Ben Stein How Not to Ruin Your Life

Because the past 15 months have been by far the most upsetting time period of many investors' lives -- including mine -- I am continuing to examine the lessons learned from this crisis. 

First, we have learned that even the most rigorous back testing of portfolios did not work during this period. The reason was simple -- no back test allowed for as much stress as markets were under from late 2007 to fall 2008. There simply was no postwar historic precedent for markets to be as volatile on the downside as they were in 2007-08. Thus, back testing (very similar to stress testing) that called for maximum falls of, say, 33 percent simply did not work when markets fell as far and fast as they did in 2007-08.

To be sure, there have been other times when the markets fell as far -- the early and mid-1970s are an example. But the daily volatility and unprecedented decline after the failure of the Treasury to rescue Lehman Brothers were simply not on most radar screens.

We Weren't Prepared 

That meant investors were not prepared, in terms of volatility, for what happened.
Nor were we prepared in terms of modern investment theory for a time when almost all categories of investment collapsed simultaneously: US large cap, US small cap, US value, US growth, foreign developed, foreign emerging, foreign growth, foreign value -- all collapsed. At the same time, corporate and municipal bonds fell sharply, as did nearly every commodity.

Real estate, both commercial and residential, also fell dramatically. No amount of diversification worked to preserve capital, other than having short- and medium-term Treasuries and insured cash.

This was not supposed to happen.

The back testing and portfolio propositions did not foresee a massive loss of confidence thanks to catastrophically wrong government moves. Thank you, Henry Paulson, for teaching us humility. Those disastrous moves told us we need to rethink our whole investment approach. It is indeed possible for us to have an investment world that mimics that of The Great Depression, even though most of us had thought that impossible.

There is still a lot of ignorance in the ruling class.

The Dangers of Useless Hedging

We also were caught off guard (or at least I was) by the amount of volume on the sell side that the hedge funds and investment banks could put into the market as they had to meet requests for redemptions and sell to meet demands of lenders. The amount of capital that these entities had to put into cash was truly prodigious and meant swings to the downside that could not have been imagined 10 or 20 years ago, once portfolio insurance largely disappeared.

Portfolio insurance is a scheme to hedge gains in portfolios by selling stock index futures short or buying put options. Once employed on a large scale, it led to a nuclear chain reaction of sales of cash versus options that dragged the market down roughly 25 percent in one day on October 19, 1987. Only extremely agile action by Alan Greenspan and the New York Fed to manipulate the options market kept the crash from becoming doomsday for capitalism. We should have learned from this about the dangers of unrestrained and totally useless "hedging" -- as in hedge funds -- but we did not.

So, again, we got hysterical moves to the downside from actions that were supposed to protect investors from just such moves.

What does all of this tell us? That, while the market can be our friend, it can also be a beast. The market can get things wildly wrong, as the extremely clever Jim Grant told us recently in his book, "Mr. Market Gets It Wrong." (Note: Jim is a hard money man, and I am not.)

Fighting the Last War

But what it mostly tells us is that we have to do even more hedging than we thought we did -- and in very basic ways. We investors, as the saying goes, are always fighting the last war. So now that we have learned to protect ourselves from volatility, we may not need to for a while.

Still, I have learned a bit of a lesson. I was wrong to have as little as I did in cash and Treasuries. I was wrong to be as sanguine as I was about my stocks and real estate in terms of their volatility. It was, in fact, possible for almost everything to collapse at once -- and it did. "The market trades to cause maximum pain" is a fine adage for investors then, now, and in the future.

Toward the end of his life, Ben Graham, Warren Buffett's brilliant teacher on value investing, told his friends that he had decided the stock market was simply too dangerous for him; he would keep all of his money in Treasuries. He was much smarter than I am; I am still foolish enough to think I should have a good chunk in stocks, especially at the current marked-down prices. Mr. Graham, by the way, died in the mid 1970s -- a terrible time to own either bonds or stocks.

The Plan Going Forward

But, although I will keep money in stocks, I will keep more than I did in insured cash and Treasuries. I will follow the advice of author and speaker Raymond J. Lucia, a dear friend and authority on financial planning, to keep many years worth of spending needs in cash or near cash. I will, in a word, hedge myself more in US government bonds and cash than I previously did.

I shake when I think of this because I feel sure inflation will eventually come back in a big way. But I am hedged on that -- I hope -- by my real estate, which I did not -- cannot -- sell.

In any event, I will take some comfort in knowing that even Warren Buffett's stock fell by about 45 percent in the 2007-2008 debacle; if the father of value investing could feel he had made mistakes, and if the gurus of value investing got clobbered, then I will not torture myself too much about the horrible year and a quarter just passed.

After all, my wife has not lost value. My dogs have not lost value. My son has gained greatly in value by getting engaged to a fabulous young woman. My friends have not lost value (but, sadly, there are fewer and fewer of them). The sunshine outside my house in Rancho Mirage, Calif., has not lost value, and every year I have left has greater value because of scarcity.

In my remaining years as an investor, I will just do the best I can -- and then go eat sushi. I recommend that you do the same.