Friday, October 19, 2007

The Commemorative Correction

The Dow Jones Industrial Average was down over 360 points today. It hurt to be a shareholder today, but it was a pale shadow of the pain endured by investors 20 years ago to the day on October 19, 1987; a day when the stock market dropped over 20% and so deeply scarred the memories of investors that it is known by not one, but two, nicknames today – “Black Monday”, and “The 87 Crash”.

Of course, the stock market did not drop today because it is the anniversary of Black Monday – traders are not that sentimental. Bad news on many fronts provided ample reasons for traders to dump shares, including:

  • Standard and Poor’s downgraded more mortgage-backed securities, creating further doubt about the health of the credit markets.
  • Oil prices made a new all-time high, crossing above the $90 level for a short time before closing at $88.
  • Lackluster earnings reports and cautious words about the economy from companies such as Caterpillar, 3M, and Harley Davidson.

So, where does that leave us, as individual investors? Relatively calm, if we have been careful to buy “great companies at great prices”; as Warren Buffett would put it. We’re also not overly concerned if we have focused our mutual fund assets in the better managed funds that are available to us, with the right mix of stocks and bonds.

It is hard to tell which direction the stock market will go in the next few days or the next few weeks, but one thing that history teaches us is that the day after a substantial drop in the market indices is not the time to sell your shares indiscriminately. It is a time to calmly assess your financial situation and your risk tolerance, and to make some adjustments to your portfolio if it is out of sync with either of these. And, if you are in the fortunate position of having cash available to invest, it is a time to buy shares in a great company that is selling at a great price because of the drop (or correction) that you have just endured.

Selling all of your stocks on October 20, 1987 would have been a big mistake, and selling all of your stocks on Monday, October 22, 2007 when the US markets next open, will almost certainly prove to be a big mistake if you choose to take that course of action.

After all, the only reason that it is possible to earn higher returns as a stockholder than you can earn in a CD is because stockholders suffer through days like today, (and occasionally, those like Black Monday). This suffering is what accounts for what Jeremy Siegel calls “the equity risk premium” – or, in plain English, the compensation that an investor gets for making a good long-term investment, and then enduring the inevitable bad days that will occur while that investment comes to fruition.

Just remember:

The payment for the pain is the chance to make a gain.

Footnotes and Foreshadowing

I’ll go into more detail about how well-chosen investments reward us for our patience (and our pain) in my next column, where I will discuss my experience owning, managing, and selling a small rental property.

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