I sure hope I'm wrong, but the international news increasingly
reminds me of the 1930s, when aggression in Europe and Asia went
unchecked, trade barriers rose, economies stagnated, and the world
slid into another war. What makes this situation dangerous for
investors is that the stock market doesn't seem to reflect the
potential threats and has been blithely setting new records
If you believe in efficient markets, as I do, then disputing the
wisdom of the mass of investors who set prices can be a dicey
business. Still, you should be prepared. If a terrible event caused
the Dow Jones industrial average to fall by 500 points in a day,
what would you do?
First, some history. In a column I wrote six days after the 9/11
attack, I cited a study by Ned Davis Associates on 28 worldwide
crises, from the fall of France in 1940 to the bombing of the World
Trade Center in 1993. The researchers found that after a global
crisis, markets fear the worst and stocks get priced accordingly.
But as the dust clears, optimism returns, stocks bounce back to
where they were, and the market responds once more to economic
signals rather than to geopolitical turmoil.
Consider what happened when Japan bombed Pearl Harbor. On the
first trading day after the attack, the Dow fell 2.9%. The broader
Standard & Poor's 500-stock index lost 4.1% in December 1941,
and over the next four months the index dropped another 14%. But
then, as the U.S. vigorously pursued enemies on three continents
and ramped up war production, the market began to climb powerfully.
From 1942 through 1945, the S&P delivered a total return of
147.5% (or 25.4% annualized).
Much the same pattern prevailed after North Korea invaded South
Korea in 1950, after Iraq invaded Kuwait in 1990, and, of course,
after 9/11 itself. The Dow closed at 9606 on September 10, 2001,
lost 14% in 11 days, returned to its pre-attack level by November
9, and closed the year at 10,022.
Of course, there's no guarantee that stocks will move
consistently upward in the longer term after a shock, as they did
during World War II. The decade following 9/11 was one of the worst
ever for stocks, with the Dow finishing 2009 at roughly where it
stood at the end of 2001. The reason for the market's miserable
performance, however, wasn't 9/11 but an unrelated financial
crisis caused by a bubble in housing prices.
What I worry about is how investors will respond to the next
cataclysm. History teaches us not to panic and, in fact, to seize
the opportunity. As I wrote in the aftermath of 9/11: "It is
precisely because the world is so uncertain that stocks are a good
investment." If investing in stocks entailed no risk, then average
annual returns would not be 10%. Instead, returns would be more
like those of Treasury bonds--about 5% annualized. Stocks reward us
well for taking the risk of becoming owners of businesses.
Still, it is a certainty that another shock is coming. I can't
tell you what it will be about or where or when it will occur. But
it will happen. Here are suggestions on how to prepare and
Diversify. The first lesson on risk is that you need to own a
lot of stocks so that winners can balance losers. My preference is
to construct a portfolio that includes at least one mutual fund
that owns large-company stocks--either a low-fee actively managed
fund such as Dodge & Cox Stock (symbol
), which has beaten the S&P 500 by an average of 1.3 percentage
points per year over the past five years (and is a member of the
Kiplinger 25), or an index fund that mimics the S&P itself,
such as Vanguard 500 Index (
)--plus about 20 stocks from a variety of sectors. Not all stocks
fell after 9/11. Coca-Cola (
), for instance, actually rose 25 cents between its close on
September 10, 2001, and its close on the first day the market
reopened a week later. Even in a catastrophe, people reach for a
soft drink. Shares of defense contractor Raytheon (
) rose by more than one-fourth in those seven horrifying days. I
like both Coke and Raytheon.
Own bonds. A diversified stock portfolio is not enough. Allocate
your assets between stocks and bonds. Because the S&P 500 has
returned nearly 19% annualized over the past five years, much more
than bonds have earned, stocks now dominate many portfolios,
either because of passivity or by design. Make sure the proportion
of bonds in your portfolio is what you intend it to be; for a
typical 50-year-old, that means about 30%. Bonds, especially
Treasuries and securities backed by government agencies, provide
the ballast you need in rough seas. When a shock comes, your
initial losses will be a lot smaller than with an all-stock
portfolio. It's worth remembering that even though the U.S. had
been attacked, prices of ten-year Treasuries soared after 9/11 as
investors stampeded into the safest securities they could find.
Invest regularly. Buying or selling because you (or I) suspect
that the economy is headed for a bad time (or a good one) is the
worst way to invest. Instead, invest in good companies, or in
mutual funds that own them, and hold on. We can't help being
affected emotionally by the events around us, so put your stock
purchases on automatic pilot. Set up a plan to invest the same
amount every paycheck or every quarter--a technique known as
dollar-cost averaging. That way, if shares fall in value, you'll be
able to purchase more of them. If you're investing regularly
through your 401(k) plan, you're already doing that.
Seek bargains. Although buying stocks regularly is a valuable
approach for most people, capitalizing on a market decline is the
single best way to lower your risk. So, if you can muster the
courage, buy at the worst of times. Think back to how you felt on
September 11, 2001. You were only human if you worried that more
attacks were ahead and that the tourism, transportation and
entertainment industries would be wrecked for years. If you thought
about your investment portfolio at all, you were probably kicking
yourself for not owning more Treasury bonds and gold. Buying
General Electric (
) after it fell by one-fourth in the two weeks after the attack was
the last thing on your mind. But the stock regained all it lost,
except for a few cents, within a month.
My advice on preparing for the next shock is based on history.
But I must issue a warning, and it's a big one: The future may not
be like the past. If you believe that this time will be different,
one recourse is to protect yourself by buying a hedge, such as a
mutual fund that rises in value when the stock market falls. An
example is ProFunds Bear (
), which seeks returns that are the opposite of the S&P 500's.
The problem with bear-market funds is that they tend to charge high
fees. Also, because investors lose money when stock prices rise,
many lack the discipline to keep buying these hedges in good times
(such as now), and that defeats the whole purpose.
The truth is that if you think the world is completely falling
apart, you shouldn't be investing anyway. You should be
spending--or maybe squirreling away freeze-dried food. In my
opinion, it's not going to come to that, but it doesn't hurt to be
James K. Glassman is a visiting fellow at the American
Enterprise Institute. He owns none of the stocks mentioned.