The Homa Files

Excerpted from WSJ: “Keep Your Money in the Market”, Burton Malkiel, Oct. 13, 2008

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As the world economy reels under the weight of the worst financial crisis since the Great Depression, we have been left with a broken financial system. Financial institutions around the world have suffered life-threatening, self-inflicted wounds by purchasing over a trillion dollars of complex mortgage-backed securities backed by dodgy loans based on inflated real-estate values.

These assets have been financed with enormous leverage and with short-term debt. Just prior to its “rescue,” Bear Stearns had a debt to equity ratio of over 30 to 1, making it susceptible to a “run on the … shadow banking system” built on derivatives.

The long-run solution to the present crisis must involve substantial deleveraging and a recapitalization of our financial institutions. In the meantime, credit has been essentially frozen and a world-wide recession seems almost inevitable.

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Investors should not panic. The best position for investors today is not “fetal and 100% in cash.”

We are not going to have a depression, and we have survived financial crises before.

A century of investing experience, as well as insights from the field of behavioral finance, suggest that investors who bail out of equities during times like these are almost always making the wrong decision.

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By all means, young 401(k) investors, and those in their prime earnings years, who are stashing away funds from every monthly paycheck, should stay the course. If you decide to eschew equities during periods of ubiquitous pessimism, you will lose all of the advantage of “dollar cost” averaging (buying more shares when prices are low than when they are high). Asset allocations should be shifted to safer securities over time as the investor ages, but only gradually and on a set schedule as through a “target maturity fund.”

If you are now approaching retirement and failed to move to a more conservative asset allocation, you should not do so now in response to a time of panic. If anything, well diversified investors should, at the end of each year, consider rebalancing to ensure that your portfolio composition remains consistent with the risk level appropriate for your financial circumstances and tolerance for risk. But this is likely to mean shifting into equities and not out of them.

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We will have a serious recession now, but a 1930s-style depression is highly unlikely. We will not let the money supply decline by 25%, as we did in the ’30s, and automatic stabilizers (like unemployment insurance) are now a significant element of fiscal policy. Don’t forget that the U.S. economy is still the most flexible in the world and our “innovation machine” is alive and well.

No one has consistently made money by selling America short, and I am confident the same lesson is true today.

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Mr. Malkiel is a professor of economics at Princeton University and the author of “A Random Walk Down Wall Street,” … he was Ken’s Econ 101 prof, and a faculty reviewer of Ken’s thesis “Money & Stock Prices: An Econometric Study”

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Full article:
http://online.wsj.com/article/SB122385741803727333.html

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