How To Invest In A Recessionary Economy Part II
August 17th, 2007There’s a good post over at Free Money Finance that talks about what to do with investments in the current economic situation. The article basically says that stocks are probably approaching their bottom in value and won’t drop much further. There is another article at Generation X Finance that more or less says the same thing, if I’m reading it right. The stock market is one of the most interesting things to analyze from a decision making perspective because it highlights so many quirky human behaviors. Referring back to our ever-growing list of Decision Making Errors:
Do what everyone else does
We are incredibly affected by what the people around us are thinking and doing. We see this in the stock market constantly, with huge groups of people buying in when things have approached their peak, and huge numbers selling out when values have dropped significantly. It almost makes me thing that the upswing in amateur investing is just a way to transfer income from average people to day traders. This is the conformity bias at work
“But it was worth twice as much six months ago!”
People succumb to referencing when valuing their investments, and they think that their investment is worth what it was when the market was booming. Worse, the endowment effect encourages them to value their asset as more than it is worth to sellers. Finally, the original investment is a sunk cost, and shouldn’t be considered in determining whether or not to sell, but it almost always plays a role.
You can see how in a declining market the conformity bias would encourage people to sell, while referencing, sunk costs, and the endowment effect would encourage people to buy. It’s plain though from historical trends that at some point panic takes over and the conformity bias becomes stronger. I like this post from Dr Housing Bubble
So what do we do?
So are the good folks at Generation X Finance and Free Money Finance right or wrong? It’s hard to say. They are right in warning that just because everyone else is worried about the markets doesn’t mean that we should be. What concerns me about this is that sometimes everyone is worried because the situation warrants it. Here are some numbers that should give you cause for concern:
- Public Debt: $8.9 Trillion or $29,653 per person.
- Consumer Debt: $2.4 Trillion, including $1.556 Trillion in non-revolving and $904 Billion in revolving debt.
- Imaginary Wealth: The economy has been sustained by an imaginary increase in wealth known as real estate values.
- ARM Resets: We still have several years of adjustable rate mortgages resetting to higher rates, and the resulting foreclosures, as shown by this image from Dr Housing Bubble.
These numbers make me cringe. I’ve seen a lot of different estimates of the expected losses due to the sketchy repackaging of high-risk mortgages to create class A investments, but it seems to be in the hundreds of billions. That’s hundreds of billions of money that didn’t actually exist.
While some people may be being alarmist about the situation, the economy stands to suffer from a major drop in wealth that just up and disappeared. When you combine this with the amount of debt that we all face, I don’t expect the economy to recover any time soon. Losses of wealth cause less investment in stocks, which leads to lower stock prices. I don’t think we’ve seen the bottom yet.
Of course, this is from the perspective of someone getting ready to start investing. If I held stocks or funds already, I’d probably stay in them just because I wouldn’t want to sell now at a loss (all those effects at work!).
Good luck. If you have a strategy you are pursuing post a comment or send me an email, I’d love to hear what you have to say.
In How To Invest In A Recessionary Economy Part I, I looked at the different places we could put our money if worried about a crashing stock market.
-zot
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