Tuesday, June 25th, 2024

Crises are inevitable, so what to do?

October 25, 2011 by  
Filed under Investing, Investor Behaviour, Mutual Funds

Every day when you open the newspaper, turn on the radio or TV news, or surf the internet, you will find at least one story about a natural disaster, political, economic or financial crisis that you could choose to worry about.  This worry can negatively affect investment decisions that you make.  What many investors ignore is that all the crises of the past have been experienced and yet progress has continued at roughly the same pace in the relatively free countries of the world.  The managers of the great businesses of the world are no strangers to crises and challenges of all types and they adapt their strategies to the changing times.  Some businesses fail when their plans prove to be weaker than those of others, and the more efficient businesses assume the market share of the weaker ones.  The owners of a diverse group of businesses see some efforts do poorly while others do well, and overall there is progress.

Since business efforts are the ultimate source of all wealth in society, it is natural that the owners of businesses have the highest level of income among citizens.  Those who do not take the risk of owning a business cannot rationally expect to make the gains that accrue to the owners.  For example, imagine a company like The Walt Disney Company decides to make an animated film and needs $100 million to produce it, so the company issues a bond and asks the investing public to lend it the money.  Many investors, considering the company to be reliable at repaying its debts, are happy to oblige and the company can borrow at a low interest rate, let’s say 5%.  Five years later, the movie has been produced and has a successful year, earning $1 billion for owners of The Walt Disney Company. The shareholders of the company can now pay back the lenders (bondholders), who have received total interest payments of 25% over five years, or $25 million.  Everyone is happy, but the owners of the company should be much happier.

One of the more interesting aspects of this scenario is that if the bondholders did not expect the company to do well, they would not lend them money because they might not get it back.  In other words, the bondholders have to lend the money, fully expecting the shareholders to do better than they will, knowingly trading off the higher perceived risk of ownership and higher returns that accrue to owners in favour of the lower returns and lower perceived risk of bonds.  The same thing happens every day at banks, where people place their money in term deposits they fully expect to be safely returned to them, while knowing the bank has to be able to make more money than they pay their depositors.  Maybe they just never think of it that way or do not understand the fundamental principles of economics?  It’s hard to understand at times.

The same principles apply for the owners of equity mutual funds.  Investing in a mutual fund, your money is diversified among a couple of dozen or even a hundred businesses by a professional money manager.  Some of the choices will not work out as expected, while others will.  Over time, you participate in the broad advance of the equity markets, which are in turn reflecting the gradual improvements in productivity achieved by individual businesses and their management and employees.  The people who choose to lend money by investing in bonds earn more stable but much lower returns and the bulk of the returns are earned by the businesses – and as an equity mutual fund owner, you own part of all the businesses in the fund – and their profits.

On any given day there are many reasons you can find to NOT be an owner of the great businesses of North America and the world.  For a while, this decision can even work out better than being an owner.  The more time that passes, however, the more likely you are to have made a bad decision and the bigger the mistake turns out to be.  These days, with the prices of great companies at prices that are both relatively and absolutely low, many people see equity ownership as very risky because market prices have been fluctuating widely.  These people are betting that the current problems cannot be solved and that economies will collapse.  They forget that if this actually happens, their money will not be worth anything because there will be no real wealth to support it.  More informed and experienced investors tend to see low prices as an amazingly good opportunity to tap into the ultimate source of all wealth in society.

Here is a partial list of crises of the last couple of decades…

1987 – Equity market crash

1989-91 – Recession and housing market slump started

1980’s – US savings and loan crisis

1991 – War in Iraq

1994 – Latin American debt crisis

1997-98 – Thai Baht crisis, Russian debt crisis, Long-Term Capital failure

2000-03 – Tech wreck

2001 – 9/11 attacks

2001 – War in Afghanistan

2003 – War in Iraq

2008 – US debt crisis , failure of Lehmann Brothers

2010  – Greek debt crisis

2011 – Euro debt crisis – PIIGS (Portugal, Italy, Ireland, Greece, Spain)

2011 – War in Libya

2012 – ??

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