Saturday, September 12, 2009

Domino Theories

If you want to get a quick sense of just how fast time flies, consider that it was only a year ago this week that Lehman Brothers filed for bankruptcy—the same day that Bank of America announced its plans to acquire Merrill Lynch, and a day on which, not surprisingly, the Dow Jones Industrial Average closed down just over 500 points. That, in turn, was just a day before the Fed authorized an $85 billion loan to AIG—and that on the same day that the net asset value of shares in the Reserve Primary Money Fund “broke the buck.” This was made all the more surreal because it was going on while we—and several hundred advisers—were in the middle of our PLANADVISER National Conference.

Let’s face it—no matter how busy or hectic your week has been, I’m betting it’s been a walk in the park compared to those times.

The funny thing is, looking back (and armed with the prism of 20/20 hindsight), there were lots of signs of the trouble that eventually cascaded like a set of dominos, resetting not only the structures of the financial services industry, but disrupting the businesses and lives of thousands (if not tens of thousands) of advisers, not to mention the retirement plans of millions of workers worldwide.

The question that many of us have been asking ourselves (or perhaps been asked by our clients) these past 12 months is—why didn’t we do something about it?

Now, doubtless, some of you did. And those of you who didn’t can hardly—IMHO—be faulted for not fully appreciating the breadth, and severity, of the financial crisis we “suddenly” found ourselves confronted with. Still, having lived through a number of other “bubbles” during the course of my career, “afterwards” I’m always wondering why so many wait so long—generally too long—to get out of the way.

“Way” Laid?

Greed explains some of it: As human beings, we may later disparage the motives of those that, with leverage and avarice, press markets to unsustainable heights (from which they inevitably fall)—though we are frequently willing to go along for the ride. Some may be explained by human proclivity to stay with the pack, even when it seems destined for trouble, and some surely by nothing more than an inability to recognize the portents that precede the coming fall. When it comes to retirement plan participants, mere inertia surely accounts for most, though some are doubtless waylaid by bad, or inattentive, counsel.

There is, of course, a behavioral finance theory called “prospect theory,” that claims that human beings value gains and losses differently; that we are more afraid of loss than optimistic about gain. An extension of that theory, the “disposition effect,” claims to explain our tendency to hold on to losing investments too long: to avoid acknowledging our investing mistakes by actually selling them. It is, IMHO, an attribute rationalized every time someone says that the losses in our portfolios are “unrealized.” Unfortunately for investors planning for their retirement, unrealized and unreal are NOT the same thing.(1)

We all know that markets move up AND down, of course, and we must do the things we do without the benefit of a crystal clear view of what lies just over the horizon. That said, as we approach the anniversary of the 2008 tumult, it seems a good time to ask: Are you looking out for trouble—as well as opportunity?

—Nevin E. Adams, JD

(1) That said, the markets have, in recent months, recovered a lot of ground. The S&P 500 index is up more than 50%—if one looks back only to its March 2009 lows. On the other hand, that index is still down a third from its 2007 peak, still 20% lower than it was a year ago. Recovery takes a long time.

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