Last Updated Feb 10, 2010 9:57 AM EST
Larry: First, I'll agree that there's a heightened risk. Regarding your investments, the important questions are: Are we the only ones who know that? Do you believe that the institutional investors who do most of the trading, and therefore set prices, are unaware of this risk?
Dr.: Of course they are.
Larry: If that's the case, then wouldn't you agree that the terrorist threat -- as well as such risks as the massive budget deficits, high unemployment, the nuclear threats now presented by Iran and North Korea, and the potential for default of Greece and Portugal -- are already factored into prices? In other words, where do you think prices would be if those risks were not present?
Dr.: The market would be higher.
Larry: I agree. Therefore, you shouldn't believe that prices should be lower because those risks exist. In other words, if you know something, then it seems likely that the market also knows it unless it's inside information. Therefore, the information has already been incorporated into prices. And it's too late to act on that information. The only reason to act would be if you believed your crystal ball was clearer than the market's crystal ball. Unfortunately, as much as we would like to believe otherwise, there's no evidence that there are forecasters (be they political or economic) who persistently get it right. And that's why while we recognize the existence of those risks, we also accept them in return for the opportunity to earn the equity risk premium.
The most sophisticated investors know that the losing strategy is to focus on managing returns, because it can't be done without a clear crystal ball. The winning strategy is to focus on the things we actually can control: the amount of risk we take -- the asset allocation decision, diversifying the risks we choose to accept as much as possible -- eliminating or minimizing unsystematic (idiosyncratic) risks, costs and tax efficiency. And once we have a written investment plan, the winner's game is to adhere to that plan, ignoring the noise of the market and the emotions caused by that noise.
The next time you hear some guru forecasting a market decline, ask yourself before you act if the reasons he gave are a national secret. Having heard it on television or radio, or read it in some publication, the obvious answer is no. Therefore, it should be ignored. As Bernard Baruch wisely commented: Something that everyone knows isn't worth knowing.