The first Capital Gains article was about the term FUD – for Fear, Uncertainty and Doubt. However, the new term of the day is Fearmongering. Fearmongering is the use of fear to influence the opinions and actions of others towards some specific end. Often times the feared object or subject is exaggerated and the pattern is repetitious. The outcome often times becomes a vicious cycle.

The seed of fear is the excess of recent years – whether on Wall Street, in real estate, or in consumer credit. The bill presented in 2008 and the first part of 2009 was far larger than the darkest pessimists expected.

The inherent turbulence on Wall Street is being fanned by so many who have turned fearmongering into an art form. Unfortunately, we can’t avoid loss simply by avoiding the object of our fear – Wall Street. We have to apply simple main street principles to our investment process.

Three Big Questions

There have been worse times for investors. But not many: You can count more dismal periods on a few fingers. If we politely measure by whole years, 2008 produced a 37 percent declines for large cap domestic stocks. If we measure from October 2007 peak to what we hope was the March 2009 bottom, large cap stocks fell more than 55 percent. However, you slice it, we’ve just experienced one of the worst stock markets in history.

So it’s not surprising that we’ve all got questions.

  • “Should I sell and wait this one out?”
  • “Have I taken too much risk?”
  • “Did anyone know it was going to get this bad?”

The answer to the first question is easy to say, but harder to do. This is not the time to be in cash. The last thing you want to be is a late-blooming market timer. That’s what going to cash amounts to if you do it today. It’s also helpful to consider how stocks have performed after other major declines. Toughing it out was a good thing in the past. We expect it will be a good thing in the future.

The best example we can think of it the 1973-1974 market crash that followed the OPEC embargo and oil price increase. Many thought it was the end of Western civilization. At the market low, the New York Times calculated that Saudi Arabia could buy the entire U.S. stock market in only a few years with their ever-growing horde of petro-dollars.

That didn’t happen.

Instead, large domestic stocks returned 325 percent over the following years. Few noticed this, however, because many people were selling. Equity mutual funds, for instance, were in net redemption until the early 1980s. This means millions of investors didn’t get to participate in the recovery. Stand pat and you’ll participate in this recovery.

The answer to the second question requires some understanding of how the market has changed. At AssetBuilder we measure risk by volatility – the amount of price movement in an asset class or portfolio as measured by standard deviation. Most of our sense of risk has been conditioned by periods of much lower market volatility. Typically, for instance, only one day in five sees market moves of 1 percent or more. Only one day in 25 sees market moves of 2 percent or more. And only one day in a hundred sees market moves of 3 percent or more.

But last year, every other day saw a move of 1 percent or more. One day in three saw market moves of 3 percent or more. January saw more of the same. The prospect is for this new level of price volatility to continue for some time. It’s a bit like thinking we were good for the junior roller coaster but found ourselves on the monster roller coaster.

The answer to the third question is problematic. Few subjects have received more ink than the incredible boom in residential real estate prices and how easy it was to borrow money. When mortgages are called “liar loans” or nicknamed “NINJAs” (for no income, no job, and no assets) you’ve got to have a clue about future foreclosures. There was even some attention to the growing volume of obscure derivatives, although it was limited to publications like Barron’s and an occasional comment in the Wall Street Journal.

But while there was broad expectation that the party would end and losses would be suffered, we can’t recall a single analyst who expected we would have a financial implosion that would virtually wipe out the equity of the entire domestic financial system. And that’s what we’re dealing with.

Recovering from a Financial Collapse

Now that we know this, we may also have a better idea of what’s coming our way in 2009 and later. Research on earlier financial wipe-outs tells us that we won’t have a V-shaped recovery. It tells us that recovery will be long and slow relative to the recoveries we’ve experienced from the run-of-the-mill economic cycles. So we’ll have to expect a lot of public-handwringing, fearmongering, and disappointment over the next two years. We believe this works well for the basic value-tilt of our AssetBuilder Model Portfolios.

A Very Important Question

The question we ask ourselves every day. Do we have the right investment strategy? Are the models performing the way we expected them to?

Our basic premise has always been very simple. Take Couch Potato investing to the next level. Do index investing. Provide the broadest diversification possible. Add value by building risk-efficient portfolios. Do our best to earn a higher return for any given level of risk. Give Investors a choice of risk level. And charge as though we were providing a humble service like laundry folding or dry-cleaning rather than acting like we have the only crystal ball in town.

Back-testing showed that we were on to something. It appeared that we had a very good shot at providing a higher return for any given level of risk. It made us confident that we were on track to do something rare in financial services – add real value for what we charged.

We still believe that is the case. And there is evidence to prove it, if you can get past the fact that we’ve lost money like everyone else.