As we enter 2013, I thought it would be interesting to take a look back at 2012 and see what lessons could be learned from all the market noise that permeated our collective psyche during the year with hopes of making us better investors.
Over most of 2012, our attention was focused on several major events or issues, including:
- The presidential election;
- The fiscal cliff;
- Our growing fiscal deficits and our ability to fund them;
- The increased possibility of rising inflation caused by fiscal stimulus (government spending) and the Federal Reserve's monetary stimulus (low interest rates and quantitative easing);
- The European fiscal crises, potential for sovereign defaults and breakup of the eurozone;
- Slowing growth in China and other developing countries.
These events made for a worrisome year; yet despite all these crises, the markets had one of their best years ever with the Dow, S&P and Nasdaq all up by double digits.
So what are the takeaways from last year?
Takeaway 1: Make sure your investment plan incorporates the virtual certainty that crises will occur and will do so with great frequency. Each time a crisis or potential crisis develops, the markets have tremendous volatility, generally to the downside. We know that the fear created by crisis causes us to lose perspective and perhaps sell after the drop, which generally is the worst thing to do. That is why it is important not to take more risk than you have the ability, willingness and need to. If you keep your risk to the level you need to accomplish your goals, you are less likely to let fear and panic and the noise of the markets cause you to abandon your plan.
Once you sell, how do you know when it is safe to go back in the water?
Takeaway 2: Practice what is called Stage 2 thinking. Stage 1 thinking is to see a crisis and the risks but be unable to see beyond today's news; this thinking leads to asset sales after the market has gone down, because investors assume the markets will continue to go lower. They assume the light at the end of the tunnel is a train heading straight for them. Stage 2 thinking is to look beyond the crisis. It is to ask, "What is likely to happen after the crisis?" While there is no certainty, we should expect that a crisis will lead governments and central banks to come up with solutions to address the problem. If the problem worsens, they will be more likely to act with urgency and scale. We saw this in connection with the last-minute avoidance of the fiscal cliff and the mitigation of the eurozone problem.
Takeaway 3: The winners of 2011 are just as likely to be 2012 dogs as they are to be winners again. The historic evidence shows that Americans like to invest in winners. They watch yesterday's winners and buy them after their great performance; they sell investments that have performed poorly, after the losses have occurred. The effect is that they buy high and sell low, which is not a recipe anyone should be following.
If you have been reading my columns, you know I am a big believer in passive investing, using index funds rather than hiring managers to pick stocks. One of the investments I use is Dimensional Fund Advisors. The two best-performing asset class funds of 2011, Real Estate and Large Cap, finished only ninth and 13th in 2012, and the two worst-performing funds in 2011, Emerging Markets Value and Emerging Markets Small, finished sixth and second. Chasing performance is a loser's game.
Takeaway 4: The economy and the stock market are very different. It would be very difficult to categorize our economy as strong; growth is anemic, and unemployment remains high. Despite this, our stock markets continue to advance. Why is this? In part it is because the results were better than expected. We didn't fall back into recession, and we continued to create jobs.
So even with all the bad news, the markets performed very well. Yet many investors did not participate in the rise. We know this because funds continued to flow out of the market in 2012 into perceived safer investments like bonds and certificates of deposit. Last year continued the trend starting in 2008, when we had the banking crisis. But as I write this article, the market has more than doubled since its 2008 lows.
Perhaps the most notable takeaway this year would be to ignore economic and market forecasters, as well as the noise. No one knows where the market is going, although there is no shortage of opinions. My advice is to develop a plan based on how much risk you need to take, and stick with it. Listening to all the noise causes you to react emotionally, which generally is detrimental to your financial health.
Since this is my first article of 2013, I would like to wish you a happy new year. Here's hoping that January's returns (6 percent) will continue, but who knows for sure? The answer is nobody.
Frank A. Insero is the CEO of Insero and Co. CPAs and Insero Wealth Strategies, a registered investment advisory firm. He can be reached at (585) 454-6996 or email@example.com.
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