On 09 October 2007, the Dow Jones Industrials hit a record high, closing at 14,279. What a difference a year makes: Last Friday, the Dow closed at 8451, and there’s a good chance it will drop even further.
Unsurprisingly, my inbox is filled with e-mail from people who wonder what they should do. Here are some typical questions from readers like you:
- “Originally we had planned to open Roth IRAs this weekend, but with the stock market being so unreasonable, we have lost our confidence. Wouldn’t it be wiser to leave the money in our savings accounts for several more months?“
- “I am 30 years old and since reading your blog, I realize how important it is to get a Roth IRA fired up. However, now that I’m financially ready, the market meltdown has confused me completely. Should I hold tight and just keep saving while I see how this rides out?“
- “I have two 401k plans. However, the last time I looked at my quarterly reports, I noticed I am losing money. I know that the US economy has been pretty bad lately, but is there anything that can be done or planned for?“
These are fantastic questions. Unfortunately, there are no fantastic answers. Nobody knows what the market will do. Nobody.
I watched a news program today in which a pundit predicted the market has hit bottom and is ready to make a recovery. But there are others who believe stocks will continue to fall. I am by nature an optimistic guy, but even I start to feel gloomy and scared for the future when I read and hear some of this stuff. (Peter Schiff, especially.)
Unfortunately, neither I nor anyone else can tell you whether now is a good time for you to invest in the stock market. Only you can make that decision. I can, however, suggest four fundamentals to help guide your thinking.
Know your risk tolerance
The first thing you should do before you invest — now or at any other time — is to gauge your risk tolerance. When you buy stocks, there is always an element of risk, the chance that the value of your investment will fall.
Some investors can tolerate more risk than others. I used to believe I could stomach a lot of risk. I thought I was bold and aggressive. Then I made a couple of dumb investments, culminating with the loss of my entire 2007 Roth IRA contribution when The Sharper Image went bankrupt.
I’ve learned that I don’t actually have a high risk tolerance. I’ve funneled all of my money into index funds, mutual funds that track the broad movement of the market. These still contain an element of risk — the “broad movement of the market” has caused my index fund to drop 17.3% over the past two weeks! — but it’s risk I can tolerate. I know that my investment is doing no worse than the market as a whole.
There are several online tools that can help you assess your own risk tolerance:
- Rutgers investment risk tolerance quiz
- MSN Money risk tolerance quiz (and an article on the subject)
- Kiplinger: Test your risk tolerance
If your risk tolerance is high, you can put more money into stocks. If your risk tolerance is very low, the stock market may not be right for you. Remember, a more risky type of stock has greater potential for gain as well as greater potential for loss. Lower risk stocks have smaller swings over the long term. If your investments are geared toward retirement, you should lower the overall risk level of your portfolio as you age.
Set investment goals
It’s important to know why you’re investing. What is your purpose? What are your goals? Do you need the money in a few years, or do you still have 40 years before you’ll need to draw upon it? Are you looking for the maximum possible growth? Or do you simply want to protect your capital — to not lose money?
- The stock market is not the right place for short-term investments, or for those who cannot afford to lose capital. If you’re saving for next year’s vacation, you’re better off putting your money into a high-yield savings account or a certificate of deposit.
- Are you saving for a medium-term goal, like a down payment for a house? Again, the stock market is probably too risky for holding this money.
- But if your investment horizon is long-term, if you’re saving for retirement in 15, 20, or 30 years, then the stock market’s historical performance makes it an attractive option, especially when it’s down 43% from its peak.
That’s not to say that the stock market is always the best choice, even for long-term investments. Coupled with your risk tolerance, your investment goals can help you determine the proper asset allocation — the best way to divide your money among possible investments.
Diversify
Diversification is one of the cornerstones of Modern Portfolio Theory. Though it seems counter-intuitive, research indicates that owning investments of different types offers higher returns at lower risk. Diversification is simply the practice of owning many investments, of not putting all your eggs in one basket.
There are several ways to approach diversification, including:
- Diversification among stocks — When you own a single stock (or a handful of stocks), you are subject to a lot of risk. But when you own a mutual fund — a collection of stocks — you are practicing diversification, spreading the risk among many securities.
- Diversification among asset classes — Only the most risk-tolerant investors place all of their money in the stock market. Most spread it around into other “asset classes”. For example, I have my retirement in stocks, but I also have an emergency fund (in cash), and am accelerating my mortgage payments (real estate). I have friends who have diversified into precious metals, such as gold and silver.
- Diversification over time — Some investors practice dollar-cost averaging as a means to mitigate risk. This can be an excellent way to invest in the market if you’re nervous about putting all of your money in at once. (Please note that dollar-cost averaging has critics with valid points.)
This asset allocation wizard from CNN Money poses a few basic questions about your goals and your risk tolerance to determine a framework for diversifying your investments. I told it that I needed my money in 20+ years, could handle some risk, was okay missing my target by a couple years, and view market sell-offs as a time to buy more stocks. The calculator’s recommendation? Almost exactly the same asset allocation as FFNOX, the index fund I’ve selected for my 401k.
Diversification can’t prevent stock market losses, but it can certainly reduce them. (Note that it also reduces market gains, however.)
