I (Zak) was taking a walk with my father the other day as my two little boys rode their bikes ahead of us (Jack and Will are both riding now, which is really fun). My Dad was expressing his concern about a specific money supply indicator that seemed to be trending in the wrong direction. Our conversation got me thinking, “It is always something.” There is always something to be concerned about.
As you may have noticed, the market took a dip at the end of August and stayed down through the end of the third quarter. This was mainly due to concerns about slowing growth primarily in emerging countries (ie., China) and uncertainty about the federal reserve increasing interest rates. Things now seem to be recovering.
As we have written before, concerns and expectations about the future move the market (sometimes dramatically) since current prices are built off of assumptions about future cash flows. The market isn’t as irrational as it seems sometimes. Projections are just continually being updated (see our previous post: What’s happening-to-stock-prices ).
Concerns about the future have been part of the human experience for a very long time. We can gain perspective by reflecting on the timeless wisdom given to us in Ecclesiastes – “Whoever watches the wind will not plant; whoever looks at the clouds will not reap.” Ecc 11:4 NIV. The writer observes the human disposition toward future uncertainty. He wisely concludes the lack of “harvest” that excessive worry can produce.
While it is not helpful to be fearful or overly anxious about market uncertainly, we do not believe in ignoring it either. We continue to remind you that there are wise actions that you can take during these times.
Review (or create) your comprehensive financial plan (LifePlan).
- Keep your fixed expenses low. Pay down debt and look for ways reduce your expenses.
- Make sure that the risk profile of your investments is aligned with your specific needs, goals and cash flow requirements. Every account should have a defined purpose.
- Consider investing money that you have “on the sidelines.”
- Utilize a wise financial coach that knows you, your situation, aligns with your worldview and has your best interest at heart. (This is us by the way!!)
My other thought during my walk with my Dad was “Thankfully there is always something to be concerned about.” Before you conclude that I am crazy, let me explain why uncertainty or volatility is absolutely essential to reaching your goals. I am going to attempt to walk through this at a summary level. If you would like a more detailed commentary, please see http://www.investopedia.com/terms/c/capm.asp
There is a concept called the “risk premium.” (Stay with me!) Risk premium states that expected return of an investment needs to line up with how risky, uncertain or volatile the investment is. For example, if the profitability of ABC company could be really low if their new product is a flop or could be really high if it is a success, there is a lot of uncertainty about ABC’s future share price. If you were considering making an investment in the ABC company, you would want a large gain if the new product was successful to compensate you for taking the risk of a loss if it was a bust. You would need to feel good about the “premium” or additional return you stand to make as compared to a more certain investment, say a CD at the bank.
This risk premium concept plays out when comparing different types of investments. It has materialized in long-term trends. Why has the long-term return of stocks produced a higher return then bonds? Why has the long-term return of small company stocks been higher then large company stocks? It is largely because of the risk premium. When people feel optimistic about the future, making things seem more certain, risk premiums go down. When people are more pessimistic, risk premiums go up.
Okay, so this is all good why? If there were not investments that we could invest in that were volatile, we wouldn’t be able to benefit from the risk premium. In other words, if stocks didn’t go up and down, as they have been since the end of August, then the additional return we could achieve over the long term by investing in stocks as compared to bond or CDs would decrease. This would be problematic. Most people, even in their retirement years, need to get a higher rate of return to achieve their goals than bonds and CDs will provide.
So do you now see the value in the market’s ups and downs? Do you understand why we need volatility to be there? We need the ups and downs of the market. They serve a critical part in most people’s success. We need to take them seriously and plan for them prudently by establishing and sticking to a principled investment strategy. This will help us continue to plant even when the winds come.
As always we are here for you. Please do not hesitate to contact us if you need something or would just like to talk,