I wrote this one year ago in the middle of the financial crisis in the stock market on my website.
I had to cut out the last several paragraphs to stay within the character limits.
STOCK MARKET CRISIS
What caused the stock market to drop so much in the past year, especially September? What can be learned from what happened? What should investors do now? Many experts agree that the market crisis is a result of the large number of subprime (high risk) real estate loans made in the last ten years. In the 1990's Congress relaxed regulation of the financial industry. Banks loaned money to people who did not provide valid proof of income or proven ability to repay loans. Many loans required no down payment or artificially low interest rates for short periods. The banks sold the mortgages to two quasi-government agencies, the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Management Corporation (FHLMC or Freddie Mac). These agencies were created many years earlier as government backed private corporations to make buying homes easier for the American public. Fannie Mae and Freddie Mac then bundled the mortgages and re-sold them to individual and institutional investors. Executives of Fannie and Freddie had incentive to approve risky mortgages because their bonuses were based on the amount of money loaned out. Housing prices rose because credit was easy. Many people speculatively bought houses larger than they could afford because they expected to sell at a profit. They did not expect to make mortgage payments for any length of time. Home building reached an all time high and the supply of houses became higher than the demand. Prices fell and people who had borrowed more than they could pay back defaulted on mortgages. Many of the mortgage backed packaged investments dropped dramatically in value. Banks foreclosed on unpaid mortgages but repossessed houses had to be sold for less than the mortgage amount. Large losses appeared on the bank's balance sheets. Financial institutions which held the defaulting mortgage investment packages began to fail, deflating their stock prices and making other institutions tighten their lending requirements. The current stock market and credit crisis is the result.
Investors are being reminded of some investment fundamentals. Markets go down as well as up. Some people can make educated guesses, but no one can predict the market direction in the short term. The purpose of asset allocation plans is to protect the investor from market fluctuations by diversifying into many different investments and categories. If stocks go down, fixed income investments usually go up. If stocks of one type go down, stocks of other types might go up. If stocks in one country go down, stocks in other countries might go up. An investment into a single stock or single sector of the market is riskier than an investment into the entire market in a broad index fund. Assets in cash and fixed income investments do not make as much money as stock market investments in good times, but do not lose as much money in bad times. Contrary to government encouragement, not everyone can own their own house. Only people who can make a down payment and monthly payments can own houses. Speculation in houses or in the stock market is extremely risky.
So what should investors do? That depends on individual circumstances. Young investors may view this market pullback as a wonderful opportunity because the market is about 30% lower than it was a year ago. Their risk is that the market may go lower in the short run, but young investors have time to stay invested for many years before selling when the market will be much, much higher. Other investors may be optimistic and buy now with the expectation that the market has overreacted to bad news, government intervention will help and the market will correct soon. Their risk is that the market may take some time to recover and they may need to sell some investments in the short run at a low price to pay short term expenses. Investors of any age who believe the market is going lower have already sold or will sell as the market goes lower. These investors gain some safety by getting out of stocks, but they lock in paper losses which will never be regained by staying in fixed income or stuffing money into a mattress. Aggressive investors who have been taking chances by putting 100% of their investments into the market may regret taking so many chances. All their money is invested in equities so they lost the most value in the market pullback. In addition, they have no available funds to invest at low prices. They may be missing a great opportunity due to their lack of available cash.
Conclusions followed, but no room here.
