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What do We See When Peering Into the Abyss By Stephen J. Butler

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The calamities of September 11 continue to unfold as we watch bond and equity markets adjust to the traumas. Are we peering into the abyss, or is there a basis for some optimism?

We can illustrate with graphs how the equity markets have responded to past major world crises. Pearl Harbor, the Cuban Missile Crisis, and the previous World Trade Center bombing were examples of major events that impacted markets over the past fifty years. It is reassuring to see how quickly the markets responded positively after major setbacks.

Joe Duran of Centurion Capital Management offered another analysis. His list included 28 major crises beginning with World War II, and the total recovery of initial losses within just 126 days is almost universal. Pearl Harbor represented one of the most severe downturns - yet even after that event, the market's recovery period was less than one year.

The market's declines of last week indicate that many people are abandoning equities. Does this make sense in the light of what we have seen after previous world crises? Probably not, if statistics mean anything.

Many sellers are convinced that they will re-enter the market as soon as it reaches bottom and starts the next upward march. Unfortunately, the markets easily frustrate this line of thinking. Major upward movements occur in very short bursts.

How short are those bursts? According to ING Aetna and Standard & Poor's the five-year average annual returns for the market ending in February 2001 were 15.7%. If you were out of the market on the ten best days of that period, your return drops to 6.5%. Missing the 20 best days drops you to 0.27%, and the 30-day figure brings you to a minus 4.7% average annual loss.

Most people trying to time the market jump in after one of those amazing one-day upward bursts and then lose patience and leave before the next burst. Similarly, Morningstar estimates that while the market was up 18% per year through the 90s, the average mutual fund investor earned only 3%. Bailing out of stocks and moving to cash is easy. It feels good to get relief from uncertainty. Professional money managers tell us that many of their clients hit a psychological wall at a loss of 30% and just throw in the towel at that point. A twenty percent loss is somehow manageable, but 30% requires a new level of intestinal fortitude. For those who succumb and cash out, the hardest part will be getting back in.

We all know that we will never meet long-term retirement goals if we stay in money markets indefinitely. Most people trying to get "back on the train" experience far more anguish than they did when they were losing sleep over their exposure to stocks.

If you are agonizing over what investment decisions to make right now, I suggest that you read the book "Why Smart People Make Big Money Mistakes" by Gary Belsky and Thomas Gilovich. It will help you understand the errors our investment minds can make under severe pressure. Reading this book on behavioral finance (also known as behavioral economics) would be far more productive than hovering in front of a television watching CNN and trying to second-guess when the next shoe will drop.

One of the key tenets of behavioral finance is that some money is more valuable to us than other money. The best illustration is the book's account of the newly-wed husband in Las Vegas who can't sleep and who goes downstairs to play the roulette wheel. Starting with $5.00 he winds up letting a number ride until he is up several million dollars. Continuing with the same number, he loses everything with one spin. When his sleepy bride asks how he did, he says, "Not bad. I only lost $5.00."

In a similar vein, $1,000 in the stock market in 1990 accumulated to almost $6,500 by the end of 1999 (based on the S&P 500 index). Since then, it has dropped to about $4,300 as of this week. We are a long way from having lost our $1,000. As badly as the market has treated us in recent months, we remain the beneficiaries of one of the financial world's most powerful tools for creating wealth. Why would we want to throw the baby out with the bath water? Retreating from the market today and struggling to return at a later date will prove to be a bad choice for all but the most traumatized.

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