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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Sunday, October 25, 2009

How Soon We Forget!

Sometimes we lose track of time. It seems like we’ve been in this economic crisis for eons, yet it was only March 9th of this year that the Dow Jones Industrial Average hit 6,440, closing that day at 6,547. Recently, on October 19, 2009, the Dow reached 10,092, a 54.1 percent gain. That took only seven months!

And here we sit with the unemployment near 10%, residential real estate still suffering and commercial real estate a worry for many. Over 100 U.S. banks have now gone under.

While many believe that stocks are becoming over-valued and are worried about a market correction, the market has continued to hold ground. Many times we’ve seen it go down a bit and then shortly reach a new high.

We sense that the continued rally may be fueled to a significant part by those who pulled out at the bottom and have, until recently, been sitting on the sideline watching the market recover. They panicked as the market went down and sold at or near the bottom. Now, worried that they will miss the rally, they are buying as the market reaches new highs, even as the economic news still gives one much cause for worry. In short, many who are perhaps fueling the rally have a habit of buying at market highs and selling at market lows.

We can all remember many times when the market has gone through such gyrations before. The tech stock bubble and 9-11 are still fresh in our memory. There will be many more such market gyrations in the future. So why can’t people learn? They continue to follow the crowd as stocks get over-priced; overloading their portfolio in the latest hot investments, only to lose a substantial portion of their gains overnight as the market comes crashing down. They then panic and pull it all out or perhaps just don’t take advantage of the buying opportunities at the market lows.

We tell our clients that they don’t want to be what we call the “typical investor”. The “typical investor” lets his or her emotions drive their investment decisions. Their fears of missing out at market highs and losing as the market dives cause them to buy high and sell low.

During the recent market lows, Warren Buffett, renowned investor invested billions in G.E and Goldman Sachs. One of our favorite quotes from Warren: “I will tell you the secret of getting rich on Wall Street. You try to be greedy when others are fearful, and you try to be very fearful when others are greedy.” In other words, Warren Buys low and sells high, just the opposite of our typical investor.

So how can you avoid the “buy high and sell low” characteristics of the typical investor and remember what the market does time and time again? You need to select a widely diversified target portfolio (six to eight asset classes, at a minimum) with an equity/bond mix that allows you to ride out wild market swings. Then, periodically (at least annually) rebalance your portfolio, selling those asset classes that are over-allocated and buying those that are under-allocated. If you can be disciplined to do this, it forces you to buy low and sell high, just the opposite of the typical investor.

This kind of discipline will help you take advantage of the market cycles that repeat, every so often. You won’t always rebalance at the perfect times (that’s tough to do) but you’ll do better over time since you’ll still have positions in all asset classes. And if you choose to do an extra rebalance during extreme market conditions, you’ll be buying low and selling high. Such a discipline will guide you, should you forget what the market does, time and time again!


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