Educate yourself
The final fundamental concept is also the most important. I believe that education is the most essential component of any investment plan.
Often, fear is a product of ignorance. When we don’t understand something, it scares us. But ignorance can be overcome through education. If the market meltdown makes you anxious, I urge you to do some research. Visit my collection of financial literacy resources and watch the video series about saving and investing. Go to the library and borrow one of these books:
- The Four Pillars of Investing [my review]
- The Random Walk Guide to Investing [my review]
- The Only Investment Guide You’ll Ever Need
- Why Smart People Make Big Money Mistakes (and How to Correct Them) [my review]
I wish I could make all new investors set aside a few hours to read The Four Pillars of Investing. There’s a good chance it won’t make today’s investors any less nervous, but at least they’ll have a basis for making informed decisions.
Investing in real life
In The Only Investment Guide You’ll Ever Need, Andrew Tobias writes, “Buy low and sell high. You laugh. Yet most people, particularly small investors, shun the market when it’s getting drubbed…It’s precisely when the market looks worst that the opportunities are best.”
We all know this, but although the market is currently getting drubbed, the average person isn’t buying. The average person is panicked. The average person is selling. Friday’s edition of Marketplace featured some shocking stats. Last week, investors pulled $43 billion out of mutual funds. Two weeks ago, that number was $6 billion. The week before that it was only $5 billion. Why is the market dropping? One reason is that the average investor has panicked.
If the average person is selling, then who’s buying? Who’s crazy enough to buy when everyone else wants out of the market? I asked some of my colleagues about their recent money moves. Here’s what they said:
- Trent from The Simple Dollar recently maxed out his Roth IRA for 2008 (placing the money in Vanguard’s Target Retirement 2045 fund)
- Nickel moved some money into a Total Stock Market Index fund last Friday.
- Jeremy from Gen X Finance told me: “Buying opportunities like this don’t come around that often, so my only regret is that I don’t have a lot of free cash on hand so that I can pick up a lot of beaten down individual stocks.”
- Patrick from Cash Money Life says: “I plan on opening a self-employed retirement account soon with my web income, and will probably also put more money in equities where I can. I’ve been hoarding cash for several months and I think it is a great buying opportunity right now. I’ve got 30 years before I reach retirement age.”
- Blunt Money writes: “I’m continuing automatic investments as well, although I did allocate a portion of new money for those to a fixed income fund. I also put additional money into single stocks.”
- JLP at All Financial Matters, a financial planner by trade, writes that for a long-term investor, the current market is a gigantic sale.
What about me? I recently took as much money as I could it and pumped it into FFNOX. I bought in at $24.20. Its current value is $20.01. It’s down 17.31% since I bought it. So what? If I had bought it a year ago, I would have paid $32.71. If I get a chance to buy more FFNOX in the next few months, I will. Yes, it’s scary to buy as the market is falling, but I know that I’m purchasing a broad-based diversified index fund. Also — and this is key — I believe that the market will turn around.
Now maybe all of us personal finance bloggers have been drinking the same Kool-Aid. Maybe we’re suffering from mass delusion. If so, we’re not the only ones. Warren Buffett, the world’s richest man, is on a buying spree. So are Mark Cuban and many others.
But you don’t care about all those other people, do you? You care about yourself and your money. Rightfully so. What should you do? You are the only one who can make that call. You are the only one who knows your own risk tolerance, your investment horizon, and your savings goals. Educate yourself about investing, and then make decisions based on your own objectives and your own assessment of the market.
If you’re still uncertain, seek professional advice. Find a fee-based financial advisor to help guide your decisions.
Conclusion
In Benjamin Graham’s classic The Intelligent Investor, he writes:
The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. He should never buy a stock because it has gone up or sell one because it has gone down. He would not be far wrong if this motto read more simply: “Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop.”
If you believe stock prices are still high, then steer clear of the market. If you think they’re low, then buy. And remember: Unless you sell your stocks, you haven’t lost anything at this point — it’s all on paper.
During the tech bubble, I was part of an investment club. The other guys and I chortled with glee as we bought tech stocks (Celera Genomics, Home Grocer, Triquint Semiconductor) near the top of the market. We thought we were going to be rich. We weren’t laughing so hard when the bubble popped; we closed the club and sold the stocks at huge losses. What lesson did I learn? The time to buy is when prices are low, not when they’re high.
I believe that for the average long-term investor, the best course of action right now is to make regular scheduled purchases of low-cost diversified index funds. That’s what I’ve done, and that’s what I intend to keep doing.
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To Kitty:
Germany was already in the midst of its own economic depression in the 1920s before the Depression began in the U.S. Germany’s depression was basically imposed by the harsh conditions of the Treaty of Versailles, which called for Germany to pay reparations for its aggression in World War I. It was more likely life under the harsh economic conditions in Germany in the 1920s that set the stage for Hitler’s rise to power on a platform of restoring Germany to its place of power on the world stage, rather than the U.S. Depression, which occurred later. The world economy is in a very different place now, so we’ll just have to watch and see what happens!
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Bond funds should be in your 401k. It does not make sense to put something so consistently low yield in your most tax advantaged account (Roth IRA).
