On April 9 2009, under enormous pressure from the banking community and politicians, the Financial Accounting Standards Board (FASB) issued Statement No. 157 to relax the “mark to market” asset valuation rules that have plagued financial institutions by requiring them to value residential mortgage assets at extremely low prices reflecting the worst credit crisis in history. Now after hundreds of billions of dollars in “toxic assets” have been written off, the world’s investors and financial institutions are breathing a collective sigh of relief in the hope that more banks won’t fail.
Against this improved outlook for banks, markets around the world have been rallying, but before celebrating, advisors should look carefully at the underpinnings of the market’s rally. Bull market rallies can only maintain momentum if they are supported by growth in corporate revenue and profit. But it may be a long time before renewed economic activity repairs the damage done to business capital structures and consumer confidence.
The basic tenet of successful investing is to buy low and sell high. Today, investors see the serious flaws in investment management based on the passive, buy-and-hold approach favored by traditional investment managers. For the last 30 years, investment pros have told investors that they will find a high return through investing in a diversified basket of growth stocks and to ignore short-term risk to losing money. That changed in 2000, as the second-worst bear market in history brought a prolonged time of poor returns and huge losses. The practice of buy and hold arose from a belief that an investor can’t time the market. The theory is that investors can’t avoid the down days without missing the few powerful up days that provide most of the return. Investors have accepted market volatility because stocks have been the only financial assets to provide a return that has outpaced inflation.
The problem is that investors don’t buy and hold: faced with a decline of half of their portfolio, they sell to conserve their remaining money. In theory, market returns will recover a portfolio, so investors need not worry themselves about short-term losses. The reality is that if an investor loses enough capital, she may never recover.
Diversification Doesn’t Suffice