Monday, May 7, 2007

The Crash(s) are coming! What should you do about it?

Thanks to all those who participated in the comments and discussion on my last post. After reviewing the article and comments, as well as email and discussions with friends, I think is is worthwhile to summarize the conclusions and take a look at what you can do today to take advantage of what the future holds.

First, the summary.:

  • Boomers have had a significant effect on markets of all types and it is reasonable to expect that to continue as the bulge makes its way through retirement. This may well include underperformance by the stock market and other investments, but it seems likely to tighten the US labor market and present greater opportunities for those in it.
  • Markets rise and fall, and it is reasonable to expect that to continue. Included in this assessment are markets of all kinds, from stocks and bonds to real estate and commodities. Booms and crashes alike are regularly fueled by imbalances. The only questions are severity, duration, timing, rotation and what we should do about them.
  • Leverage can increase returns, but it also increases risk. In boom times it can create outstanding performance. In crashes it can be disastrous.

I know most of the above is pretty obvious, but it is amazing how often these facts and their results are ignored or obscured by those selling various schemes. For more details than shown in the summary above, please check out my previous post and comments. More important than understanding the above facts is understanding what you should and should not do about them. That is where I really want to take the discussion.

It is very tempting to conclude, based on the above, that the way to invest is to ride each boom to its crest and them jump to the next booming market, repeating this process as markets rotate. And, in fact, if you could do this consistently it would be the route to quick riches. Unfortunately, this process looks simple in hindsight, but is virtually impossible to maintain in real time. There are a number of reasons for this, but I think the key reason is that it is very difficult emotionally to jump ship as a market is hitting new highs, or to climb on as a market is near a bottom. It is human nature to believe that recent history will be repeated. If a market is up dramatically this year, it is almost impossible to believe it will reverse tomorrow. If a market is down dramatically it is almost impossible to find the courage to buy. Worse, most of the experts will reinforce this natural inclination. When markets are cresting, most of the media coverage will be euphoric, when markets are down the media will be negative.

I mention above that getting into booming markets early is easy in hindsight, and most sales pitches take advantage of this phenomenan. They look back in history, see what is obvious from this vantage point and paint a picture of what was possible based on this "obvious" insight. Then, they convince you they have the insight to repeat the process. After many years of observation, it has become obvious to me that they rarely, if ever, do. Trying to find the gold in this haystack is like going to the might get lucky now and then, but over time you will almost certainly lose.

So, what can you do to take advantage of the obvious facts? There are some proven tactics, which, while they won't make you rich quickly, will help you perform better than most, and will help you become financially independent over your life time. Here's what you need to know to get there.

  • Smile and take with a grain of salt what you see in the media and from get-rich-quick artists about the best investment today.
  • Use leverage only rarely and puts you into the casino realm. You want to be in the long term financial success realm.
  • Invest broadly in an asset allocation that reflects your timing and risk tolerance. In light of the baby boom phenomenan, I believe more than ever, this includes significant international exposure
  • Add to your investments and rebalance regularly. In so doing, you will, in affect jump from the crests to the bottoms. But, again, in a way that keeps you out of the casino realm and on the track to long term success. This method allows you to take advantage of the above facts, while reducing risk. And, it satisfies the emotional need to do something in the time of booms or busts, while taking the emotion and the need for brilliant decisions out of the jumping process.

Based on my experience, the simple steps above are what is necessary to profit from the booms and busts that are surely coming. If you need help with the details of how you go about executing these steps, you'll find it in my previous posts, or you can post a comment or question. The expertise is out there reading and ready. I'm also open to alternative approaches. Let the discussion begin!

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