The stock market right now is incredibly cheap. It’s like going to Target and buying off the clearance rack.
Here are the bottom line two questions.
1) Are you investing for the long term?
2) Do you have faith that the US economy will not collapse?
If your answer is “yes” to both questions, buy buy buy!!!
(I will say, though, #2 is NOT a given.)
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To Allison:
It is indeed true that the Germany was hit hard by the Treaty of Versailles, so the economic situation in Germany in the 20s was not good. However, it was propped up by huge loans from the US in 1924 (under the Dawes plan) and in 1929 (the Young Plan). After the crash in 1929, America needed these loans back to assist American economy. After the crash, America gave Germany 90 days to start to re-pay the money which devastated Germany – between 1929 and 1930 the unemployment doubled. In 1930 – one year after the crash, the Nazis gained a whole lot of seats in parliament – a lot more than expected.
Here are some articles that outline the impact of the great depression on Germany.
http://www.historylearningsite.co.uk/weimar_depression_1929.htm
http://www.historyplace.com/worldwar2/riseofhitler/begins.htm
If you google for the Great Depression + Germany, you’ll find a lot more information that confirm what I said.
Yes, the world is a different place. But given the world government interventions in the current crisis, I don’t believe we are headed for the great depression. If we are than heaven helps us all as some of the emerging markets can be hit badly, and they may not be that stable politically.
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Unless you are planning to liquidate your holdings within the next week, you are not “participating in 1000 point daily volatility.” I don’t care (at least with respect to my 401(k)) whether the market drops 1000 points tomorrow. I’m not retiring for another 35 years.
If you are planning to liquidate your holdings within the next week, then you shouldn’t be in the stock market.
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And remember: Unless you sell your stocks, you haven’t lost anything at this point — it’s all on paper.
I’ve heard this advice before and I understand it is supposed to help investors cope with volatility. That said, I think it’s a terrible way to invest.
J.D. provides great examples of why it is poor advice in his very next paragraph. Home Grocer went to zero, while Celera Genomics and Triquint Semiconductor are down ~80% from 2000. Investors in Home Grocer lost everything – and it wasn’t just ‘on paper’ – and Celera Genomics and Triquint Semiconductor would have to go up 500% to recover their losses.
Take Lehman Brothers or Washington Mutual as more recent examples… both trading around $0.10. That’s nearly a 100% loss from pre-crisis levels.
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Josh @55: Good comment. It is important to look at paper losses as just that, and NOT get freaked out when you see you’ve lost $2,000 in the last week.
It is not really true that you haven’t lost anything when stocks drop that $2,000. You HAVE lost $2,000. You own an asset that dropped in value by $2,000. I’m not sure what is confusing about that.
The point of that comment is that the $2,000 is possibly normal market fluctuation. People who own SUVs saw the value of that SUV drop when gas prices skyrocketed. Did they “lose” money? They sure did. But they still have the same amount of cash and assets as they did before they lost that money. Thus, they will not REALIZE that loss until they sell the SUV. That does not mean they have not lost it, though.
Consider this:
wealth = cash + suv = $50k + $10k
then price of gas skyrockets and value of the SUV drops
wealth = cash + suv = $50k + $8k
Have they lost $2,000? They sure have. But they still have $50k in cash and the same SUV, so nothing has changed for them yet (ie, they have not realized the loss).
It is misleading to say “Unless you sell your stocks, you haven’t lost anything at this point”. Yes, you have, and you better not take cutting your losses off the table as an option. BUT don’t let normal market volatility push you into buying high and selling low. In fact, I would suggest re-reading JD’s entire article again and just skipping the above sentence. The rest of the article about risk tolerance, etc. is spot on.
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You own an asset that dropped in value by $2,000. I’m not sure what is confusing about that.
There is nothing confusing about it, its just not true. Its only an estimate of the value that declined. That estimate is extrapolated from the price that the people who were buying and selling today settled on.
Investors in Home Grocer lost everything – and it wasn’t just ‘on paper’ – and Celera Genomics and Triquint Semiconductor would have to go up 500% to recover their losses.
Take Lehman Brothers or Washington Mutual as more recent examples… both trading around $0.10. That’s nearly a 100% loss from pre-crisis levels.
I don’t think anyone should believe it is inevitable that they will get the opportunity to sell at a higher price than they can today. But until they sell, they haven’t made or lost any money.
In the examples you use the company went out of business. They have no value – their shareholder’s losses have been realized. That is not a market estimate.
But in a market where lots of people want to sell at any price and lots of people don’t want to buy at any price, the market price is going to be low. You can’t really extrapolate a value from that. It just doesn’t tell you anything (or much of anything) about the value of the companies you own shares in. It just tells you how those transactions happened today.
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‘If the average person is selling, then who’s buying?’
I couldn’t be more than surprised to read this line. It was as if you overheard my conversation with a friend from across continent!
Just the information that I was looking for! Keep up the good job!
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The real estate market is a good example of how unrealized gains and losses don’t translate into money. The market value of a lot of people’s homes doubled or tripled. But to realize those gains, they would have had to sell the house and find another place to live. Which would either cost as much as the one they sold or not be as nice. In essence, the value of their house hadn’t changed at all.
