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We've Lost Some Money -- Now What? By Stephen J. Butler

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I was shopping at the local Safeway a few weeks ago when a former participant in a client company's 401(k) plan approached me. This single mother declared that she had moved all of her retirement money out of stocks and into a money market fund. She couldn't tolerate the uncertainty about what would happen next with the stock market. 

I'm not sure what kind of response she was expecting, so I mumbled something soothing and resumed my journey through Safeway's produce section.

On the drive home, however, I got to thinking: To what extent is this woman's sentiment reflected across the country?  Is getting out of stocks a sensible response to the volatility in today's markets?  

Richard Thaler, an economist who popularized the concept of behavioral economics, shocked a Stanford audience not long ago by proposing that investors should be barred from viewing investment results any more often than once every five years. On the other extreme, many investors are re-calculating net worths throughout the trading day, either on CNBC or over the Internet.

Somewhere in the middle lies the right response. What we experienced in the year 2000 was the bursting of a bubble.  NASDAQ, a collection of newer companies, experienced a wonderful run-up in values that ended with a thud in April. Comparing this speculative burst to Holland's tulip bulb mania of the 1600's was, as one financial wag put it, "paying a disservice to the flowers." 

How else could you describe a situation where the price/earnings (P/E) ratio of the 100 largest NASDAQ-listed companies soared to over 800:1? In contrast, P/E ratios for the rest of the market are about 30:1.

Unfortunately, those of us wanting to invest conservatively in mutual funds, such as an S&P 500 index fund, have also been hurt, as volatile Internet companies such as Yahoo infiltrated this roster of the largest companies. This explains, in part, why even the giant index funds were off 10% for the year.

So now what do we do? 

First, we need to appreciate reality: it is impossible to remove uncertainty from our lives.  There is a powerful tendency to adopt what is termed "representation," which says that what is happening presently is an indication of what will happen in the future. When the stock market booms, our natural inclination is to assume that the boom will continue indefinitely, so we make decisions accordingly. When real estate booms, we say things like, "They're not making any more land, so the prices will always go up." 

For those of us hoping to apply more rational thinking, we have World War II to thank. After Pearl Harbor, the U.S. Department of Statistics was brought out of hibernation and used for the first time by Army generals trying to determine the probability of success versus the cost in lives for bombing runs over Europe. 

"Tex" Thornton, who later founded Litton Industries, became the youngest colonel in Armed Services history, as his command of statistics contributed to major wartime decisions.  He was later joined by Robert McNamara. They became the "Whiz Kids" whose introduction of computer modeling saved the Ford Motor Company in the post-WWII years. (McNamara's brilliant reputation was sullied during the Vietnam War, but that's another story.)

Statistics as a predictive tool has become a bigger factor in investment decision-making in the past fifteen years. By comparison, over its first two hundred years, the American stock market was a mystery to investors.  "The Behavior of Crowds" was a book that attempted to explain the inevitable ups and downs. 

Now, the measure of an investment's volatility, whether a single stock or a mutual fund, offers us some measure of how that investment will perform in the future.  Modern statistics tells us that the stock market has a 68% chance of dropping (or rising) by as much as 19% in a year and only a 5% chance of dropping (or rising) by 40%.  Statistics like these are not pat answers, but they spell out guidelines we can live with.  

Statistics, then, can teach us what to expect. Stanford's William Sharpe refined the concept of Standard Deviation, which offers a measurement of how much we can expect our stocks or mutual funds will go up or down in value.  His web site, www.financialengines.com, enables us to plug in our actual mix of current investments and generate a Standard Deviation analysis for only $14.99.

With powerful tools available to tell us what the future MAY bring, how do we incorporate the knowledge into action steps? 

We can start by asking ourselves how important the money is.  We have some amount of money that is absolutely critical to our future well-being.  Studies show that people are much more risk averse with money that is important than they are with less important money. 

Less important money falls at the two ends of the scale.  We may risk a small amount of money on an evening of gambling (which we categorize as entertainment), or we may subject money to risk that is at the far end of the spectrum beyond what we need for a comfortable retirement.  This latter category is best described by that wonderful bumper sticker seen on campers, "We're spending our kids' inheritance." 

People are inclined to take more risk when they have more money. Daniel Bernoulli, an eighteenth-century mathematician, determined that the amount of risk people take is directly related to the amount of money they already have.  Believe it or not, this was a big breakthrough in the concept of understanding risk. 

How do the rich get richer?  Facts support the notion that accepting more risk and wider swings of positive and negative returns will generate a higher average return over time.  The stock market earning 10% versus money market funds averaging 4% is the simplest example.

Bill Sharpe went one step further.  His studies determined that it was not necessarily the amount of wealth that determined acceptance of risk; but rather, it was the change in wealth.  Regardless of how much someone has, losing money makes them less inclined to subject capital to risk.  Making money on some good investments whets the appetite for taking more risk.

The past year's market offers a perfect laboratory for exploring our feelings about risk and investing. As a therapist would say, "Let's look at that." When buffeted by the combined forces of markets and emotions, we should remain mindful of The Big Picture.  

(Next week's column will continue this discussion.  I'll describe how you can create your own personal Big Picture - and in the process, you'll learn to love the dismal year 2000.)   

The securities markets are subject to the risks of fluctuating prices and the uncertainty of rates of return and yields inherent in investing.  Past performance is no guarantee of future results.

BUYandHOLD does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular security, portfolio of securities, transaction or investment strategy. Any investment decisions you make will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy and past performance is no guarantee of future results.