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Not Fortune Telling, Just Good Sense

Crystall Ball
image: telegraph.co.uk

About two years ago, actually the date was November 10, 2008, I got the following email from a client and friend. It read:

Hey Ben,
Hope all is going well. Everything is going well here. I need your input on house that my wife and I are looking at. My wife and I are looking at a buying a foreclosure. We have submit an offer as soon as possible. My proposal is to use a substantial amount of my account as a down payment and then replace the money in my account when our current house is sold. I’m thinking that my current house may take a month to sale. Do you see any issues with this plan?… I look forward to hearing from you.
Thanks,
Client X

My response was:

Hey Client X,
Sorry you couldn’t reach me. Feel free to call me on my cell at anytime. The voicemail was full because as you might guess, I’ve been getting a lot of calls lately…
I would really like to answer your question thoroughly. So that I cover most of the pro and cons of this financial decision, I will take a little more time to write something up. But, for your immediate gratification, let me say that I think the plan you have laid out has significant financial downside. That is not to say executing your plan the way you’ve spelled it out won’t be the right thing for you and your spouse to do. It may suit your immediate lifestyle and emotional needs. However, financially, there are much better ways to approach the purchase of a new home given your circumstances and the current environment. In a nutshell, I think the plan as laid out would set you back financially but that your finances are not the only factors that should be considered. There are the lifestyle/emotional factors as well.
I will write something up for you that will explain more thoroughly the financial downsides tonight and email you promptly. I will be available to speak by phone anytime after 3pm tomorrow.
Til then,
Ben

The letter in its entirety can be found here. My advice then:


1. Stay put. It was not the time to sell and investors that opted out of the market by withdrawing funds would likely lose out on a strong recovery.
A recent study by DALBAR showed investors on average have a very strong track record. Unfortunately it’s a track record of making the wrong investment decisions at the wrong time! Had most investors stayed put in their funds, which they did not (see results), they would have enjoyed a one year return of 32.20% compared to 26.45% for the S&P 500 by the end of 2009.
That habit of selling into down markets results in poor performance over a long period. For the period ending 12/31/2009, the S&P 500 returned 8.10% for the last 20 years (the 1990′s and 2000′s). [Correction]: Investors in mutual funds only received 3.17% over that time, just above the rate of inflation which was 2.8%. Unfortunately, investor “mis” behavior costs dearly. The fact is in 15 years I’ve seen over and over those invested in growth equities sell low and buy high when left to their own devices. In 2009 our Core Model Portfolio returned 43.04% and in 2010 it returned 20.37%.
Result: Investors fled the equity market, withdrawing $234 billion from equity mutual funds in 2008 and another $9 billion in 2009 and as of September of 2010, have withdrawn another $29 billion (see here & here).
2. Buy more: Participate in the stock market’s recovery because stocks are cheap relative to their business value.
I said the market will likely return above its historical 10.5% return (at the time). I went as far as to say, although there is no guarantee, the market could easily return 15% over the next 3 to 5 years.
Result: In the two years ending December 31, 2010 the Wilshire 5000 has returned an annualized 22.6% and the S&P 500 returned an annualized 20.6%.
3. Wait until real estate prices bottom: Since I felt real estate prices would continue to fall, the bargain Client X thought he was getting was less of a bargain than he thought.
Real estate, like all assets, advance and decline. The nation had been lulled into believing real estate prices only go up. So when they were declining many still held on to that belief, telling themselves, “Any day now this thing is going to turn around.” Well it didn’t just turn around. In fact, real estate prices are still in the process of correcting.
Result: At the end of 2008 the average home sales price was $198,100. As of September 2010, that price had declined to $171,700. That’s a decline of 13.5%.
4. Wait until mortgage rates improved: Home mortgages would be hard to get.
Result: The Fed’s quarterly survey of senior bank loan officers assesses supply and demand for bank loans to businesses and consumers. The past few reports (here and here) showed that banks had been easing lending standards for large corporations.
Pretty much, everything I told Client X came to fruition. Investors fled mutual funds and those who did are likely to see their returns lag the market over the long term. The stock market is recovering handsomely. Real estate prices continued to decline (but are hopefully stabilizing). And lending practices are beginning to ease. I am no fortune teller. But a little patience and some broad perspective helps in making wise financial decisions especially when it comes to the stock market.

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