Some people still made a lot of money in real estate and others have lost (and will continue to lose) real money. But for people who owned homes through the bubble and never refinanced, they never really made any money and they aren’t losing it now. Until they realize the change, its just a mind game.
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Ross @57: I find your comment odd, to say the least. If you have an identical product to one being purchased by the market at $x, how can you say that the current market value of your product is anything other than $x? If no one is willing to pay >$x, then it is not worth >$x. This is a fundamental (perhaps slightly simplified) meaning of “worth”. I don’t understand your comment that this market value is only an estimate of current market value (seems inherently contradictory). In this case, if the market is willing to purchase a car identical to yours for $2000 less than it did the day before, then your current wealth has fallen by $2000. If all your wealth is in gold, then your wealth would be measured by the current dollar value of that gold. This is not the only measurement of wealth, but it is what one would typically use, as it removes the complexity of measuring wealth in buying power (ie, attempting to account for inflation).
The only other value that is worth discussing is what you personally value the product at, which may or may not be $x. In this case, even if the market value of your car has fallen $2000, if you still value it the same then the personal valuation of your wealth has not changed.
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Ross @59: Again, I am struck by your comment. In fact your example is a great mental exercise to counter your argument. The very fact that one can refinance and “extract” more money out of their home without selling is exactly evidence that the value has increased. It is not a “mind game” but real change in value. If the value had not changed, banks would not be willing to lend money beyond the purchase price (illegal bank tricks aside).
Purchase price: $200,000
Loan: $180,000
Equity: $20,000
After two years:
Home value: $250,000
Original loan remaining: $170,000
Equity: $20,000 (down) + $10,000 (payments) + $50,000 (appreciation)
Refinanced loan: $225,000
Equity: $25,000
Cash out: $55,000
How do you explain this if the value did not actually increase? Are you suggesting that the refinance in itself CREATED value? The refinance is only a measure or an evidence of a change in value. A refinance cannot create value.
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I think there is some talking past one another going on here. The question is whether you made or lost “money”. Value is a much broader term.
The very fact that one can refinance and “extract” more money out of their home without selling is exactly evidence that the value has increased.
If a real estate appraiser puts a $400,000 valuation on your house one day and another appraisor says its only worht $350,000 have you lost $50,000? Or made $50,000? That is how the market sets value – it is an estimate and until you actually sell or buy, that is all it is.
How do you explain this if the value did not actually increase?
After your original purchase you own one home and owe the bank $180,000. After refinancing, you own the same home and owe the bank $225,000. You also have $55,000 in cash, including the additional $45,000 you have borrowed and the $10,000 you paid on the first loan.
Explain to me where the money you made is.
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If no one buys my goods at the market today, does that make them worthless? Of course not. Actual monetary value is determined when something is sold and that value realized, until then we use the market to estimate its likely value. But its a guess extrapolated from a very small sample.
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Ross @62: “Explain to me where the money you made is.”
Again, like I said in my original comment, this is evidence of increased asset value. Your math with the loan is a red herring. Take out financing altogether and assume that there was no original loan and the individual bought the home out outright prior to the $50,000 appreciation.
I don’t know why you are bringing up appraisals. Appraisals are an estimate of market value. It’s one guy or gal saying what he or she believes the market will pay for the asset. The answer to which estimate is correct is based on what the market would actually pay. This is akin to a small group in your company pricing a product to what it believes the market will pay. There IS AN EXACT MARKET VALUE at that very moment, and your estimation will either be correct or wrong.
Ross @63: If no one is willing you purchase your goods at the market today at any price, THEN THEY HAVE NO MARKET VALUE. If no one is willing to purchase your goods at the market today at the price you are selling, then your price is too high (see above about price vs market value). Again, this is not complicated. I’m not sure what the problem is here.
These are NOT estimates. The market determines the market value, and that can change on a day to day or minute to minute basis. It does not make sense to say the value of your asset has not changed if the market has changed its mind about the value of your asset.
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our math with the loan is a red herring. Take out financing altogether and assume that there was no original loan and the individual bought the home out outright prior to the $50,000 appreciation.
Its not a red herring, as your new example again demonstrates. To start with they owned a home. After taking out the loan they won the same home, they owe $50,000 on a loan and they have $50,000 in cash. Again, where is the “money” they made on the house?
The answer, of course, is that there isn’t any. Until they sell the house and realize a profit all they have is an estimate – a guess – about what the house will sell for. And, as many people have recently discovered, that is not the same as money in the bank.
if no one is willing you purchase your goods at the market today at any price, THEN THEY HAVE NO MARKET VALUE.
And presumably neither do the goods you didn’t offer for sale? It seems a bit bizarre to say that the tomatoes the farmer offered for sale, but failed to sell, are worthless. But the tomatoes he left in his storehouse are worth whatever other farmers sold their tomatoes for that same day.
The reality is that the tomatoes’ monetary value isn’t set until they are sold. Until then, you are extrapolating a value. Its just an educated guess about how much they might sell for.
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@Matt: I read the whole article and I think it’s terrific. That one sentence just rubs me the wrong way.
@Ross:
I don’t think anyone should believe it is inevitable that they will get the opportunity to sell at a higher price than they can today. But until they sell, they haven’t made or lost any money.
