Prepare for the Worst, Hope for the Best

What is going on with the stock market this year? Less than six months ago, the financial press (yes, I try to ignore them) seemed all but certain that the European debt crisis was going to send the United States economy back into recession. Today, the sentiment on Wall Street is positive –employment numbers are improving, the housing market is recovering, borrowing costs are low, and consumers are spending. Heck, the IPO market is even gaining traction again.

If you were enjoying Spring Break last week, you may not have noticed the following news items: S&P 500 passes 1,400 (first time since May 2008), NASDAQ closes above 3,000 (first time since November 2000), DJIA pushes through 13,000 (only 7% below an all-time high). For investors, life seems good again–hold that thought.

Remember the “fear gauge” that was so popular during the bear market of 2008-09? Traders refer to it by its ticker symbol, VIX. It is a measure of implied volatility and is often used to assess investor expectations for stock market volatility over the near term. In other words, when the VIX is high (most recently in November 2011), investors are usually scared. Last week, the VIX hit a post-financial-crisis low, meaning that fear is in scarce supply. Isn’t it amazing how quickly we can feel safe or frightened when it comes to our finances? Certainly, the underlying fundamentals of our economy are not so capricious.

A prudent investor realizes that neither the good times nor the bad times are continuous. The economy is cyclical and its future direction can not be predicted with certainty. Most people fall into the trap of making investment decisions near the apex or trough of these economic cycles. They allow their own emotion and the “madness of the crowd” to convince themselves that a major reaction is necessary. It’s human nature (fight or flight). While this inherent trait can be helpful in some situations (facing the school bully on the playground), it can be disastrous when it comes to our personal finances.

For example, those who were lured into the Florida real estate market in 2006 with the promise of easy money are probably not too happy today. The same is true for those who sold significant stock holdings in late 2008 and early 2009 because (at the time) it seemed obvious that our country and economy were doomed. Unfortunately, the examples don’t have to be so dramatic or unusual to cause real damage. The family who uses a recent increase of income and a five percent down payment to justify the big house are also headed toward potential disaster. The margin for error is slight.

The stock market doesn’t always make sense in the short run, but we believe that corporate earnings will drive stock prices higher over the long run. There will be bumps along the road and we know that; in fact, we expect it. The next downturn might occur this year. It might not. Either way, I am prepared because my projections are conservative and economic downturns have already been factored into my Financial Plan. If you don’t have a Plan, you need to create one. If you want help, give us a call. Managing risk is not as exciting as seeking return, but it is crucial to your success.