The Greek Debt Crisis

Last Updated May 7, 2010 1:13 PM EDT

With yesterday's massive drop in the market fueled by the situation in Greece (among other European countries), you may be wondering what this means for your investments.

There's no doubt that things are bad for some of the weaker members of the European Union, and it's certainly possible that things will get worse for these countries. However, knowing this information isn't enough for you to make a profit (or avoid a loss). For you to capitalize on the current crisis, you would need to know whether things will be worse or better than the market already anticipates. The best indication of how bad things will get is the reaction of the financial markets. This is manifested in the yield of Greek bonds and the price of credit-default swaps on Greek sovereign debt.

Clearly, the market is aware of the situation in Greece and has factored the expected outcome into prices. If things turn out worse than expected, prices will fall. However, if things turn out better than expected, prices will rise. Smart investors know that the world is a risky place and factor this into their investment plan. This plan accounts for all kinds of risk, not just the most recent debt crisis in Greece. Choosing the asset allocation that fits your ability, willingness and need to take risk is the best way to be prepared for the risks of the market.

One of the biggest problems investors have to deal with is hindsight bias. There is an old saying that we all make great quarterbacks on Monday morning. With the benefit of hindsight, the right play to call and the winning strategy are always obvious. Unfortunately, it seems to be a human failing that we're either unable or unwilling to recall what our beliefs were before the events actually occurred. We have a tendency to exaggerate our pre-event estimate of the probability of an event occurring. This hindsight bias may lead us to believe that even events the "experts" failed to foresee were not only painfully obvious, but also possibly even inevitable. Every day, we hear after-the-fact analysis explaining market moves in a way that sounds as if an event were predictable.

None of us has a clear crystal ball as to how events will play out. It's certainly possible that we could see a repeat of the "Asian Contagion" that caused a sharp market correction in the summer of 1998. On the other hand, the problem could be solved quickly and markets return to normal. Unfortunately, if we do experience a severe market, many investors will believe that it was obvious that it would occur and they should have acted. And obviously there will be some market gurus making such a forecast -- just as there were gurus who last March, with the S&P at 600, were predicting it would drop all the way to 400 (such as Nouriel Roubini). However, there is an overwhelming body of evidence that efforts to time the market based on forecasts of events is the loser's game.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 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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