In the examples you use the company went out of business. They have no value – their shareholder’s losses have been realized. That is not a market estimate.
Only one of the companies in my example went out of business (Home Grocer). Both Lehman and WaMu still trade, as do the other two companies J.D. invested in. Therefore, shareholder’s losses have not been realized.
Your logic dictates that investors in these companies haven’t lost any money over the past 6 years.
The ‘real estate’ and ‘market goods’ examples are poor. They demonstrate effects of illiquid markets. Stocks, on the other hand, are generally very liquid.
If the investments in your retirement portfolio currently trade at 50% of your purchase price, it’s very dangerous to think that you haven’t lost any ‘money’ because you haven’t realized the losses.
One can’t pretend that they have not lost money simply because they haven’t made a transaction at the current market price.
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If the investments in your retirement portfolio currently trade at 50% of your purchase price, it’s very dangerous to think that you haven’t lost any ‘money’ because you haven’t realized the losses.
It is equally dangerous to think you have made “money” if you haven’t realized the gains. In both cases, you still own the same stock you bought and until you sell it you haven’t lost or made any money.
If you own Home Grocer stock, there are plenty of reasons other than the market estimate to wonder about how much value it has. When your house burns down you don’t need market comparables to know its worth less than what you paid for it.
Your logic dictates that investors in these companies haven’t lost any money over the past 6 years.
Where is the money they lost? The spent money to buy stock, they still own the stock. Until they sell it they don’t know how much money they have lost. The market is giving them an estimate – but that’s all it is. There are plenty of reason’s to think the current market does not provide a very good estimate.
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Ross, I think we’re disagreeing about what money is. Your contention seems rather academic and semantic, thus not very practical.
Would you agree with this statement:
When you buy 100 shares of stock at $50/share, you lose $5,000 of “money”.
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When you buy 100 shares of stock at $50/share, you lose $5,000 of “money”.
No – I don’t “lose” money at the grocery store. You spend money on stock, but stock is not the same as money in the bank.
Your contention seems rather academic and semantic, thus not very practical.
There is nothing academic about the consequences to people who they had made “money” on their house during the real estate bubble. Many of them spent that “money” on all sorts of things. Now they are discovering that money wasn’t theirs, it was just another loan like charging stuff on a credit card only at a lower interest rate.
The same is true for people who own stock. The consequences of the misconception that you make or lose “money” when the market goes up and down can be seen in the public debate over creating personal investment accounts as an alternative to Social Security. Just talk to someone who is having to cash out their stock for living expenses right now. It doesn’t matter how much the stock was worth a year ago.
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Just talk to someone who is having to cash out their stock for living expenses right now. It doesn’t matter how much the stock was worth a year ago.
By your definition, it doesn’t matter how much the stock was worth one tick before they sold, let alone last year. This person wouldn’t have lost any “money” until the instant they sold; no sooner. Until that very second, it was all on paper.
So would you argue that they shouldn’t have done anything like:
- reduce living expenses as their account value fell,
- planed to work longer,
- invested more money into their account,
- or engaged in any other behavior to react to their declining account value?
Please don’t address whether this person could do the above; that is not your argument. You claim they haven’t lost any “money”. Why should they change their behavior?
Before you take exception to the above, remember what you recommended those who made “money” on their house during the real estate bubble should have done: nothing. They shouldn’t have spent “money” they didn’t have. The same reasoning dictates that you shouldn’t concern yourself with “money” you haven’t lost.
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Let’s try to break this done once more.
If I purchase a widget for $10, then theoretically the widget and $10 are worth the same.
If a year later I sell the same widget for $15, then theoretically the widget and $15 are worth the same.
The sale did not cause a change in value. The change in value happened over the year in between transactions. The sale is simply evidence of that valuation change.
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This person wouldn’t have lost any “money” until the instant they sold; no sooner. Until that very second, it was all on paper.
That’s right. And if they didn’t sell, they haven’t lost any “money”.
The sale did not cause a change in value.
Of course it didn’t. But you certainly didn’t make any money until you sold it. And how much money you estimated you would receive three months earlier or three months later is irrelevant.
You claim they haven’t lost any “money”. Why should they change their behavior?
They shouldn’t. Isn’t that basically the argument being made for why people should stay in the market? Their behavior shouldn’t be based on what is happening to stock values. And that is the same reason people should move their assets into money as they get closer to needing to use it.
People who equated stock value with money are the ones making forced sales of stock right now. And if you are one of those people, then yes you need to change your behavior. But if you always treated stock values as estimates then, no, you shouldn’t have to change your behavior when stock values fall.
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“But you certainly didn’t make any money until you sold it.”
Ok, I think I finally understand what the problem is here. You are talking literally about dollars. Yes, you don’t make any “money” from gold appreciating 50% because the value is still in gold. But that is kind of a pointless distinction. If today I can buy 3 widgets with my 1 gold bar and tomorrow I can buy 5 widgets with my 1 gold bar, the 1 gold bar has increased in value. Have I made “money”? Well, no, if you are talking about dollar bills, because I have not decided to exchange my 1 gold bar for dollar bills. But I have certainly become more wealthy, (holding the value of a widget constant).
