Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. The following is Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year.
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Like many years, 2007 was filled with news that might have made investors sell stocks if they had a perfectly clear crystal ball. Let's review some of the bad news.
International Events
The showdown with Iran over its nuclear weapons program dominated the headlines. And Pakistan, a nuclear power already threatened by terrorism in the region, experienced a political crisis.
Commodity Prices
The price of a barrel of oil more than doubled to end the year at about $96. The price of many other commodities, including gold and silver, also rose dramatically. This raised the threat of inflation, which is a negative for both the stock and bond markets.
The Falling Dollar
The dollar collapsed against most major currencies, including the Canadian dollar and the euro. The headlines contained predictions about global investors abandoning the dollar.
Financial Mess
The U.S. capital markets experienced one of the most significant financial crises in history, fueled by turmoil in the subprime mortgage market. And with globalization, the holdings of subprime debt had spread around the world. The losses from the subprime mortgage meltdown are already in the tens of billions. This led to a general flight to quality, a drying up of liquidity in lending markets (not just mortgage-related lending), and a resulting widening of credit spreads. The central banks of the world had to orchestrate massive efforts to provide liquidity and keep the markets functioning.
Housing Recession
The U.S. housing market experienced its worst recession since the Great Depression. This created the threat of an overall recession.
Hedge Funds
Several large hedge funds experienced huge losses due to market volatility.
Lesson 1: Stay the Course
One can only wonder how many investors abandoned their investment plans in the face of all this bad news. Despite the bad news, the markets performed well overall. Treasury bond yields fell across the board in spite of rising commodity prices and the threat of a falling dollar. Thus, with the exception of junk bonds (and other risky credits), fixed income investments produced strong returns. Both the S&P 500 Index and Vanguard's Total Stock Market Index Fund produced returns of about 5.5 percent. And with the exception of small-cap and small-cap value and real estate asset classes, most equities around the globe provided good returns as well.
The lesson is that not only should investors ignore economic forecasts, but also that even if events were forecast accurately, investors still might make poor investment decisions based on that information. Thus, the prudent strategy is to have the right investment plan in place - one that reflects the investor's ability, willingness and need to take risk. Having such a plan gives investors a much better chance of ignoring the fear and panic caused by bad news.
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