At the time of writing global stock markets have been falling for several weeks. Economic news is predominantly bad and no-one knows how the US and Europe will wriggle out of their massive debts. Savings and pension schemes, still trying to recover from the financial meltdown of 2008, are reeling yet again. Most investors are no better off now than they were 10 years ago. Is it time to pull the plug on stocks?
REASONS WHY WE SHOULD ABANDON THEM
The days of double digit growth each year in the value of shares seem to have gone – perhaps forever? Relying on a portfolio of shares as a secure basis for retirement is now looking a very risky strategy.
To understand what the capital markets are all about it is easier to think of them in their simplest terms. Let’s say you decide to build a restaurant in Bali. If you have enough money of your own you plough it into the business and reap all the profits. Or suffer all the losses. If you do not have enough resources yourself you might find say four other people to invest equal amounts. Thus the business now has five shareholders. If the business is profitable you decide how to share the profits, effectively paying yourselves dividends. If the venture fails, you all lose your money, but not as much as if just one person was the investor. If one of the group wishes to sell his share he can do so to a willing and able buyer and for an amount that reflects the market value.
This is exactly how the capital markets work, except on a much grander scale. When the company is large it can trade on recognized stock markets so that anyone can freely buy or sell its shares. If you invest in the right companies you can make a lot of money. Warren Buffet became the second richest man in the world through his stock-picking skills.
But Warren Buffet’s strategy was to seek out good value, buy the shares and hold on to them for years. This was his way of showing his faith in those companies and giving them his support. It paid off great dividends for himself and subsequent investors in the huge investment company he created himself, Berkshire Hathaway. This was an example of the capitalism that helped to make the US the strongest economy in the world and its people the most prosperous.
But what do we see today? In recent days when the major markets were gaining and (mainly) losing at least 4% per day stocks on the US stock exchange were changing hands on average every 20 minutes! Shares were often held for as little as 3 minutes. How come? Because computerised trading has largely replaced the human effort and analysis that would be applied before making investment decisions. Of course, humans have created the programmes, but once created the computer makes all the decisions. And at lightning speed. Some would say the stock market has become a casino. There is no way the small investor can compete with the computers.
REASONS WHY WE SHOULD NOT ABANDON THE MARKETS
Many individual investors have long decided that they will not go near the markets. This includes many who have lost small fortunes. But in most cases this can be put down to timing and human nature. Investing, essential as it is to everyone who wishes to conserve or build up their wealth, is driven by greed and fear. When an asset class, whether it be stocks, gold or property, is riding high everyone wants a piece of the action. When the asset collapses in value everyone wants out. Consequently most people tend to buy high and sell low. I read once that one of the biggest mutual funds in the world had a good five year run in which it gained 80%. Yet most of the people who invested in it lost money! How is that possible? Because during those five years there were several peaks and troughs. And yes, you guessed it, most people bought when the market was high and sold when it fell.
If only people could control their emotions and either hang in for the long term like Warren Buffet or be courageous enough to buy when everyone else is shunning the markets and to sell when markets are high then they would all be winners. You may think it is not a good idea any more to invest in the S&P 500, representing the 500 top companies on the New York stock exchange. Yet, the S&P index rose 100% from its depths following the financial meltdown in March 2009 to May of this year. In other words, if you had invested in March 2009 when everyone was predicting the end of the world you would have doubled your money in just over two years! Of course, nobody to my knowledge did, and if they did they probably stayed in the markets which are now spiraling down again! But this does show that profits can still be made in stocks – if you get the timing right. Getting it right perfectly is impossible but there are certainties you can depend upon. For example, if the market has gone down 20% there is no arguing that you can buy in at a price 20% lower than it was previously. Similarly, if your shares have risen 20% your gain really is 20% - but only if you sell!
Another strong argument for not abandoning the markets is that today many, if not most companies remain highly profitable. The private sector continues to thrive. It is the governments and in many cases the banks that have squandered or misused the money. If everyone abandoned the capital markets governments and banks as we know them would cease to exist.
SO WHAT IS THE CONCLUSION?
My conclusion is that, tempting as it is after a decade of disappointments, we cannot and should not abandon investing in stock markets. HOWEVER, I believe that individual investors and institutions such as pension funds should reduce the proportion of funds traditionally held in stocks and seek more innovative ways of investing and generating income. My earlier articles have identified many of these opportunities. If the trustees or managers of a pension scheme are still blindly following the old formula of cash, bonds and equities, perhaps in a ratio of 10-40-50 then they are likely to have achieved nothing in the past ten years. Many huge pension schemes are in fact in big trouble, and continuing to fund them has put an immense burden on the companies’ balance sheets. Large institutions can make the same human errors as individuals. Pension scheme managers can be persuaded either by themselves or their members to pull out of stock markets after a crash, only to find their funds are making no money in cash or bonds when stock markets are rising again. But since human nature cannot be changed we can reduce its influence by seeking asset classes that are not correlated with the stock and bond markets. And there are plenty of them. But because they are ‘outside the box’ individuals and institutions alike are slow to take them on board. Until they eventually become mainstream and belatedly they try to get on the boat.
In summary, don’t abandon the stock markets, but do reduce reliance on them and seek alternative opportunities.
Colin Bloodworth has worked as a financial adviser in Indonesia since 1992 and is now Director of PPI Indonesia, based in Jakarta. He visits Bali regularly and can be contacted for advice at email@example.com or firstname.lastname@example.org or 021 3004 8024.