Investors always gravitate between fear and greed. The pendulum had swung too far toward greed in recent times. Now investors have been traumatized and the danger is that they will stay fearful and lose opportunities.
Both extremes are bad. Being too fearful is less destructive than taking too much risk but it is still a huge problem. Whether someone is saving for their first house, to send children to college or to have a secure retirement they must invest prudently. But to do that, they must accept prudent risk. Every investment carries some risk whether an investor identifies that risk or not.
A measure of the level of panic is the investment posture of major institutions. Short-term treasury bills are being issued at close to zero percent interest. What that means is that major market players are willing to hand over their money to the biggest borrower in the world in return for -- nothing. There are trillions of dollars under the government's mattress and major institutions are asking for nothing in return except for a piece of paper that says the U.S. government will give the money back, with no interest, at a specific time.
So if the big institutions panic, should individuals panic too? While panic was certainly justified for several months in the fall -- just because I'm paranoid doesn't mean someone isn't out to get me -- one should examine the current environment in weighing investment decisions.
It's highly likely that the world economy will go through a brutal slump for most of 2009 and recovery for late 2009 or even 2010 is problematic. While there are some grounds for being more optimistic, it's not necessary to rely on that to chart an investment course.
Going back as far as we have good records, to 1926, the broad stock market has increased on average by more than 10 percent per year. That takes into account the 85 percent drop during the Great Depression, the dark days early in World War II when the Germans and Japanese raced toward victory, the brink of nuclear war in the Cuban missile crisis, the ravages of inflation and the prolonged economic slump of the U.S. in the 70s and early 80s and the tech stock collapse at the dawn of the millenium. Through all that, the stock market has recovered and grown in line with the economy.
On average through all those bleak periods and boom periods, the stock market has doubled every 7 years and quadrupled every 14 years. It's never smooth and never guaranteed but it has worked for a long time. While there were periods this fall when it looked like the world economy could completely derail, the greatest danger seems past. Now it is a matter of being patient and enduring pain but the outcome should be similiar to that of all the many times over the last century.
Most investors do not have access to anything that can equal the returns of stocks over the long term. Investing in a broadly diversified representation of the stock market makes it possible to realize those returns with the least risk. Investors should not abandon that avenue as part of their investment arsenal just because of some recent trauma -- the second worst year of the last century. This too shall pass. From past experience we also know that whenever the market does recover, it is likely to be suddenly and with big moves. A big part of the gains will be concentrated in a short period and few people will realize what has happened until after it is over.