Stock market gyrations

Terrence Wall, a well-known developer for Dane County and beyond, writes from a businessman’s perspective. Often, he writes about the intersection of politics and business for IB, and how pending mandates or legislation affect the bottom line. However, his topics vary.

Down 600 points, up 400, down 500, up 400. … What’s an investor to do? Stock market advisors aren’t going to like me saying this, but I have become convinced that investing in the stock market is too risky for the average person. Over the last five to 10 years, you would have been better off with a less risky, tangible investment that returned a steady, single-digit return.

Admittedly, as a client, I’ve been fired by two different “investment advisors” (once for insisting on selling my stocks just 30 days before the tech market crash of March 2000, and once for selling when the Dow peaked in October 2007 at 14,000). I probably drive my current advisors crazy, insisting on selling three weeks before the Dow dropped about 11% in early August.

Given the market’s herd mentality and all the new influences that exist today that didn’t exist “in the old days,” I can’t see how an investor on Main Street can possibly get a fair shake. Here’s why: Computerized trading drives the market down in a few minutes, before an investor can even react. Most investors don’t know that there is a delay in stock quotes to the public as compared to licensed brokers and traders who receive the information in real time, which gives insiders time to exit a down market before the public even knows what’s happening.

Options and other derivatives give insiders a window into the future direction of the market – information that the public doesn’t have. The market may be headed in one direction, but if Wall Street knows that options or more selling triggered by margin calls will drive the market down, insiders can react before we can.

Worse still is that the average 401(k) or mutual fund investor doesn’t know that when you buy or sell, you receive the end-of-day closing price for the fund, not the price quoted at the time you placed your trade. If you had wanted to exit the market first thing in the morning on the Monday after the U.S. credit rating was downgraded and before the market dropped, which it did by 600-plus Dow points, you would have received the lower closing price even though you sold when the market opened. (In reverse, if the market were to rise significantly in one day, you could wait until about 1 p.m. to place your buy order to ensure that you bought into a rising market.) Another little-known rule: If you bought into a mutual fund but later wanted to sell within 90 days of buying, you’d probably be charged additional fees.

Interestingly, unlike many other investments, a more risky investment in the stock market frequently results in lower net returns compared to a lower-risk strategy. Over the last couple years, I have been running an experiment by maintaining a low-risk portfolio for my wife, while maintaining an experimental higher-risk portfolio for myself. Sure enough, the lower-risk portfolio earned the higher return!

Supporting this experiment is a chart that every investment advisor holds that shows returns for different risk levels. If you look at it carefully, you’ll see that you’ll capture only 1% additional return for a whole lot more risk. Is it really worth potentially losing half your capital in exchange for 1% more return? Only you can decide.

All I can say is that for the last 10 years, the S&P 500 has been a poor investment, and over the last five years, it’s been a money loser.

Bond market

The bond market has similar “global” risk that impacts the value of your bonds more than the individual performance of the company or government that issued the bonds, which makes investing in individual bonds extremely difficult and much more risky. In fact, probably the only way to invest in bonds these days is to do so on an overall-market basis.

In other words, invest in the bond market, not individual bonds, and be ready and willing to enter and exit the market frequently. Why? Because the value of individual bonds is now more influenced, in my opinion, by global and national factors and overall market trends than by anything an individual company or city or state or federal government can do to affect their value.

For example, regardless of the creditworthiness of an individual company or municipal government (or even the creditworthiness of the federal government), the value of bonds plunges when interest rates rise.

And think about it: With short-term interest rates being maintained by the Fed at near zero (in order to finance the federal government debt less expensively) that means that bond values are at an all-time high. Long-term rates are historically low as well. This means that any movement upward in interest rates will cause your bond values to decline on a direct relationship.

And then there is the added risk of the government interference in the bond market these days. So-called QE2 (quantitative easing, round 2) was designed by the Fed to deliberately lower interest rates on new bonds (thereby increasing the value of existing bonds that held higher rates of return), but what that means is that those new lower-rate bonds will decline in value as the Fed eases off the accelerator and lets rates naturally rise.

The Fed artificially holding down rates and moving in and out of the bond market makes bond investing unpredictable and much more risky. In fact, we now know that rates actually rose while the Fed was implementing QE2, directly the opposite of the Fed’s intended goal, making even what appears to be an obvious “play” (if you invested based upon the Fed’s activities) a big loser. Why did that happen?

Because, as I speculated during that time, something else was going on – something none of us knew about, but that the Fed did know about – and that you could only ascertain by watching rates rise while the Fed pumped $600 billion into the bond market. That something was that the world’s largest buyer and holder of U.S. Treasury bonds, PIMCO, had decided to sell all its Treasury holdings. I speculate that since the Fed and PIMCO stay in close touch, the Fed’s QE2 program was really designed to offset or counter PIMCO’s exit so as to prevent that exit from causing interest rates to rise significantly. In fact, the real truth is that PIMCO could not have exited that quickly without the Fed interfering in the market.

Those who invested in bonds over the last year thinking they were a safe haven had no way of knowing that so much interference would be launched by the Fed and PIMCO. But you can count on the insiders having known and having exited before you could.

The point is that investing in the bond market as an individual investor on Main Street during these times of uncertainty when you could be wiped out through no fault of your own is now a high-risk proposition.

So the natural response to this claim would be that you should hire a professional to invest in bond mutual funds – “let the pros handle it.” Well, unfortunately, the pros had no clue what was going on either – and they have a natural bias toward staying invested in the market even when it’s crashing. Unfortunately, that fee-based arrangement creates the bias in which they want you to stay invested even if they know – yes, know – that the market is crashing.

You’ve heard it all before: “Don’t panic,” “stay the course,” or “we invest for the long term.” It’s all a bunch of baloney. An investment advisor should be looking out for your interests. Your advisor should be willing to move you in and out of the market as he or she sees trends and risks growing. For example, investors will tell you to diversify and invest in international stock and bond funds, but who in their right mind would invest in Europe right now? With half a dozen countries overextended and about to go broke, the remaining nations are at risk of paying the cost to bail out the defaulting nations. And then there is the risk to the euro itself.

So my advice is this: Don’t listen to your investment advisor if he or she tells you to stay the course, stay invested, or other similar statements. Make sure you have an advisor who is willing to move your investments in and out of the markets as you dictate or as he or she sees the risks developing. Staying invested for the long run right now is a plan that doesn’t work. Maybe some day, when the government situation settles down, things will change. For now, it’s a non-starter with the volatility the markets are experiencing.

Sign up for the free IB Update – your weekly resource for local business news, analysis, voices, and the names you need to know. Click here.