“And how much money you estimated you would receive three months earlier or three months later is irrelevant.”
It is not an estimate! It is a true change in value. I still do not understand the breakdown we’re having here. Does the above example that does not involve dollar bills clear up the point of estimate vs. true current market value??
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ut that is kind of a pointless distinction.
No it isn’t pointless. What is pointless is saying you made “money” because someone else paid more for a widget than you did. And its even more pointless to say you “lost money” because someone else paid less than that the next day. Whether you bought them with gold bars or dollars is not really relevant.
Perhaps the real question is whether we are talking about real money, or abstract points for keeping score.
It is a true change in value.
Its true value to you is whatever you ultimately sell it for, just like that farmer with his tomatoes. He doesn’t make money until they are sold. No matter how much other farmers got for their tomatoes.
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“What is pointless is saying you made “money” because someone else paid more for a widget than you did. And its even more pointless to say you “lost money” because someone else paid less than that the next day”
We are not talking about one person. We are talking about the market as a whole. We are also talking about a situation where the asset being valued is completely identical to those being bought and sold that day in the market.
This is just about the purest form of market valuation.
Thanks,
-Matt
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We are not talking about one person.
We are talking about a very small number of people who traded stock on that particular day.
We are also talking about a situation where the asset being valued is completely identical to those being bought and sold that day in the market.
With the emphasis on “that day”. Because the market almost certainly made a different estimate of their value yesterday and will again tomorrow.
Lets be clear, the issue is not whether market estimates have uses. They do. But confusing the values they set with money in the bank is not one of them.
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“Lets be clear, the issue is not whether market estimates have uses. They do. But confusing the values they set with money in the bank is not one of them.”
If you don’t get it by now, I don’t think you’re going to. Money is only a single representation of wealth. It too fluctuates in market value, like any other asset. It does not matter whether your wealth is in dollars, yen, gold, puppies, real estate, or cattle. The same wealth can be held in each asset, and the value of that wealth will change as asset valuations fluctuate with respect to each other. Individual transactions from one asset type to another is evidence, but not proof, of that asset’s true market value. The true market value is an averaging of “buy price” and “sell price” for an arbitrarily defined period for all individuals in the market for that asset.
The counterpoint to your argument is simply this: if you purchase asset A for $x and then tomorrow and forever no one is willing to purchase asset A for $x, then asset A has fallen in true market value. There is no estimation here and it does not matter if you ever sell asset A for less. Your wealth has decreased.
Similarly, if you hold all your wealth in dollars and those dollars fall in value by 50% due to inflation or other means, then your wealth has decreased. You do not have to wait until you exchange those dollars for another asset. You may not “know” the change in value, but that has nothing to do with the fact that there IS a new market value and it is different from the original.
For the benefit of everyone, I will stop trying to explain this to you now.
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For the benefit of everyone, I will stop trying to explain this to you now.
I will also stop trying. Perhaps Robert Shiller, the Yale economist of the Shiller-Case index, can do a better job:
“Robert Shiller, an economist at Yale, puts it bluntly: The notion that you lose a pile of money whenever the stock market tanks is a “fallacy.” He says the price of a stock has never been the same thing as money — it’s simply the “best guess” of what the stock is worth.
“It’s in people’s minds,” Shiller explains. “We’re just recording a measure of what people think the stock market is worth. What the people who are willing to trade today — who are very, very few people — are actually trading at. So we’re just extrapolating that and thinking, well, maybe that’s what everyone thinks it’s worth.”
Shiller uses the example of an appraiser who values a house at $350,000, a week after saying it was worth $400,000.
“In a sense, $50,000 just disappeared when he said that,” he said. “But it’s all in the mind.””
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Ross, your appeal to authority doesn’t make your statements true, no matter how many times you quote Schiller. It’s discouraging to see all of your arguments summed up in quotes he made this past Saturday.
You spend money on stock, but stock is not the same as money in the bank.
Exactly, and this is why – according to your logic – you lost money when you bought stock. When you trade money for stock, you lose an exact amount of money and gain stock. Then, when you sell, you gain or lose money.
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Ross, your appeal to authority doesn’t make your statements true,
Of course not. Nor does someone’s inability to understand a statement make it untrue. I thought maybe the Shiller quote would help clarify that this is hardly an idiosyncratic concept.
Exactly, and this is why – according to your logic – you lost money when you bought stock.
How is that my “logic”. If you spend money when you buy stock, you now own stock. You didn’t “lose” anything.
No one is suggesting the stock you buy is worthless any more than a house is worthless once you buy it. Or tomatoes in a warehouse for that matter. They have value, but they are not the same as money.
As, in the farmer who has tomatoes in his warehouse. One week tomatoes in the market are cheap, but he isn’t selling any. The next week they are expensive, but he still isn’t selling them. He doesn’t go home and say “Boy, I made a lot of money in the market this week.”
Instead, he understands that the only price that matters is the one he gets when he sells. That current market price only gives him a glimpse of what that price might be. And that tomato prices at the market may change several times before he is ready to sell his.
Warren Buffet quite famously buys stock in companies he thinks the market undervalues. In other words, he thinks the stock is worth more than the price the market estimates its worth. And he is usually right.
