How the shutdown affects your investment plan

(MoneyWatch) I've been getting many calls and emails from investors who are very concerned about the stock market, given the partial shutdown of the federal government and the looming crisis if the debt ceiling isn't lifted. The concerns are typically greatest among older investors who not only remember the bear markets of 2000-02 and 2008, but who also worry about having neither the time horizon to recover, nor the stomach to experience a repeat performance.

To begin, it's important to acknowledge that the concerns are real and well-placed. While a short-term shutdown of the government likely will have a minor impact on the economy, as it has in the past, no one can accurately forecast the consequences of a default on our debt. As a good example of the impossibility of knowing the answer to that one, in hindsight is safe to assume that the Federal Reserve would not have allowed Lehman Brothers to fail in the way it did in 2008. That was the event that precipitated the seizing up of the capital markets. And a repeat, or worse, performance could result if we defaulted.

The first important point to make is that crises like these are actually the norm -- they occur with great frequency, far greater than most investors are aware. For example, consider this partial list of major financial and economic crises investors have had to face over the last 40 years:

  • 1973: Oil prices soared, causing the worst bear market since the Great Depression.
  • Early 1980s: Less-developed-country debt crisis threatened to bankrupt many major U.S. banks.
  • 1984: Seventh-largest bank in the U.S. (at the time), Continental Illinois, became insolvent.
  • Oct. 19, 1987: Dow Jones industrial average dropped almost 23 percent, with "Black Monday" the largest one-day percentage decline in its history.
  • 1989-1995: During the savings and loan crisis, 747 S&Ls failed.
  • 1990: Japanese asset bubble collapsed. Japan has yet to recover.
  • Early 1990s: Banking crisis engulfed Sweden, Norway and Finland.
  • Sept. 16, 1992: On Black Wednesday, speculative attacks on the British pound forced the Bank of England to withdraw from the European Exchange Rate Mechanism.
  • 1994: Mexican economic crisis led to devaluation of the peso. U.S. lent Mexico $20 billion as a part of a $50 billion international rescue package to help prevent the crisis from spreading.
  • 1997: "Asian contagion" caused assets to lose value and banking crises to spread across Asia.
  • August 13, 1998: Russian stock, bond and currency markets collapsed. From January to August, the Russian stock market lost more than 75 percent of its value.
  • September 1998: Hedge fund Long-Term Capital Management collapsed, with the Federal Reserve being forced to organized a bailout by Wall Street banks.
  • March 2000: With the Nasdaq at more than 5,100, the dot-com bubble burst.
  • Sept. 11, 2001: Attacks on the World Trade Center in New York and in Washington shuttered the New York Stock Exchange until Sept. 17, the longest closure since 1933. When it reopened, the Dow fell 684 points. Around the globe, economies went into recessions and equity markets crashed.
  • 2007: U.S. financial crisis began.
  • 2010: Greek debt crisis threatened the viability of the eurozone.
  • August 2011: U.S. lost its AAA credit rating.

Meanwhile, according to historian Bonnie Goodman there have been 17 shutdowns in American history, concentrated between the 1970s and the 1990s.

The point of the lengthy list is to demonstrate that crises are the norm. They are in fact the very reason for the existence of the historically large equity risk premium (about 8 percent). Investors demand compensation for having to suffer through such periods, and do so with no assurance that things will turn out well. That's what we do know about crises -- that they occur with great frequency.

What we don't know is when they will happen, what will be the cause, how long the bear market will last and how deep will it be? In other words, your investment plan must incorporate the virtual certainty that you are going to have to live through many crises, perhaps about one every other year or so, and live through them with equanimity, without panicking and selling.

Tomorrow, we'll discuss how emotions generated by crises can cause investors to take rash, risky actions.

Image courtesy of Flickr user KAZ Vorpal

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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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