Past Investment Mistakes Are Great Teachers for Stock Purchases Today - dummies

Past Investment Mistakes Are Great Teachers for Stock Purchases Today

By Paul Mladjenovic

Because most stock investors ignored some basic observations about economics in the late 1990s, they subsequently lost trillions in their stock portfolios during 2000–2002.

During 2000–2008, the U.S. experienced the greatest expansion of total debt in history, coupled with a record expansion of the money supply. The Federal Reserve (or “the Fed”), the U.S. government’s central bank, controls both. This growth of debt and money supply resulted in more consumer (and corporate) borrowing, spending, and investing.

The debt and spending that hyper-stimulated the stock market during the late 1990s (stocks rose 25 percent per year for five straight years during that time period) came back with a vengeance afterwards. When the stock market bubble popped during 2000–2002, it was soon replaced with the housing bubble, which popped during 2005–2006. As of 2012, both the housing market and the general economy are still hobbled.

Of course, you should always be happy to earn 25 percent per year with your investments, but such a return can’t be sustained and encourages speculation. This artificial stimulation by the Fed resulted in the following:

  • More and more people depleted their savings. After all, why settle for 1–3 percent in the bank when you can get 25 percent in the stock market?

  • More and more people bought on credit. If the economy is booming, why not buy now and pay later? Consumer credit hit record highs.

  • More and more people borrowed against their homes. Why not borrow and get rich now? “I can pay off my debt later” was at the forefront of these folks’ minds at the time.

  • More and more companies sold more goods as consumers took more vacations and bought SUVs, electronics, and so on. Companies then borrowed to finance expansion, open new stores, and so on.

  • More and more companies went public and offered stock to take advantage of the increase in money that was flowing to the markets from banks and other financial institutions.

In the end, spending started to slow down because consumers and businesses became too indebted. This slowdown in turn caused the sales of goods and services to taper off. Companies were left with too much overhead, capacity, and debt because they had expanded too eagerly.

At this point, businesses were caught in a financial bind. Too much debt and too many expenses in a slowing economy mean one thing: Profits shrink or disappear. To stay in business, companies had to do the logical thing — cut expenses. Many companies started laying off employees. As a result, consumer spending dropped further because more people were either laid off or had second thoughts about their own job security.

As people had little in the way of savings and too much in the way of debt, they had to sell their stock to pay their bills. This trend was a major reason that stocks started to fall in 2000. Earnings started to drop because of shrinking sales from a sputtering economy. As earnings fell, stock prices also fell.

The lessons from the 1990s and 2000s are important ones for investors today:

  • Stocks are not a replacement for savings accounts. Always have some money in the bank.

  • Stocks should never occupy 100 percent of your investment funds.

  • When anyone (including an expert) tells you that the economy will keep growing indefinitely, be skeptical and read diverse sources of information.

  • If stocks do well in your portfolio, consider protecting your stocks (both your original investment and any gains) with stop-loss orders.

  • Keep debt and expenses to a minimum.

  • If the economy is booming, a decline is sure to follow as the ebb and flow of the economy’s business cycle continues.