It’s discouraging to see all of your arguments summed up in quotes he made this past Saturday.
I am going to stop, since you obviously aren’t reading my arguments if you think that sums them up.
The fact is no one makes money when their home value increases unless they sell the home. The same is true of stock. And recognizing that is an important part of realistic financial planning. The folks who treated the market values of their home or stock as “money in the bank” are hurting.
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1 – Risk Tolerance. Understand your risk tolerance is great, but also understand that conservative investing will lead to conservative results in the long run.
2 – Diversification is good, until you are so diversified where you returns are not making what you want. A few goods ETFs may be your best choice.
Otherwise, look for investment growth in what you invest. Don’t just invest and assume. Also, learn to use market volatility indicators, like the VIX, to get out of you investments.
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How is that my “logic”. If you spend money when you buy stock, you now own stock. You didn’t “lose” anything.
No one is suggesting the stock you buy is worthless any more than a house is worthless once you buy it. Or tomatoes in a warehouse for that matter. They have value, but they are not the same as money.
I wasn’t suggesting anyone was suggesting the stock is worthless. I was just stating that stock isn’t the same as money in the bank; therefore, you have less money because you traded it for stock. You won’t know how much money you have until you sell the stock. I am not introducing new arguments here – I’m recapitulating yours.
You gave your own examples expanded on *why* it was dangerous to succomb to Schiller’s ‘fallacy’, but much of what you’ve written seems extrapolated from his quotes. Both you and Schiller wrote:
1) unrealized stock (or any asset) changes are not the same as money in the bank,
2) stock prices are estimates – sometimes poor – of companies’ (or any assets’) true value,
3) stock prices (or any asset prices) are set by very few traders (market participants) each day.
Additionally, you used Schiller’s exact house price example (aside from quoting it). I may have missed some of what you’ve said, but most of it seems to fall into those three categories and the sentence prior to the list.
I never claimed that stock values are *always* the same as money. Stocks and money/cash are obviously different, but that does not make true the implications of the saying “don’t worry about the loss, it’s only on paper”.
Also, as you would probably agree, it’s not prudent to view unrealized capital gains as increases wealth. However, I think it’s equally imprudent to ignore unrealized capital losses as decreases in wealth. This is mostly because having less money than expected tends to pose a larger problem than having more.
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Both you and Schiller wrote:
Here is my first post on the subject:
“As the Yale economist Robert Shiller has pointed out, stock values aren’t “money”. They are just guesses of the stock’s value based on what a very small group of people who are buying and selling today think the stock is worth at this moment. We extrapolate a value from that.
This is why, unlike money, stock value can just disappear and reappear.”
So if you are claiming some of my ideas come from Shiller, then you are merely restating the obvious since I attributed them to him from the start. So what?
I never claimed that stock values are *always* the same as money.
When do you think they are? And when do you think they aren’t?
It’s not prudent to view unrealized capital gains as increases wealth. However, I think it’s equally imprudent to ignore unrealized capital losses as decreases in wealth.
The reason we call them “unrealized” is because they aren’t “real”. If you have a 20 year horizon for investments and no intention of selling or buying, then the current market estimate has almost no meaning in terms of the price you are likely to get in 20 years. The market price is very likely to go up and down several times between now and then. About the only use a current market estimate has is to rebalance your portfolio.
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“If you have a 20 year horizon for investments and no intention of selling or buying, then the current market estimate has almost no meaning in terms of the price you are likely to get in 20 years.”
If that is what you have been trying to convey, you aren’t doing a very good job of it. If you had said that to begin with, I would have wholeheartedly agreed with you. Current valuation does NOT necessarily indicate what future valuation will be.
However, for you to take it a step further and say that the current valuation is the valuation at time of purchase and does not change until the asset is sold is misguided.
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you to take it a step further and say that the current valuation is the valuation at time of purchase
I didn’t say anything of the sort. You seem to be using “wealth”, “value”, “market valuation”, “current valuation” and “money” as if they are interchangeable. So I have no idea what you are actually talking about.
Let’s take a simple example. If you have a government bond with a maturity of 30 years and hold it for 30 years you know exactly how much money it will produce.
There is also a market in bonds and that bond will sell at different prices during those 30 years. Those prices are irrelevant to someone who is holding it to maturity.
You can’t say they “lost money” just because they can now buy the same bond for less than they paid for it. Or that they “made money” because they can sell it for a higher price. Just like our farmer with his tomatoes, you have to actually sell them to make any money.
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Ross, you have been talking about “money”, not me. I’m talking about the asset’s value. You seem very hung up on dollars. Dollars are just another asset with their own market value, which can and does fluctuate. When you exchange an asset for more dollars than you purchased it, you are not “making money.” The value of the asset has increased or the value of the dollar has decreased and you are engaging in a fair exchange between two assets. There is no increase or decrease in wealth during that transaction. That is the point I have been trying to make this whole time, and that is what I’m “talking about”, since you say I have been unclear.
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“Ross, you have been talking about “money”, not me.”
Here was your original comment that started this exchange:
“Again, I am struck by your comment. In fact your example is a great mental exercise to counter your argument. The very fact that one can refinance and “extract” more money out of their home without selling is exactly evidence that the value has increased. It is not a “mind game” but real change in value.”
