Wednesday, March 18, 2009

Phantom Market

This morning I listened to a fascinating piece on National Public Radio that gives some additional insight into our investing primal instincts. After years of learned reality, a neurosurgeon explained that a patient cannot mentally decipher a new reality, such an amputated limb. The result was excruciating pain in a limb that was no longer there. As I listened to this report I thought of a generation of learned investment market behavior. Could they be be analogous?

After years of the Greenspan Put, whereby any stutter in markets and the economy was immediately met with lowered interest rates, could we too have a mental impediment to rational behavior? For two decades mutual fund sales forces and brokers trotted out proof of average 10% annual gains in the equity markets and retirement illustrations assured us of everlasting financial security. Now we are facing a serious case of cognitive dissonance. The limb (20 year bull market) is no longer there but we still feel it, even to the point of disbelief. Listen to the interview at the NPR site.

As an investment advisor the challenge is twofold now. Find the investments that will perform well in a changed economic environment and then helping clients accept that changing behavior will provide positive performance. Simply saying the limb is gone meets remarkable learned resistance. If the human brain cannot accept that an amputated limb is no longer there, what chance does our brain have of letting go of General Electric shares that served us well for years?

For example, having been taught the advantages of tax deferral in 401-k's and traditional IRA's, facing higher tax rates in the future, clients may find that deferring taxes is no longer the best approach. Realizing gains and income sooner rather than later should be considered.

While equities reflect underlying economic growth, seeking out non-equity investments should undertaken. As economic growth slows for the foreseeable future, there will be opportunities but the glide path will be flatter. Expectations for the stock market alone should be reexamined.

We all profited in a world in easily available credit, declining interest rates, high employment, high asset valuations and increasing leverage. Does it make sense to invest as if none of that has changed when all of it has changed. Investors need new limbs, and they are available for those who look.

John Barnyak