly are you afraid of? Not being a wise-guy, in your fear you are assigning some probability to an outcome that is not acceptable to you.
Losing all of your money, literally going to zero, is not acceptable to anyone. Nor is it in the realm of possibility (remember, diversified portfolios). How many stocks do you own that have gone to zero? Do you even use stocks or do you use indexes?
From the peak the S&P 500 is down 24% (add in dividends if you care to). If you have a reasonably diversified portfolio and took no defensive action you are down something similar in the equity portion of your portfolio, maybe a little better maybe a little worse but close.
How low do you fear the market will go? 100% is off the table. I have yet to read anywhere that makes a compelling case for this being worse than the great depression, so that would take 80% down off the table. Earlier in the decade the market cut in half with a starting PE ratio in the mid thirties (charted above). Based on the chart the PE at the peak on this go around was in the teens. I am not a fan of PE ratios for predicting anything but at a minimum it contributes to the case for the market not cutting in half in this bear phase.
Even if it does cut in half what will happen after that? After it bottoms, regardless of the level or the date, what will happen? You know the answer because you have lived through this before it will turn up. Bear markets end with new bull markets. You know this will happen but don't know when.
When the last bear bottomed it took five years to make a new high. At some point we will look at the bottom of this bear and say it took X years to make new high.
Another dimension to the fear is "I won't have enough money when I retire." Assuming proper asset allocation (that is important) and a diversified portfolio your fate in this regard will not be determined by one bear market.
If you are 60 and you retire today you have two outcomes, you either live a long time or you do not. If you live a long time you need the portfolio to grow to keep up with inflation (assuming a prudent withdrawal rate) for a long time. If you get hit by lightning carrying your box of stuff out to the car on your last day you don't need any money but you might leave a spouse who will face the same thing; living a long time or not, same worries about inflation or not.
If you dropped all 50% in the last bear market what have you done about it since? Save more? Take out less (if you are retired)? Seek out defensive a strategy? Something else? In all likelihood you did something (even if not in the portfolio) that otherwise mitigates at least some of the setback of cutting in half a few years ago.
The reason people run out of money (again assuming a diversified portfolio and not total mismanagement of a bear market like selling out at the low and buying back after a 20% lift) is they spend too much money or manage debt poorly one way or another (the two are obviously related). If the portfolio drops 25% and at the same time you take out 10% you're going to have a problem. That magic four point whatever percent withdrawal rate is such that it can withstand big drops. Bigger withdrawals; not so much.
As kind of a repeat theme, the numbers work a certain way. One way to mitigate the fear of not having enough; don't bet you can outsmart the numbers.