Table of Contents

Marketplace Mania

By Randall K. Barton

Introduction

The financial markets have experienced momentum perhaps unparalleled in the United States since the 1920s. For 5 years in a row, a particular asset class—growth stocks—substantially outperformed all other asset classes. Within the growth stock class, the high-tech, communications, and ".com" sectors have shown phenomenal gains and price increases.

While these last 5 years may have little precedent in the context of modern theories of asset allocation, financial euphoria surrounding a particular "can’t miss" investment opportunity is as old as the free enterprise system itself.

Financial Euphoria

A brief discussion of financial euphoria helps put the current market mania into perspective. History is full of examples of financial euphoria and the corresponding "can’t miss" investment opportunities:

• In the 1630s, tulip-bulb mania struck Holland. Nearly every adult traded in tulip bulbs. By the end of 1636, a single bulb was exchanged for "a new carriage, two gray horses, and complete harnesses." By 1637, the end came, and rare tulip bulbs trading for $25,000 became worth $25 overnight.
• In the early 18th century, both in France and England, speculation surrounding the New World economy with promises of fabulous mineral deposits and lucrative trade routes resulted in unprecedented growth in joint-stock companies given the privileges to take advantage of the wealth of the Americas. By 1720, the speculation came to an end, with disastrous results for the economies of both France and England.
• One of the United States’ first "can’t miss" investment cycles came with the railroad boom in the late 1860s and early 1870s. The opportunity to take advantage of the new economics from the expansion to the West came to a complete crash by 1873.
• The most famous economic crash in United States history occurred in the 1920s as the U.S. stock market (through leverage) experienced unprecedented growth from 1924–29. The crash of October 1929 brought in the era of a Great Depression and a somewhat passive investment climate for almost 25 years.
• In the 1960s there was the "nifty fifty" large corporations reflecting the new economy in the United States. These "can’t miss" stocks dominated market capitalization. The correction in the market experienced in 1969 resulted in a decade of flat market experience and left millions of people disillusioned with the market.
• In the late 1970s, "can’t miss" opportunities abounded in oil, gas, and precious metals. This boom became a giant bust by the mid-1980s.
• By 1989, Japan was the hot opportunity for all investors. Japan’s unparalleled economic growth and unbelievable stock and real estate valuations created enormous wealth for the country and its citizens. Of course, the crash came in 1990.

In most episodes of notable financial speculation, at least three elements are present:

1. Pride in seemingly the discovery of something new in the world of investment opportunity, which is confirmed as others rush in to exploit their own, usually slightly later, version of this investment opportunity.

2. Debt or asset valuations that in one fashion or another have become dangerously out of scale in relation to the underlying means of payment or producing profit.

3. Participation by the masses in the financial euphoria so demand outstrips supply of the investment. Speculation building on itself thus provides its own momentum.

Outguessing Market Corrections

Unfortunately, investment success often develops in the participants an attitude of investment superiority relative to an understanding of the market. A common characteristic of those with that newly discovered "genius gene" is the supposed ability to outguess when the correction will come.

Can you expect to be able to predict market corrections and prophetically adjust your portfolio to take advantage of fluctuations? For that matter, can sophisticated professional investors expect to add value through tactical adjustments to investment strategies? Ernie Ankrim, director of portfolio research for world-renown Frank Russell Investment Company, declares an emphatic "No" to these questions.

Consider these studies:

• In 1975, William F. Sharpe analyzed results of market timing over 43 years from 1929 to 1972 and concluded a market timer must be right three out of four times merely to match the overall performance of those who stay fully invested.

• In 1985, a study of 100 large pension funds reported that only 11 improved rates of return through market timing and 89 underperformed the benchmark by 4.5 percent annualized over the five-year study.

• In 1996, Ernie Ankrim examined 70 years of historical returns, searching for any patterns that could be exploited by investors with foresight to recognize those patterns. The result? Past returns hold no predictive value or significant patterns to help investors decide when to get in and out of the market based on past performance.

What is the cost of bailing out through market timing? Ankrim writes, "Timers tend to get out too early and get back in too late, so they miss the up markets before and after the bailing. You’d have to be very accurate twice—getting out and getting back in." Getting back in is especially difficult because upward moves happen in accelerated bursts. In fact, an average annual return of 9.5 percent is concentrated in the first 20 trading days of a bull market.

The bottom line? Don’t be seduced by short-term market timing success. After more than 25 years of evaluating the most talented investment managers in the world, Frank Russell Company has consistently concluded, "We haven’t seen anyone who has consistently added value through market timing. Some win big, but they lose big, too. Unfortunately, the public often only hears about the upside of a market timer’s performance."

Avoiding the Collapse

As responsible investors, we should avoid the greed brought about by financial excesses. Proverbs 28:20 promises, "A faithful man will be richly blessed, but one eager to get rich will not go unpunished."* Proverbs 23:4 further admonishes, "Do not wear yourself out to get rich; have the wisdom to show restraint."

Success in the investment world does not come by jumping on the bandwagon of financial speculation (or off at just the right time); it instead comes from consistency and diversification.

For your retirement and investment planning, follow three simple rules:

1. Diversify and invest in equities and fixed income. Diversifying works because the value and return of different investments rise and fall independently of each other. As you get older, gradually reduce your exposure to equities but still diversify.

2. Diversify among different investment managers. Invest with those who consistently perform in the top 25 percent over a number of years. Don’t pick last year’s biggest performer, and definitely not the hottest sector. They are probably due for a correction.

3. Diversify with different investment styles. Some investment managers invest only in large cap companies; others look for value; still others look for growth. Styles of investing fall in and out of favor in the marketplace; but by investing in managers with different styles, you reduce the volatility of your investments while providing an opportunity to share in the upswing when a particular investment is in style.

Ministers Benefit Association provides the investment opportunities, educational tools, and choices to assist you with making decisions that are right for you. Through the award-winning LifePoints program, you can accurately and effectively understand your individual risk tolerance and translate that into an appropriate allocation between equities and fixed income. Examine the opportunities for yourself at: mba.ag.org.

Conclusion

History teaches us what happens once a particular investment becomes so popular that financial euphoria replaces rational market behavior. Unfortunately, at the end of such episodes, a fall always occurs. Built in is the fact it cannot come gently or gradually. Simply put, all groups participating in the speculation prepare for sudden escape.

Through proper diversification and a disciplined investment strategy, you avoid the need for an exit strategy. While market corrections will affect your returns for the current cycle, it should have little impact on your long-term investment goals and objectives.

*Scripture references are from the New International Version.

Randall K. Barton is CEO, Assemblies of God Financial Services Group, Springfield, Missouri.