What the Greek Crisis Means for Your Portfolio

Last Updated Jun 21, 2011 10:14 AM EDT

Greek Debt CrisisAs you might expect, I've received lots of calls and e-mails asking what to do about the Greek crisis. So I thought I'd share my thoughts.

The first and most important point is that if you have a well-developed investment plan, it will have anticipated crises and incorporated that they'll occur. During the financial crisis of 2008, I developed a talk titled "When Will Things Return to Normal?" The key point I made was that frequent crises were the norm. I showed that from 1973 through 2008, there had been at least 15 other crises. I also showed the evidence that stock returns weren't normally distributed, and then point out that this is actually good news. The frequency of crises and the resulting bear markets (such as the three in that period with losses of about 50 percent) are why the equity risk premium is so large: Investors are risk averse and demand a large risk premium to accept the high volatility of investing in stocks.

I conclude the talk by noting that there are only three things we don't know about bear markets:
  • When they will occur
  • How long they will last
  • How deep they will be
In other words, we live in a world of uncertainty. And since there are no clear crystal balls, the investment plans we construct must anticipate that there will future crises. As Napoleon Bonaparte stated, "Most battles are won or lost [in the preparation stage] long before the first shot is fired." That means we shouldn't take more risk than we have the ability, willingness or need to take. Having a plan that anticipates severe bear markets gives you the greatest chance of staying disciplined and avoiding panic selling.

So, returning to the Greek situation. Yes, this crisis creates the potential for another financial "meltdown." Because of the huge exposures of European banks to not only Greek debt, but also to the debt of the other PIGS (Portugal, Ireland and Spain), it's possible that we could see a contagion spread across Europe, and financial markets could once again seize up as they did in 2008. If that were to occur, we would almost certainly see a flight to quality and liquidity, and the correlation of all risky assets (not just stocks) would likely rise towards one again. The potential for this occurring is why the Treasury bond market has defied Bill Gross's forecast that rates were sure to rise.

The problem is that we don't know what will happen. The crisis could be resolved, or we could see a default, the end of the Euro and who knows what. If your stomach is growling and you're losing sleep worrying about the outcome, you likely either don't have a well-developed plan or you were overconfident about your ability to deal with bad economic times. If the former is the case, then you should immediately develop a plan. If it's the latter, you should probably rewrite your plan and permanently lower you equity allocation, because this likely won't be the last crisis you'll have to deal with.

In summary, investing in stocks is always risky. A well-developed plan, one that anticipates crises and takes appropriate risk, provides you with the greatest chance of achieving your goal. If you either don't have a plan or take too much risk, the next crisis may cause you to sell and present you with a new set of problems. You won't know when to get back in the market. There's never an all-clear signal telling you when it's safe to buy stocks. Never.

Remember that market timing is difficult because you have to get it right both times:
  • When you sell
  • When you buy
And the evidence from study after study shows that most investors get it wrong. They tend to sell (low) well after the bear has awoken from his hibernation, and they tend to buy (high) well after the bull has entered the arena. On the other hand, those who have plans that anticipate bear markets get to play Warren Buffett -- they get to buy when there is blood on the street. They're able to do this, because they're adhering to their investment plan and need to rebalance.

Photo courtesy of archer10 (Dennis) on Flickr.
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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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