Fact finding and soul searching in a bear market: investors have found their real risk tolerance in the last 930 days

Money Digest, Oct, 2002 by Chris Cahill

It is most interesting to observe how the media enjoys the drama of bear markets. Editors and television producers seem to deliver the most negative news, hoping to keep you glued to their medium, and thereby increasing their advertising revenue. As an example, a top headline in The Globe and Mail's business section on August 3, 2002 reported "Investors flee mutual funds yanking $1.1B in July." The article under the headline did mention that most of the money came from money market funds, and, in fact, only 10% came from equity funds. However, the article was remiss in pointing out that $1.1 billion represents 0.25% (that's one quarter of 1%) of the $400 billion invested in funds. But if you read only the headline, you think investors were feeling the markets en masse. It is not a crime for the media to be dramatic, but you, as an investor, should obtain balanced information. It is helpful to know that the media has a negative bias and many journalists add a little drama.

The futility of market timing

During the last four days of July, we witnessed the largest surge in the Dow since 1933. This 10% rise could not be timed, which is why we suggest that market timing is futile. I know you have heard this before, but just to review the statistics: The S&P averaged 15% from 1982 to 2001, but if you missed the best 50 days, you earned 5.4%.

If you missed the best 20 days, you earned 10%. Market timing just doesn't work! This advice may sound hollow, with the indexes down almost 45% since March 2000, but according to history, markets do recover.

People who bail out and wait for the markets to recover miss the most powerful days. It's a constant "come to the party late" syndrome. It's technology after the fact. It's real estate after the fact. It's getting into bonds now.

Investor risk tolerance has changed

We are all re-calibrating our expectations; it's safe to say that the risk tolerance of most investors has changed. After the long 1990s bull market, everyone was lulled into believing their investments would go straight up. People who used to say, "I don't mind taking some risk", have changed their attitudes. We had no idea what risk we had undertaken until terrorists and corporate greed got a hold of us during the last 12 months. Most of us have discovered our risk tolerance is not as strong as we thought.

The events of 2002 have had a huge impact! This is the longest bear market we've had in three decades. The 1973 bear market was 693 days; we are currently heading to 935 days. This is the deepest bear market on the Dow, currently at -34%, since 1973-to-1974, which was -45%.

The merits of a diversified portfolio

If we can locate any good news, it is that your portfolio is probably holding up well, due to good money managers and the anchoring effect of bonds. In fact, mutual funds have done a wonderful job of protecting client money in the environment of the S&P/TSX Composite and S&P 500 being down almost 45% from the highs of 2000. Even this year the indexes are off 20%. That is grim news, but the largest funds have done a good job. Ivy Canadian and Trimark Canadian are up 4% in the past 12 months. The average small cap fund is up 5%.

So, the big question is...do you remix when equities are down? By making a move at this time, you may satisfy your jittery mood, but could miss the upside. If you are losing sleep about your portfolio, it may be reasonable to add more bond content and accept the trade-off of missing a recovery. No one knows when the recovery will happen. If you can sleep, or you have a longer time horizon, and a risk tolerance made of steel, this may be a reasonable time to add more to your equities. We have all found our real risk tolerance in the last 930 days.

What can we learn from this experience? First, more bad laundry is coming down the chute. Second, don't watch TV; they love the drama. Warren Buffett said in 1987: "An investor will succeed by coupling good business judgment with an ability to insulate his/her thoughts and behaviour from the super-contagious emotions that swirl about the marketplace." This was true 15 years ago, before the proliferation of news channels and the Internet. It still holds true today. Third, acting on rational disciplines and being diversified by asset class, management styles, and region will allow you to weather the toughest storms.

Chris Cahill, B.A., C.F.P., C.L.U., Ch.F.C., is President of Financial Strategies Group, a broadcaster, a weekly columnist and co-author of Harvesting Your Wealth. Phone: (519) 438-3308; fax: (519) 438-7424; e-mail: cahill@cjcahill.com.