This article was published in the Almanac in November 2008. Three years later, we cannot say that the “hurricane” has passed.
After the last few weeks, it is clear that those who crave excitement can get their fill by investing on Wall Street. The turmoil reminds us that the world economy only grows at a certain rate despite the wishes of eager investors. History shows that a spell of easy credit always produces a boom in business ventures. If the loose credit goes on too long, money finds its way to “cats and dogs” (shaky or mediocre investments), making them appear very profitable.
Investment firms on Wall Street and insurance companies rashly offered to guarantee the value of cat and dog investments for a fee. This was part of the trade in “derivatives.” Thinking that the risk of loss had been eliminated, investment firms and banks became more careless in the things they invested in and the people to whom they loaned money. When a few loans went sour, people began adding up all the guarantees that might have to be honored. For example, Lehman Brothers bonds were covered by $400 billion in guarantees – a staggering sum, and for just one firm.
It turned out that $400 billion represented a huge multiple of the actual loss. Many companies had taken on a bit of the risk of default by Lehman Brothers and passed part of the risk on, but the risk was counted over and over. The loss at Lehman was settled for $5.2 billion in cash and the remaining $395 billion of potential risk cancelled out. So potential losses represented by derivatives may be overstated.
The federal bailout has been criticised for saving Wall Street wizards who made many bad decisions. But businesses need to borrow money from time to time, and banks can’t make loans without capital (money from people who bought stock in the bank). Mortgage and other investments that are bad or suspected to be bad had frozen the ability of banks to lend. Now the government is buying stock in banks to allow them to get back to serving their customers who need loans. At some point, fear will be replaced with the understanding that sound businesses will survive.
What does depressing Wall Street news mean to small investors? Consider that some good things which you own may have been forced down to very low prices. In a panic, desperate sellers sell the best they have, not the cats and dogs. If you own bonds, and the issuer is not bankrupt, you can get your money back by holding the bond until maturity, regardless of how low the price has fallen. You likely will not have to wait that long.
The best course of action to take depends on how soon you need to use money that you put in the stock market. If you have decided that you were too aggressive in your investments, you probably should sell some of your holdings – enough to sleep at night. When fear and panic are in command, even today’s values in the market may not hold.
If you have 5 or 10 years to recoup a loss, holding on is probably the best option. On the bright side, market turmoil gives patient investors a chance to review their holdings and pick up better stocks at bargain prices. For investors willing to sell underperforming stocks, every day is a new day on Wall Street.
If you are just starting out as an investor, and putting a little money in mutual funds each month, you are the winner in this mess. Stick to your investing plan; you’ll pick up great stocks at once-in-a-decade prices.