3 Years After the Stock Market Peak: Here are the Lessons

On October 9, 2007, the Dow Jones Industrial Average closed above 14,164 points, an all time high. Since the tech bubble bottom in 2002, US stocks had more than doubled and international stocks had tripled in value. Little did we know that exactly 17 months later, the Dow would close at only 6,547 points. Even taking into account dividends, the Dow lost more than half its value.

Financial markets 3 years ago
To figure out where we are going from here, it helps to look back to October, 2007, when the real estate market was booming and the only requirement for getting a mortgage was to have a pulse. Embracing the widely-held paradigm that real estate values could never decline, lenders didn't bat an eye at lending 105 percent of a home's value.

Just as they had in 1999, investors thought the good times were here to stay. This optimism was reflected in risk profile questionnaires that financial advisors give to clients. Investors overwhelming indicated that they could take a ton of risk. Why not? Financial pundits were nearly unanimous in reinforcing the rosiness of the moment, predicting that it would continue, and were banging the drum on the need to be in stocks for the long run. Everywhere you turned the message was "Jump on in, investors, the risk water is fine."

And when I spoke to investors back then, everyone acknowledged two things:

The stock market will not go up every year.
When the market declines, one must rebalance by buying more stocks.

Financial markets 2 years ago
One year later, in October 2008, the market crashed, leading to the most painful economic hangover in our lifetimes. Lehman Brothers and AIG were household names. Suddenly, the risk mavericks were jumping ship like rats off the Titanic. Even Cramer was telling us to get out of stocks. And the market kept on falling, eventually bottoming out on March 9, 2009, when The Great Depression Ahead was a best-selling book.

Rather than rebalancing portfolios -- selling overpriced bonds and buying cheap stocks -- investors were fleeing stocks in droves. They decided that cash was king, and clung to it like a life preserver. Instead of seizing a once-in-a-decade opportunity to add to their stock portfolios, they chased performance and bought Treasury bonds, which were more expensive than they'd been in half a century.

Financial markets today
On Friday, October 8, the Dow Jones Industrial Average closed at 11,006 -- up about 75 percent from the bottom with dividends reinvested. In fact, when you factor in those dividends, the Dow's total return is only 17 percent below all-time high. And, despite the apocalyptic talk, a portfolio of 60 percent stocks and 40 percent bonds is actually higher today than it was at the end of 2007. Who knew that all one needed to do was stick with the same strategy that worked in boom times: Buy broadly diversified low-cost index funds and rebalance your portfolio once a year. This dull investing strategy worked again, as it always has.

Unfortunately, many investors never benefited from this recovery. They bought into the media hype and sold just in time to miss the rebound. The new paradigm that "capitalism is dead" ended up being just as silly as the one that caused the bubble: "Real estate values can never decline."

Lessons Learned
No good market plunge, or market recovery, should go wasted. Here are the key lessons learned from the past three years and my advice for the future.

The way human beings think about risk is unstable. We think we can take risk and handle pain, but we're really just fair weather risk takers who'll run for the hills when the market falls. Pick a more conservative asset allocation and stick to it.
Understand that an even bigger enemy than Wall Street is you. Always examine the role your emotions are playing when making seemingly logical decisions.
Be skeptical -- in good times and bad. View optimism as a time to rebalance and sell stocks, and pessimism as a sign to buy. Remember that the media usually predicts the past, and neither good times nor bad times last forever.
Don't buy into the next new paradigm. It will only suck away your hard-earned savings and make you feel foolish when it fizzles out. Talk about adding insult to injury.

While I clearly don't know what the next three years holds for investors, I know that common sense isn't actually all that common. I also know the dull index fund investors, who dare to go against the herd and rebalance, are the ones who are likely to profit from the investors who think they are smarter than the market.

More on MoneyWatch
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How to Profit From Irrational Investors - Which is Almost Everybody
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Bear Markets Suck, But Don't Give Into The Pain

Allan Roth

Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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