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Don't Just Do Something, Stand There!

A Special Report by Ric Edelman

July 2008

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Every week for the past four months, as my advisors and I have gathered for our regular meeting, we’ve asked ourselves: Is it time to provide an analysis to our clients to update them on the status of the financial world?

And every week for the past four months, we’ve agreed not to. There’s nothing to say, we agreed, that they don’t already know. Food and oil prices are rising, the housing market is in a slump, interest rates are no longer falling and the economy is sluggish. Everyone knows all that.

What people don’t know, of course, is what’s going to happen next in the stock market, and we’ve hesitated in providing a market update because the stock market has been so volatile -- rising hundreds of points one day and falling hundreds the next -- that anything we write will be out of date by the time anyone reads it. So, we resisted issuing an update.

Until now, that is. As recently as July 1, my colleagues and I were opposed to the idea of this report. But when we posed the question to ourselves recently, we knew the time had come. There was no debate.

You see, on Wednesday, July 2, the Dow Jones Industrial Average¹ declined 167 points, settling at 11,215. Analysts say a decline of 20% or more constitutes a bear market, and July 2 left the Dow 21% below its October 2007 high of 14,164. So, it’s official. We’re in a bear market.

Frankly, we shrugged at this supposedly “momentous” news. The media are making a big deal of it, just as they’ve made a big deal of every movement and iteration of the stock market over the past eight months -- almost like new parents marveling at their infant’s every move.

News that isn’t news but which is positioned as news (got that?) is worth explaining. Thus, the real questions are: What does this news mean, and what action should investors take? This report will provide you the answers.

First, let’s separate the news from the noise. Much of the news that consumers are hearing today is actually noise designed to scare you into listening, watching, reading and subscribing. That’s how the media get paid, after all. They have to do something to get you to tune in, and what better way than to take exaggerated positions on a regular basis?

Here’s one recent example: On Friday, June 27, the day after the Dow fell 358 points, CNBC’s Jim Cramer wrote in his daily column, “Sell everything. Nothing’s working. Revisit when the prices are adjusted for a big recession, soaring inflation and a crushed consumer. Sell at 12,000 and come back at 10,000. Even better: short it.” Then, just two business days later (Tuesday, July 1), in a column titled 10 Reasons the Rally Could Last, he wrote, “This is a real turnaround from hopelessness, and it will be hard for the bears to believe that they might actually be on the receiving end of the pain. I have to believe that it can last for more than one day.”

What had happened between Cramer’s Friday panic (sell everything!) and Tuesday’s euphoria (this is a real turnaround!)? Absolutely nothing: The Dow on Monday had gained a mere 3 points.

Okay, so Cramer is a bit extreme -- but he’s not alone. Take money manager Jason Trennert. USA TODAY called him the nation’s most bullish strategist. In January he predicted that the stock market would gain 14% this year -- but on July 3, with the Dow down 15.4% for the year, he told USA TODAY that “we will be lucky if we get back to even.”

The media are filled with such folly. They and the pundits they quote regularly treat ordinary events as historic milestones, and they try to make us think that our financial security is at risk if we don’t listen to them.

So here’s our advice: Don’t listen.

Admittedly, that’s hard to do. It’s human nature to act in the face of adversity. Think of how many times you’ve heard the phrase, “Don’t just stand there -- do something!”

But is that adage correct? Should you, in fact, take action in times like this? If you do, be careful that you’re taking action for the right reason. Too often, people change their investments during periods of turmoil or uncertainty simply because they feel the need to do something, not because they know what to do.

A fascinating study published in the Journal of Economic Psychology confirms this. Scientists examined “action bias” among elite soccer goalkeepers during penalty kicks. As you’ll see, the study has important implications regarding your investment decisions.

Because the ball in a penalty kick takes only a few hundredths of a second to reach the goal line, the goalkeeper must decide before the ball is kicked whether to jump left, jump right or stay in the middle. Because the study found that the ball is kicked to each of the three areas in equal proportions, you’d assume that goalies do each of the three in equal amounts. But the researchers discovered that goalies stay in the center only 6.3% of the time.

From an empirical perspective, that makes no sense. You’d expect goalies to stand in the center a third of time, because that’s how often the ball goes there. So why don’t they?

The reason is simple. The goalie knows he’s likely to fail; indeed, 80% of the time a goal is scored. So the fear is not that he’ll fail -- the fear is that he’ll look stupid while failing.

