The Financial Markets in 2011

The best summary of what happened in the financial markets in 2011 comes courtesy of James Surowiecki at The New Yorker:

In 2011, the S. & P. 500 finished the year where it started. (To be precise, it fell 0.003 per cent.) But it was anything but a placid year in the stock market. Instead, there was extraordinary tumult throughout 2011, with a series of sharp rallies and brutal selloffs, the biggest of which sent the market down seventeen per cent in a couple of weeks. Even on a daily basis, stocks were startlingly volatile: the Dow Jones Industrial Average moved more than a hundred points on forty per cent of trading days, and there were more than sixty days on which the S. & P. index moved about two per cent or more (which in 2005, for example, it didn’t do once). Ordinary investors, who have watched the value of their 401(k)s yo-yo seemingly at random, have been left feeling understandably dazed and confused as they head into the new year.

Traders and professional money managers don’t seem to have any real clue about what’s going to happen, either. You might think that volatility would allow people with superior information and market sense to get ahead. But last year money managers did a very poor job of playing the market. According to estimates made by Goldman Sachs, as of the last week in December seventy-two per cent of core large-cap mutual funds had underperformed their market indexes. The average stock-market mutual fund was down almost three per cent for the year. And hedge-fund managers, who are supposed to thrive on volatility, did even worse, with hedge funds that focus on stocks falling more than seven per cent. Strikingly, some of the biggest flops came from superstars: Bruce Berkowitz, whom Morningstar named one of the money managers of the past decade, saw his flagship fund fall more than thirty per cent; the hedge-fund manager John Paulson, whose bet against mortgage-backed securities a few years ago has been called “the greatest trade ever,” saw one of his funds drop nearly fifty per cent.

Surowiecki then mentions that ordinary investors “chase performance” and suggests:

The sensible solution would be for investors to put their money into low-cost index funds and just keep it there. But that’s hard to do when the market is extremely volatile. Most of us find it difficult enough in normal times to take a long-term approach. So when prices are rising and falling two per cent a day, and when it seems like getting in or out of the market could be worth ten per cent of our portfolio’s value, the temptation to try to time the market is hard to resist.

Here’s where I don’t agree with Surowiecki. What’s so hard about choosing to allocate a certain percentage (or a set sum of your savings/salary) per year to index funds (regardless of market volatility)? You can’t time the market, so you might as well invest in an index (or a fund) that tracks the S&P 500 and let your cash sit there for as long as possible.

I had a positive return on my portfolio in 2011, the majority of which consists of index funds. The key is diversification and a “buy and hold” strategy.

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