A lot of people believed that fallacy and are now paying a heavy price for it because they pledged their home as collateral on a loan they can’t afford to pay back.
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Ross, I’m not sure where your confusion is. The issue with mortgages relates to banks intentionally overvaluing assets and lending loans to risky borrowers. What’s your point?
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That is a different subject. It has nothing to do with people who took out a loan on their house thinking the market estimate of its value was money in the bank.
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If you have the extra cash or risk tolerance like you mentioned, there are a lot of great values out there.
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JD’s article talks about “Investing in a Bear Market.” Considering the events of the last 3 months, perhaps the article is worth revisiting. The Dow fell from its peak of 14,279 on 10/11/2007 to 9,387 on 10/13/08 when JD posted the article. Yesterday (12/24/08), the Dow closed at 8468, down 5,811 points (40%) from its peak. Many GRS readers with long investment time horizons commented that they don’t care too much about market volatility and see the current market climate as an opportunity to buy.
Of course, the market could head lower from here. Is it possible that the stock US market could follow in the footsteps of the Japanese stock market which peaked nearly 20 years ago when their real estate bubble burst? Today the Japanese stock market is mired at just 20% of its peak. What if that was the scenario of the US stock market 20 years from now?
If you could choose between two slightly different investment strategies (Strategy 1 and Strategy 2 below), and you had to live with your choice from now through retirement, which of the following would you choose?
–Both strategies would invest in exactly the same funds.
–From a historical perspective, both strategies returned a compounded annual growth rate between 11%-12% over 35 years through the end of 2007.
–Strategy 1 requires you to simply buy and hold (or dollar cost average into) a pre-determined group of funds. You will do nothing other than to spend about 1 hour per year rebalancing your portfolio. Even though the compounded annual growth rate for Strategy 1 was 11%-12% over the 35 years ending in 2007, the individual yearly returns of Strategy 1 ranged between -12% (worst year) to +27% (best year). The maximum portfolio drawdown from peak-to-trough was 20% measured monthly during that period. However, in 2008, Strategy 1 lost 36% of its total value.
–Strategy 2 requires you to spend about 6.5 hours per year (an average of 30 minutes every 4 weeks) reviewing the performance of the same pre-determined funds used in Strategy 1. Sometimes you will buy or sell individual funds based on signals generated by an unemotional, purely mathematical model. For Strategy 2 the compounded annual growth rate was 11%-12% over the 35 years ending in 2007, but the individual yearly returns of Strategy 2 ranged between +1% (worst year) to +26% (best year). The maximum portfolio drawdown from peak-to-trough was 10%. In 2008, Strategy 2 lost 1% of its total value.
Which strategy would you choose going forward?
Whether you are in a bull or a bear market, pick an investment strategy with risk characteristics that work for you. Follow the strategy without fail.
Paul at http://www.sageinvestmentstrategies.com
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“Sometimes you will buy or sell individual funds based on signals generated by an unemotional, purely mathematical model.”
No such thing exists. The calculations may be unemotional but the decisions of what calculations go into the model aren’t.
Mathematical models that “predict” past stock performance are a dime a dozen. They are mostly just fancy ways to time the market based on some “objective” past performance. While every prospectus reminds people that past performance is no guarantee of future performance, most of us never really take that reality to heart.
2) Most of us are only rarely in “buy and hold” mode. With our retirement savings, we are either continuously buying prior to retirement or continuously selling after retirement. We do cost-averaging out of necessity, if not by design. The exception is if we get a windfall from somewhere.
3) The only real question for people who have their money in a balanced portfolio, is when to rebalance. At that point, you are going to be taking money out of cash and bonds and buying stock. But low, sell high, keep it simple.
Of course, “deciding” when to rebalance, rather than doing it on a regular schedule is still trying to time the market.
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Hi Ross,
Thanks for your thoughtful comments. I appreciate your point of view.
In my earlier experiences as a modeler, I sometimes found it an emotional challenge to follow my SISTM (Sage Investment Strategies Timing Model) without question. Sometimes the model would tell me to do one thing while my emotions tugged at me to do something else which might have seemed more logical at the time. Whenever I allowed my emotions to get the best of me and did not follow one of the signals, the SISTM almost always proved to be right.
Over time I gained complete confidence in my SISTM and disciplined myself to follow its signals. That confidence and self-discipline kept me out of trouble in 2008. I’m 60 years old and can’t afford to lose a big chunk of my portfolio as I did during the 2000-2003 bear market before becoming a modeler. I designed my SISTM to optimize both nominal and risk-adjusted returns. I measure standard deviation, Sharpe Ratio and peak-to-trough drawdown and compare them with key benchmarks as well as a buy-and-hold portfolio.
Looking back at 2008, one of the most the most difficult and tumultuous periods in financial markets in the last 80 years, I’m very pleased with the performance of my SISTM. From 2007 onward, I invested 100% of my own, my wife’s and my mother’s money using the “buy” and “sell” signals that my SISTM generated. The results which I update weekly on my website speak for themselves.
Paul
http://www.sageinvestmentstrategies.com
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