Imagine that you’re the goalie. You’re standing on the goal line. The ball is kicked to the left or right -- and you’re just standing there. You know what everyone is thinking: Why didn’t you do something? Thus, goalies figure that since they are unlikely to stop the ball, jumping to one side makes them look like they’ve tried. They feel that action is better than inaction -- even though such action actually hurts their results.

Writing in the Journal of Economic Psychology, the study’s authors state, “The action/omission bias…has very important implications for economics and management. For example, the action/omission bias might affect the decision of investors whether to change their portfolio (action) or not (inaction).”

In other words, don’t just do something, stand there! The alternative is to buy and sell in a frenzy, without really knowing why you’re doing it. This explains the trauma of Jim Cramer -- selling on Friday and buying on Tuesday.

Therefore, we study the state of the markets, evaluating Federal Reserve Board actions, economic indicators, government data, corporate filings and third-party analyses, and we compare this information to clients’ portfolios in an effort to determine if any changes are needed -- either in the specific investments they own, or in the mix of assets that comprise their portfolios.

More often than not, our conclusion is that no changes are warranted. We are convinced that, for now at least, just standing there is the best approach. As soccer goalies would do well to consider, lack of action does not mean lack of attention.

Our decision is bolstered by the fact that, year-to-date through June 30, our portfolios are doing better and in some cases, far better against various benchmarks (the S&P 500, DJIA, NASDAQ). For example, as the chart below shows², the most commonly used portfolio in our investment program, the Edelman Managed Asset Program®, is down 5.2%, while the S&P 500 is down more than twice as much, having lost 11.9%. Every EMAP portfolio has performed similarly well against the benchmarks. (Note: The EMAP performance shown is reduced by EMAP’s maximum management fee even though most clients do not pay that rate.)

We do want to warn investors that the market’s turmoil is likely to continue for a while longer. As we’ve warned for several years now, we believe this August will bring the peak in mortgage foreclosures. We believe this because August of 2005 was the biggest month for sales of adjustable-rate mortgages -- and most of them were 3-year ARMs. As the interest rates for these loans reset, millions more Americans may find themselves unable to afford their new mortgage payments. The media will certainly make a big deal of this, and will act shocked by the news -- which isn’t really news, and certainly shouldn’t be shocking. Summer months also traditionally bring higher gas prices due to vacation travel, so we wouldn’t be surprised to see higher fuel prices, either. And uncertainty about the election -- coupled with the likelihood that taxes will rise under the next president (regardless of who is elected) -- will add to consumer and investor angst.

Thus, we’re in a bear market, and we’re likely to remain in a funk for some time. What does this mean for investments? We’ve told our clients that whether their goals are paying for college or retirement many years from now, or whether they’re already in retirement, they needn’t worry about the next several months, for this shall all pass before too long. We say this not because of hubris or overconfidence, but history. As the chart below shows, we’ve experienced bear markets before. Since 1945, according to Leuthold Weeden Institutional Research, the S&P 500 Stock Index has fallen 20% or more 13 times. The average decline was 30% and lasted 15 months.

By that reckoning, we’re a lot closer to the end of our current malaise than the beginning. Our market peaked last October -- eight months ago -- and the decline so far is 21%. By the calendar, that suggests the bear market is more than half-way finished; by the returns, we’re nearly three-quarters finished.

Averages, of course, are merely averages. The longest bear market of the past 63 years (which occurred in 1946-49) lasted three years, while the shortest (1998) was over in just 45 days.

So no matter which kind of bear market we experience -- long and deep, or short and superficial -- one fact is clear: As have the ones in our past, our current bear market will eventually end. That is why we are focused as much on the future as the present. And by looking at the future, we can get downright excited. The reason? Every bear market in history has been followed by a tremendous bull market. On average, the S&P 500 has risen 38.1% in the first 12 months, according to Ibbotson Associates.

Yet some people aren’t convinced. A few callers to my radio show have insisted that “this time it’s different.” Is it?

No.

In fact, we’ve heard that line often over the past 22 years. When the stock market crashed in 1987, when we assured clients that the world was not coming to an end, several told me that “this time it’s different.” We heard similar refrains during the 1991 recession and the bear market of 2000-2002. Interestingly, this mantra is not cited only during down markets: When we warned in 1998-1999 that tech stocks were too high and certain to fall sharply, investors going gaga responded that “this time it’s different.” And when we told people in 2005 that the real estate market was overheated and that prices would not continue to rise, we were told, “this time it’s different.” In each of these cases, no it wasn’t.

