The national economy versus your personal economy
Yesterday I attended the mid-winter conference of the local financial planning association. I listened to various speakers talk about the economy and how it relates to personal finance.
One of the presenters was John Mitchell, a local financial guru, who spoke about the current economic climate in the state, the nation, and the world. Mitchell's presentation was outstanding — I wish I had recorded it. He argues that this country has encountered similar problems before, and has always overcome them. He's confident we'll overcome this one, too, but it's going to be painful, and it might take a long time.
Mitchell says that the current recession is a “generation-changing moment”. Events like The Great Depression, Pearl Harbor, 9/11 — and the current economic crisis — fundamentally change the way people act and behave. He cited his own father, who was a teenager during The Great Depression. “For him, high-risk investment was a passbook account,” Mitchell joked. Because he had seen the bank failures of the 1930s, he was leery of even a basic savings account.
The current economic crisis will create the same sort of scars. Mitchell noted that it used to be when somebody moved to a new city and planned to stay a couple of years, they bought a house, confident that they could sell it later for more than the purchase price. Not anymore. Now when somebody intends to stay someplace for a short time, they're reluctant to consider a home purchase.
Mitchell seems to think that economic calm lulled us into complacency. “When there are only 16 months of recession in 25 years, what assumptions do you make?” he asked the audience. People become accustomed to unending growth. Their risk tolerances relax. They make choices that don't mesh with history, because the only history they see is recent history. Now risk tolerances are swinging the other way. People are panicking because, again, they're only looking at recent history.
In fact, some investors have rushed to abandon the stock market. This reminds me of a comment that NickK left here last autumn:
I'm in the [financial] industry…I can tell you now that when the markets tanked during October, people with less than (approximately) 100k behaved significantly different from investors with 100k+ in the market. Also, people who did not have an emergency fund behaved significantly different than those who did, generally to their own detriment.
These actions lead me to believe that people with substantial assets tend to ride out the market and not worry about short-term fluctuations, whereas people with smaller amounts of assets lock in losses by removing assets from the market at poor times. Then, when/if they get back in, they've missed out on several days of big gains…
As it was happening I was shocked by the clear income demarcation that seemed to separate rational behavior from irrational behavior. Do small investors make behavioral mistakes that keep them from becoming wealthy?
I've read a lot of commentary lately about how the stock market is a sucker's game, and that the wealthy just want you to buy in for their own ends. Here's an alternate proposition: Maybe the wealthy recommend buying into the market because that's what has worked for them in the past. And maybe they're wealthy because they're willing to take risks when others won't. (Note that I'm not saying that you should put all of your savings into the market. I'm asking you to think about the current situation with some historical perspective.)
Another speaker at the financial planning conference was a woman named Kevin from the Oregon Division of Finance and Corporate Securities. Similar to NickK above, Kevin observed that a lot of people have been calling financial advisers and asking them to move 100% of their portfolio to cash. Kevin cautioned advisers against this.
“Advisers are not order-takers,” Kevin said. “You have a fiduciary responsibility. If, as an investment adviser, you think this is foolish, it's your job to resist. You may even have to fire the client.” The implication — and the sentiment in the room — seemed to be that it doesn't make sense to move to a 100% cash position.
As in any economic climate, it's important to understand risk tolerance, asset allocation, and diversification. Remember: On the whole, diversification decreases risk while increasing returns.
I've written before about why it pays to ignore financial news. The media is in the business of selling news, and to do that, they sensationalize it. “Irrational exuberance has become pervasive gloom,” John Mitchell said at the end of his presentation. Neither state of mind makes sense. They're both extremes that lead investors to make poor decisions.
When you pay too much attention to national or international economic news, you can find yourself making decisions that don't make sense for your personal economy. Three years ago when the housing bubble was in full swing and credit was flowing freely, many people bought into the idea that quick profits could be made from real estate. Now some of them — including my own brother — are facing foreclosure. That media-fueled frenzy has turned into media-fueled despair. If you didn't give in before, don't give in now.
It's my by belief that a strong personal economy is still built on fundamentals such as these:
- Clear financial goals
- An adequate emergency fund
- Limited use of debt
- The practice of thrift
- Smart investing for the future
The national economic situation does affect our personal financial decisions to some degree. When unemployment soars, it's important to maintain an adequate emergency fund and to limit your use of debt. When the stock market is down, you need to understand your investment objectives, and how these relate to your risk tolerance and your investment timeline.
The foundation of a strong personal economy is education. To become a wise investor, you must be an educated investor. And you must recognize what you can and cannot control. The national (and global) economy affects your personal economy, but ultimately all you can control are your personal finances.
If you need more information on investing, go to your public library and borrow The Random Walk Guide to Investing [my review] or The Four Pillars of Investing [my review]. The Oregon Division of Finance and Corporate Securities features some excellent free publications for download, including The Basics of Wise Investing [PDF]. Read up on the subject, seek a professional adviser, and make your decisions from a position of knowledge and strength, not from a position of fear.