Panicky Investors Hurt Themselves in the Long Run The sun will rise tomorrow.

A recent article on Bloomberg.com pointed out that hedge funds are aggravating the worst market decline in 50 years as they dump assets to meet investor redemptions and keep lenders at bay. The story quotes Mohamed El-Erian, Co-Chief Executive Officer of Pacific Investments, as telling CNBC that, “Even the really good hedge funds are being forced to sell.”

The good news is... someone is buying.

On the other side of the trade, from all those people liquidating their portfolios, are other investors who are happy to buy. Some are market timers, others see this as a long-term buying opportunity.

George Muzea, author of The Vital Few vs. Trivial Many, looks at the markets from a different perspective than most. Here is how he views the current market environment:

• The Vital Few (smart money): Insiders are not buying as aggressively as they did in the 1974, 1987, and 2002-2003 bottoms. However, there is almost no meaningful selling, always a sign of value.

• The Trivial Many (reverse indicators): The moods of the media, friends, and acquaintances are very bearish. The American Association of Individual Investors is seeing more bears than it has in 20 years. To Muzea, these reverse indicators keep him locked in the full buy mode.

Increased nervousness has caused many investors to contemplate getting out now.

“The way investors do violence to their financial security is to establish an investment position outside of their actual tolerance for risk, believing they can manage the risk by panicking to sell if the market drops lower. As prices drop, poor investors set an ultimatum for the market by saying, ‘If this thing loses one more dime, I'm out,’” says portfolio manager John P. Hussman. “Invariably, the thing will lose that dime and the investor will get out near the bottom, having taken most of the losses, but abandoning any prospect for recovery and subsequent growth”, he adds.

Waiting on a bear market in cash sounds like a great idea ... but, is it? A study by consulting firm SEI in 2002 showed what happened when investors cashed out during a bear market. Those who waited until the market recovered before getting back in, jumped in too late and lost out on double-digit gains. Investors who held on throughout the last 12 bear markets gained on average 32.5% in the following first year and recovered in 1.5 years. Investors who jumped in one week later gained 24.3% and recovered in 2.5 years. Finally, if you jumped in three months too late, the return was 14.8%, and took three years to recover. Even this down market will end – and, probably, when we least expect it.

Perhaps a more constructive way to approach recent concerns is to consider the importance of portfolio rebalancing. Consider a study by JPMorgan Asset Management. Assuming a hypothetical portfolio of 50% stocks/50% bonds, using the Lehman Aggregate Bond Index (Fixed Income) and the S&P 500 (Equities), an allocation on October 9, 2007 to October 23, 2008, has seen the weighting of stocks decline to only 36%, potentially leaving investors dramatically underweighted in stocks. In time, this could hurt investors who don't rebalance, as their portfolio might not be in a position to take advantage of an eventual rebound.

In bad times, demand for risky assets falls. So, the compensation for taking this risk needs to rise to attract investors. Lower share price relative to fundamentals just means expected returns may be higher.

Anxiety over the market downturn is understandable. But, we’ve had crises before. The world moves on and risk appetites have a tendency to reassert themselves.

The sun will rise tomorrow.



(Hedge Funds generally involve substantial risk and limited liquidity. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.)  12:24 PM •