And no, it isn’t this time, either. During every period of extreme volatility -- both high and low -- people insist that “this time” is different from all the other times. It never proves true. Instead, the markets obey a mathematical concept called “reversion to the mean” -- meaning that periods of unusually high or low returns are followed by periods of opposite performance, so that the market’s long-term performance returns (reverts) to long-term average (mean).

For example, the S&P 500’s average annual return since 1926 is 10.3%, according to Ibbotson Associates. But during the dot-com boom of 1995-1999, the S&P 500 gained 28.6% per year! Thus it was no wonder that stock prices fell thereafter; from 2000-2002, the S&P 500’s average return was -14.6% -- for a combined 1995-2002 average of (drumroll please) 10.3%! (Tah-dah!)

By this, we don’t mean to suggest that our nation isn’t facing very real problems. We are. But then, we have always been experiencing very real problems. And yet, somehow, we always manage to get through them. We will this time, too, for this time isn’t different. This is why, as we continue to manage clients’ investments, we do so with as much attention to their future goals as we do the current economy. After all, today’s economy is fleeting, but their need to achieve their goals is not.

Our clients have learned that it is essential to continue with their current investment strategies. Thanks to EMAP’s daily rebalancing review, market volatility is not something to fear, but rather exploit: By selling assets that have enjoyed a sudden rise in value, we capture that profit and use the capital to acquire additional shares of assets that have momentarily fallen in price, like buying on sale. Our rebalancing strategy -- unique in the financial services industry -- is a big reason why we’re able to help reduce investment risk. (It’s equally important for consumers to continue to contribute to their IRAs and retirement plans at work. Instead of being discouraged that account values are down, get excited about the opportunity to accumulate new shares at lower prices! Buying low -- now that’s the smart way to create long-term wealth, even if it doesn’t feel good at the moment.)

Another important way we manage risk is through extensive diversification. Each EMAP portfolio holds as many as 19 asset classes and market sectors. Our portfolios haven’t suffered as much as the U.S. stock market for the simple reason that the money isn’t invested solely in that asset class. Other segments of the global financial marketplace have been performing far better than U.S. stocks, and the investments in those sectors have helped to offset losses in domestic stocks. This is the point of diversifying -- and it’s vital that you maintain this risk-reducing approach.

Is your portfolio sufficiently diversified to protect you during this volatile market? If you have questions or concerns about your investments or want to learn more about how we can help, feel free to contact us at 888-PLAN-RIC (888-752-6742).

Ric Edelman is chairman of Edelman Financial, which manages $4 billion in investments for clients nationwide. He is rated the No. 2 independent financial advisor in the country in a current ranking by Barron’s.

For more of Ric’s advice on investing and personal finance listen to The Ric Edelman Show, broadcast weekly on the ABC Radio Networks, or read his current best seller, The Lies About Money.

² The graph below is for illustrative purposes only, and does not represent that past returns are indicative of future returns. Over time, returns can vary greatly and any investment should be made in the context of, amongst other considerations, the tolerance for risk, net worth, time horizon, taxes, and liquidity requirements.

Performance figures for the Washington portfolio are model results and do not reflect actual client account performance. Model results are adjusted downward to reflect the highest management fee charged by EMAP of 2.00% per annum. Model results assume dividends and other income are reinvested. Model results do not represent actual recommendations or trading.

The S&P 500 Stock Index was chosen as a representative benchmark because it is broadly recognized as the benchmark for equity investment returns in the US.Index. Performance returns do not reflect any management fees, transaction costs or expenses. The volatility of the index is materially different from the model portfolio. Indexes are unmanaged and one cannot invest directly in an index.

Past performance does not guarantee future results, and the performance of a specific individual account may vary from the model performance. Therefore, no current or prospective client should assume that future performance will be profitable or equal the model performance. Additionally, for reasons including variances in portfolio account holdings, variances in the investment management fee incurred, market fluctuation, and any account contributions or withdrawals, the performance of a specific client’s account may vary materially from the model performance results.

Barron’s cover story “Top 100 Independent Financial Advisers,” August 27, 2007 (compiled by independent financial industry researcher R.J. Shook, based on assets under management, advisor’s contributions to the firm’s revenues and profits, quality of service, and client satisfaction).

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