Investment Consult

Good lessons from bad times

The debacles of 1974, 1987, and 2000 reveal important points about investing.

Lewis J. Altfest, PhD, CFA, CFP

In the past 30 years, the stock market has declined steeply three times. You know about the most recent drop: Technology stocks, fed in part by the Internet craze, soared to incredible heights in the late 1990s, only to crash back to earth in 2000.

A similar cycle occurred in the 1970s. Early that decade, many tech stocks were selling at prices 40 or more times their earnings. They fell from grace swiftly in 1974—along with many of the stocks collectively known as the "Nifty Fifty"—although the decline had begun the year before. The crash of 1987, on the other hand, was extremely short-lived and more evenly spread across all types of stocks.

Some of the lessons you can learn from these sharp declines are ones I've shared with you before, but all are worth repeating.

Corrections can happen at any time. Even though the Big Three were spaced 13 years apart, there's no guarantee the next correction won't come much sooner. Because financial information is disseminated faster these days, via TV and the Internet, the markets have become very efficient: Information is reflected in stock prices quickly. The downside is that negative news can cause investors to head for the exits faster than they would have if they'd had to get this information from their broker or financial planner or dig it out for themselves.

Volatility often spells trouble. Fluctuations in a stock's price—even a series of sharp increases—should serve as a warning. In 1976, for my PhD dissertation, I examined volatile stocks at length, and I can tell you things haven't changed: A pronounced upturn in volatility is still grounds for selling. Greater-than-market volatility is expressed by a beta coefficient higher than 1.0,* but even a stock with a below-market beta should be considered suspect if its beta subsequently rises sharply. When gauging volatility, I also take heed when a stock's price moves up or down by more than 20 percent over a few weeks, without the overall market experiencing a similar shift.

Following the herd is dumb. If everyone seems to think one way about investing, you ought to question the premise. Groupthink was rampant in the early 1970s, when investors thought "Nifty Fifty" companies (which included Avon, Digital Equipment, IBM, Polaroid, Simplicity Pattern, Texas Instruments, and Xerox) would show strong earnings growth until the end of time. The same could be said of the late 1990s, as investors fixated on the likes of Cisco, Dell, eBay, and Oracle at cocktail parties and in online chat rooms. If the masses believe a stock or sector is a sure thing—for example, it's "recession proof"—you or your adviser had better exercise due diligence before buying.

Momentum investing is poor investing. Just as you shouldn't act impulsively on tips, you shouldn't plow all your money into stocks or funds with the best recent returns thinking they indicate future returns—something known as "rear-view-mirror investing." A great act is tough to follow in investing as in any other field.

Yet momentum investing reached new heights in 2000: Otherwise smart mutual fund managers bought stocks that they knew were overpriced, so their funds' returns wouldn't deviate much from that of the overall market. They, too, got caught up in the hype and believed that the prices of already-overvalued stocks would continue to rise.

If a stock you're considering has a price-earnings ratio that has increased by more than five points over a few months, you should find out the reason. If it isn't because earnings have accelerated, think about the downside.

Diversification isn't a dirty word. Some considered it one in 1974 and during the late 1990s, when a lot of people thought it was incredibly stupid to dilute their gains by diversifying their assets. Well, who looks stupid now?

Large-cap growth funds, once the darlings of momentum players, performed poorly in 2000. On the flip side, large-cap and small-cap value funds (whose prices don't fully reflect their true worth) rose significantly last year, and small-cap value was still going strong as of August. Unless you can predict the future—and if you can, I'd like to talk to you—spreading your bets is always wise, because it's your best protection during market downturns.

*See Investment Consult, Jan. 22, 2001.

The author, a fee-only financial planner, is president of L.J. Altfest & Co.( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

 

Lewis Altfest. Investment Consult: Good lessons from bad times. Medical Economics 2001;18:18.