Lessons from a Very Bad Year

Lessons from a Very Bad Year
by Ben Stein
Posted on Monday, December 22, 2008, 12:00AM

At last, this horrible year is almost behind us. Let's hope we never see another one like it.
If someone had told me that the market -- adjusted for inflation -- would be down by more than it was in the Great Depression while most Americans still basically had high prosperity, I wouldn't have believed it possible. It goes to show what stupendously bad Treasury stewardship can do.
If someone had told me Treasury and the Fed would allow the fourth- or fifth-biggest investment bank in America to fail, I would've scoffed. But they did it, and we got a stock market crash, a severe recession, and national fear as the result. The night Paulson and Bernanke let Lehman fail was the night they drove old American investors down.
Theoretical Failings
Meanwhile, we look to the future. And we try to learn from the past. What have we learned?
1. Efficient market theory is extremely limited as a market predictor in times like these. Efficient market theory says that at any given moment, the market price of all stocks reflects all that is known about them -- the price at any given moment is the best estimate of future price.
This is true as far as it goes. And, again, in most times, it goes very far. But in times when what is not known lurks below the waterline like the bottom of an iceberg, dwarfing what lies above and can be seen, efficient market theory is not only limited in effectiveness but downright dangerous.
It turned out that what lay waiting unknown to most of us -- and to the market -- was a wild miscalculation about the true liabilities associated with credit in this country. The true liability on subprime included staggering amounts of derivatives, a high multiple of subprime itself. Ditto for credit card debt, and now, as we're seeing, ditto for commercial mortgage debt.
Not only was that debt questionable, but players had added super-sized bets so big that the markets simply couldn't adjust to them without a serious correction.
Mr. Market Gets It Wrong
So efficient market theory is sunk. The problem is that we have nothing else to replace it except the predictions of many different analysts. Some are right and some are wrong, and they're usually not even close to being as helpful as Mr. Market.
But as my pal Jim Grant notes in his masterful new book, "Mr. Market Miscalculates: The Bubble Years and Beyond," the market is far from infallible and can lead the investor to disaster. Efficient market theory is highly fallible, but it may still be better than anything else.
Bye-Bye, Buy and Hold?
Another lesson to be drawn from this year:
2. Buy and hold as a strategy is very questionable, as my pal Robert Lobban says. It's worked in the past, but in times of severe market stress it just doesn't work. We've now gone 10 years -- many of which were banner years for profits -- without a gain in the broad indices. In some areas, such as REITs and commodities and energy and autos, the losses have been breathtaking.
But trading doesn't work well for most investors either. Even for the best hedge fund geniuses (and actually I don't consider them geniuses at all), trading has often been a catastrophe in the last 15 months.
So, what's the solution? Ben Graham, a real genius who mentored Warren Buffett, concluded near the end of his life that stocks were simply too risky and investors should only be in Treasury bonds.
My pal, Phil DeMuth, along with many others, has long said that investors should have half in bonds. He's right, but even bonds, except for Treasuries, have been whacked this year. But his approach is definitely the right one. Ray Lucia, a super-smart investment guru, says you should have seven years of expenses in cash or near-cash to ride out events like this if you're retired or close to retirement. This turns out to be a simply brilliant suggestion. Ray has a lot of them.
What we're left with is maybe that buy and hold is far from perfect, but if we have enough cash to get us through the bad times we might yet see it work. If not, one hardly knows what to suggest.
Historical Ignorance
The final lesson from 2008:
3. We can't count on the people who rule us to have learned a darned thing from past history. "Those who do not know the past are condemned to repeat it," said the famous Harvard philosopher George Santayana.
Of course, that's a cliche by now and has been for decades. But it is true of Henry Paulson, our pitiful Secretary of the Treasury and, very, very sadly, of Ben Bernanke, our Fed chairman.
Paulson is simply an ignorant, bullying fraud. I never expected much from him. But Bernanke is a scholar, or so I thought, and should've known better than to destroy confidence by allowing Lehman to fail. That was a mistake that no real student of the Great Depression, as Bernanke is, should've made. I would never have thought it could happen, but it did.
It makes me wonder what other mistakes and foolishness our rulers have in mind, and it scares me plenty.
Only Human
In the meantime, please don't blame yourself for your losses. We all make mistakes, yours truly especially. My hat is off to those like Doug Kass who saw it all coming. My hat is not off to those who claimed afterward to have seen it coming. I have met so many people who tell me they sold out in October 2007 that I think I must be the only person left in this country with any stock. (That would make me by far the richest man on the planet, and I guarantee that I'm not.)
We're just human beings with human failings. Efficient market theory fooled us. Buy and hold fooled us. Trust in government fooled us. My own failings fooled me. Something else will fool us next time. As my grandmother used to say when her children made a mistake, "Don't worry, you'll do it again." If we learn even a little from what's happened, we're far ahead of Henry Paulson.
In that spirit, have a Merry Christmas, Happy Hanukkah, and Happy New Year.

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