How to View the Current Economic Situation

As advisors and students of financial history, we know that investors hate uncertainty. While most of us understand that only legends in their own mind have perfect clarity as to the future, when presented with conditions that create a heightened sense of uncertainty, even investors with well-designed plans react, letting their emotions and stomachs take over. And stomachs don't make good decisions. Fear, and eventually panic, tends to set in.

Unfortunately, we can't remove the uncertainty that may have your stomach rumbling. While it seems to be an all-too-human need to believe that there's someone who can protect us from bear markets, the evidence from academic research demonstrates that no such person exists. All crystal balls are cloudy, including mine.

Instead, I'd like to provide some perspective on what has been happening and to prevent you from committing costly errors -- failing to differentiate information from insights you can use to outperform the market and engaging in what I call "stage one-thinking."

Information or Actual Insight Let's start with confusing information with insights that can be used to outperform the market. The wrong way to think about all the bad news is to believe that prices must go lower. The right way to think about all the bad news is to understand that prices are where they are because of the bad news. In other words, if the news was bad, but not quite so bad, prices would actually be higher. In addition, low current valuations mean that future expected (though not guaranteed) returns are high. So before you sell, you should ask yourself: "Does it make sense to buy when valuations are high because things look safe, and expected returns are low? And does it make sense to sell when things look dark and valuations are low and expected returns are high?" That doesn't seem very rational. Yet, that's exactly the behavior of most investors. Consider the following.

On March 9, 2009 the S&P 500 closed at 676. By the close of May 2, 2011, it had more than doubled to 1,361, and that doesn't count the return from dividends. How were investors reacting during the greatest bull market since the 1930s? They were withdrawing hundreds of billions of dollars from equity mutual funds. That's why it has been said that bear markets are the mechanism by which wealth is transferred from those without plans, or the discipline to stick to plans if they exist, to those with plans and the discipline to adhere to them. Those who stuck to their plans in 2008-2010, simply rebalancing, were able to buy at low prices, when expected returns were high, and then sell (at much higher prices) when markets had recovered, taking precious chips off the table. In addition, the gains for some were so great that they were able to lower their equity allocation and still be likely to achieve their life and financial goals.

As was noted earlier, we don't have a clear crystal ball as to the outcome of this or any other crisis. It's certainly possible that the uncertainty in Greece and other countries could drag on for months without a solution, in which case risk premiums would likely expand, creating the potential for a repeat of 2008 in terms of the depths of a bear market. It's also possible that we could quickly get agreement on a broad solution, including recapitalizing the banks. That would restore confidence, risk premiums would likely contract sharply, and all the losses could be quickly erased. There's simply no way to know what scenario will play out.

• Next: Stage One Thinking

I'd now like to turn back to the second of the two costly mistakes I mentioned at the beginning that far too many investors make -- they limit their thinking to "stage one." Let me explain. When there are crises, investors focus on the negative news and fail to consider the likelihood, if not certainty, that governments and central banks will act to try to resolve the crises and restore their economies to a healthy state. Those who engage in "stage two" thinking understand that crises lead to actions to counter the problem. (In fact, it often takes crises like our budget crisis to get governments to act.) Faced with crises, governments typically enact stimulative fiscal policies, and central banks implement stimulative monetary policies. Those policies often take time to produce results, but markets are forward looking. That means that well-designed policies will typically lead to the financial markets recovering well before the economies recover.

This is why the stock market is one of the government's nine components of the index of leading economic indicators. The failure to think beyond stage one and look to stage two causes panicked selling and the resulting sell-low/buy-high outcomes most investors experience. And because it often takes a crisis to get the action, and the more severe the crisis the more likely you will get action and the stronger the measures are likely to be, the more likely it is that if investors limit themselves to stage one thinking, the more likely it is they will sell just before the markets begin to recover.

There's one other critical point we need to cover regarding stage-one thinking. Those who decide to sell until the "green light" comes back on, indicating that it's once again safe to invest in stocks, don't understand that there's never a green light when it comes to equity investing. It's never safe to invest. There's always a high degree of risk. For example, if you had sold in March of 2009, when would have it been safe to again invest in stocks?

• The unemployment rate continued to rise and stay at very high levels.
• We had a series of mid-East revolutions.
• North Korea launched an attack on South Korea.
• Our budget deficit problems have not been solved in any way.
• The U.S's credit rating was downgraded.
• Oil soared from below 50 to well over 100.
• We had the PIGS crisis.
• We had a flash crash.
• Housing prices continued to fall.
• Hundreds of banks failed.
• Let's not forget Meredith Whitney's dire forecast for municipal bonds.

There are very few investors who can avoid all risks and still achieve their life and financial goals. And the evidence against trying to time the market is that efforts are highly unlikely to prove successful. That means that the strategy most likely to allow you to achieve your goals is to abandon hope of trying to time the market, and instead focus on the things you can control:

• The amount of risk you take
• Diversifying the risks you take as much as possible
• Keeping costs low and tax efficiency high

Before closing I would like to discuss one other issue, diversification. Today, I hear many people saying the U.S. is the safest place to invest. That is probably a result of the S&P 500 Index outperforming the MSCI EAFE and MSCI Emerging Markets Indexes. However, the proper perspective is that this crisis demonstrates that international diversification is important. All one has to do is to think about the issue from the perspective of a European. If one of them had chosen to limit investments to the countries of the European Monetary Union, they would certainly be regretting it today.

In conclusion, the key to successful investing is to understand what Napoleon knew -- most battles are won in the preparatory stage. For investors that means having a plan that incorporates the certainty that they'll have to face many crises over their investment careers. Therefore, it's critical to not take more risk than you have the ability, willingness or need to take. A Monte Carlo simulation can help you determine the right asset allocation for you. If your stomach is roiling now, check to see if you are able to lower your equity allocation and still be able to achieve your goals. And if you find that is not the case, then you should at least consider lowering your goals, spending less now (saving more so don't have to take as much risk), or planning on working longer.

Before closing, I offer these words of wisdom. It's critical to remember that once something bad has happened, and we know the outcome, it's too late to act because markets have already done so. You have already taken the risks and incurred the loss. Any reaction at this point is likely to be an overreaction, caused by panicked selling.

And finally, I would like to note what I consider to be an amusing irony. While most investors revere Warren Buffett, they ignore virtually all of his advice, including his advice to ignore all market forecasts and his advice to not try and time the market, but if you do you should buy when others are panicking and sell when others are getting greedy.

More on MoneyWatch:
Update on the Greek Crisis and Some Good News John Bogle's Dream Fund The Behavior of Human Investors: To Err Is Human The Accuracy of Expert Forecasts Has the Small-Cap Premium Disappeared?
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