Many young investors have heard tales of the "Bear Market." Since they have
never seen it for
themselves, they think it is a myth. But it's not, as the following column shows. (The
column is set a
few years in the future. Since my time machine occasionally malfunctions, this column is
an
illustrative example and does not attempt to portray market events exactly as they will
happen. Also,
it is extremely scary, so read it at your own risk.)
***
This column depicts an event that took place outside a small investment advisor's office
in Maryland.
The time is April 2003. Two years ago, three young cynical analysts (we'll call them
Brian, Heather
and Greg) set out to prove that the legendary "Bear Market" did not exist.
Although they have heard
tales of the Bear Market gobbling up investors' portfolios in the past, their vast
experience (after all,
they have been investing for 10 years) convinced them that the Bear Market was either
purely
fictional, or had long since died off.
It's true, over the past two decades there have been occasional phenomena suggesting that
the Bear
Market was indeed up to its old tricks. There was the time back in 1994 when little Evan
Robinson
went wandering into the exchanges, and his portfolio completely disappeared. However, the
three
young analysts convinced themselves that this event was so minor as to be trivial.
Before that, there was the mysterious "Black Monday" of 1987, when thousands of
investors
reported being harmed by the Bear Market. Our three brave analysts were troubled by that
event,
but noted that it was short-lived, and pointed out that the investors who had sufficient
provisions to
remain in the exchanges came out unscathed. Emboldened by such research, the bullish
threesome
were determined not to be swayed by the myth of the Bear Market, and started investing
aggressively in early 2001.
Heather, Brian and Greg did not begin their search for investments completely unprepared.
They
were ready to accept some losses, and felt that they might be able to withstand a
short-term hit of
as much as 25%. Initially, even this seemed unnecessary, since their portfolio earned
money during
the first quarter.
Supported by their initial findings, they became reckless, eschewing the traditional
benefits of a
diversified portfolio and wandering into the area where the Bear Market poses the greatest
threat --
high price-to-earning ratio (growth) stocks. Only Greg, the least convinced of the three,
was shaken
by a 10% decline in stocks during a single week in May 2001. He stayed in the field after
being
chastised by the leader, Heather. She seemed to be proven right when stocks recovered
during
June and the group's portfolio was up by a large amount for the year.
Then weird things started to happen. Productivity, which had been steadily improving since
the early
1990s, began to level off. Signs of inflation began showing up. The growth of the Internet
and
computer sectors started to creep downward, into single digits. And for the first time in
a decade,
Microsoft announced earnings below expectations. For the year 2001, stocks in general were
down
by 9% -- their first decline in seven years.
Our intrepid trio still held fast to their belief that these were natural occurrences and
that the Bear
Market did not really exist. However, in May 2002, the Fed raised interest rates for the
third time in
less than a year, and the market fell another 8%. Moreover, although stocks as a whole
were down
17%, our heroes' portfolio had fallen by 24%.
At this point, Greg disappeared. No one knows where he went, but remnants of his brokerage
statements were found near a bank selling certificates of deposit.
Brian and Heather, although shaken by Greg's disappearance, vowed to continue on. But the
market free fall did not stop. In November, economic figures showed that inflation was on
the rise
while employment was falling. Major companies announced layoffs, and consumer confidence
fell to
its lowest level in 20 years. By the end of the year their stocks had fallen an aggregate
38%, and
Brian and Heather has lost 52%.
Heather lost track of Brian and was forced to weather the storm alone. In an emotional
note to her
family, she apologized for losing so much of their money. Then, although there were some
signs of
stability from international and basic manufacturing stocks, Heather stopped accessing her
online
portfolio tracker. In the end, she had lost nearly 60%, and, apparently, her will to
continue.
***
Back to 1999.
O.K., so that was a bit melodramatic. But my concern is that many investors are
substantially
underestimating the potential volatility of the stock market. Moreover, they are
increasing their risk
by taking large positions in particular sectors. Some investors may be unaware of how far
a market
can drop (to see an example, visit our "Bear's Cave") while others may feel that
risks are lower in
today's market. Well, everyone is entitled to his or her opinion, but I see no evidence
that stocks are
any more stable now than they were in the 1970s.
I am not literally predicting that there will be a huge market downturn in the next few
years. Nor am
I suggesting that investors should get out of the stock market -- in fact, all of my money
is in
equities. However, it is vital to be broadly diversified across various sectors, and to be
aware of the
risks you are taking. The problem with underestimating stock market volatility is that a
sustained
downward move for which you are not prepared could cause you to pull out of stocks at the
worst
possible time -- the bottom of the market.
Now if you'll excuse me, I've got to get back to work on my column based on "Boogie
Nights."
 Lummer's
Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.
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