Tuesday, February 26, 2013

When Markets Fall ... There's Safety in Investing Knowledge ... Self Knowledge, That Is

After weeks of nothing but big and persistent increases in stock prices, the U.S. stock market got hit hard yesterday afternoon. It's the Europeans' turn today.

The Italians voted against austerity and in favor of gridlock in their government. As a result, all hell has broken loose in the world of daily 'investing,' aka trading. The reason for the big declines could just as easily have been something else, such as "reversion to the mean" selling, of course, but in this specific instance the Italian voters seem to be the culprits.

See Messy Italian Election Shakes World Markets which describes the fluid situation this way:

"ROME—In a national election meant to push Italy further down a path of economic reform, voters delivered political gridlock that could once again rattle Europe's financial stability. . . .

In early trading, stock markets in France, Germany, Spain and Italy were each down more than 2%. Hardest hit was the Italian benchmark, which traded down around 4%. Italian banks suffered particularly. . . .

The Dow Jones Industrial Average swung nearly 300 points Monday, ending with its worst day in almost four months, as the prospects of a stable government appeared to drop.

 A majority of voters endorsed parties that had promised to tone down or even reverse the financial sacrifices Italy has promised its European partners, giving surprise lifts to both the center-right coalition of former premier Silvio Berlusconi and a party of protest led by a former comedian.

Early Tuesday, the left-wing coalition led by the Democratic Party's Pier Luigi Bersani appeared to have gained a razor-thin victory in the lower house of parliament over the center-right coalition headed by Mr. Berlusconi—29.6% to 29.2%, final data from the Interior Ministry showed. By leading the vote count in the lower house, the Democratic Party will automatically get the majority of 340 out 630 seats and, therefore, will likely receive the mandate to form a government.

The Senate, however, appeared headed for political impasse. The Democratic Party was the leading vote-getter in the upper house as well, by less than one percentage point. But its 31.6% result fails to provide its coalition with a majority to pass legislation. If a new government isn't able to guarantee clear parliamentary support, Italians could return to the polls within months. . . .
Messrs. Grillo and Berlusconi both gave voice to Italian anger over tax increases and pension cuts introduced by the emergency government of Mario Monti, whose own Civic Choice coalition ended up with about 10% of the national vote in both houses, according final data.

"The situation looks ungovernable, and that's the worst outcome you can imagine," said Guido Rosa, president of the Italian Foreign Bank Association.

The result is that Italy may, over the next few weeks, try to form a temporary government backed by a grand coalition of left and right-wing forces with the sole aim of changing Italy's electoral law and then going to a vote again as early as summer. It isn't clear who would run such a short-lived government, however.

Italy's elections close the door on more than a year of emergency government that was ushered in during the fall of 2011, when investors led a mass selloff of Italian bonds, threatening the country's solvency. Panic was widespread because Italy is considered too big to allow to default in the way that Greece did."


When Markets Fall

Until yesterday's news from Italy, the U.S. stock market had virtually gone straight up during the first several weeks of the new year.

What does yesterday's fall suggest that individual investors should do now? Nothing, I would suggest. Nothing at all. So let's discuss that.

When investing, taking the time to know thyself is a good rule of thumb.

Another good rule of thumb is that we should take the time to learn as much as possible about anything that's important to our financial well being. And being somewhat knowledgeable about the basics of investing is important to each of us.

That knowledge provides comfort in the face of uncertain times and will assist us in making an appropriate decision, or non-decision, when the circumstances so dictate.

All that said, investing is as much about our individual temperament as much as it is about knowing how financial markets function. Still, the more we know about how the market really works, the better able we will be to make appropriate investing decisions during adulthood.

You're Not as Good an Investor as You Think You Are contains several interesting tidbits for us to consider:

"Markets have been rising and investors returning to stocks, thanks to cheap money from central banks, a rash of takeover deals, the glimmers of economic recovery—and an epidemic of amnesia.

Are those who can't remember the crash condemned to repeat it?

Many investors have been behaving as if the bloodbath between October 2007 and March 2009, when the U.S. and global stock markets lost at least 50%, had never happened. More worrisome, investors are forgetting the agonizingly real fear they felt during the financial crisis.

That could lead some to take more risk than they should and incur losses they can't withstand. So it is vital to evaluate whether you suffer from investing amnesia and, if you are, to counteract it before it is too late. . . .

People are revising their memory of the financial crisis, as if they were looking into a rearview mirror made of rose-colored glass. Financial planners report that clients are increasingly saying 2008 and 2009 were no big deal. . . .

You might think memory works like an engraving plate onto which events are carved in stone and preserved for decades until they fade with age. In reality, psychologists have shown, memory works more like an Etch A Sketch, on which events are traced but then often altered or erased entirely.

Elizabeth Loftus, a psychologist at the University of California, Irvine, says people are prone to "spontaneous distortions of memory that make us feel better about ourselves." Studies have shown, for example, that people remember voting regularly in national elections even when they haven't cast a ballot in at least six years and that 71% of students who earned D grades in high school later recall getting higher marks.

"One thing that might make some investors feel better about themselves," Ms. Loftus says, "is remembering that their losses were smaller or their gains were bigger than they actually were."

That's exactly the kind of polishing of the past that seems to be going on in many investors' minds right now. . . .

You shouldn't trust your recollections of how you felt in 2008 and 2009. Instead, ask your spouse or a close friend how afraid you were . . . . The best guide to how you will act in the next market downturn is how you did act in the last one.

The great financial analyst Benjamin Graham wrote in his book "The Intelligent Investor," after which this column is named, that "the investor's chief problem—and even his worst enemy—is likely to be himself."

If you can't remember the pain you felt in the past when you lost money, you will have no one to blame but yourself if you end up feeling the same anguish all over again."

Summing Up

Well said.

Know thyself is the best investment advice possible.

That said, learning more about how things really work is also worthwhile investment advice.

And well worth knowing is that owning the stocks of solid companies, while inevitably involving periods of market volatility, will provide individual investors with substantial financial rewards over time.

Finally, the knowledge that it pays to keep individual investing costs low and that the KISS method of investing is always in style is further indispensable knowledge.

That way we'll always know why we own what we own and will make the correct decision to stay the course when the fit hits the shan, which it definitely did yesterday.

But this Italian political stuff du jour shall pass. As will the U.S. sequester and countless other political "crises" down the road.

That's my take.

Thanks. Bob.

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