How to Know What to Do When It’s Hard to Know What to Do

I thought it was time to address some of the gloom and doom that has so dominated the news of late.  Not, by the way, with the intent of dispelling it (or supporting it, for that matter) but more with the aim of addressing the question of what we can best do to operate in an uncertain world. To begin, allow me to recap some recent developments:

The pace of economic recovery is slowing.  Second quarter economic growth in the US was revised downward last week from 2.4% to 1.6%.  At the same time, unemployment moved up a notch and home sales moved down a notch (or two).  Fed Chairman Ben Bernanke, observing these developments from the monetary policy meeting in Jackson Hole, suggested on Friday that a little more fiscal stimulus might be welcome.  He knows, of course, that this is currently a political non-starter.  Writing in yesterday’s New York Times, meanwhile, Laura Tyson, UC Berkeley economist and past chair of the president’s council of economic advisors, made the case for why the slowing recovery calls unambiguously for a second stimulus.  And just to round things out, Nobel Laureate economist Paul Krugman has declared that this is not a recovery in any meaningful sense of the word unless the pace of growth is fast enough to bring down the unemployment rate quickly and significantly. Few are predicting that the economy will resume such a pace this year.

The news is not all dire on the policy front, however.  Notwithstanding the lack of consensus for a second stimulus, the White House is pressing forward with several initiatives that could help.  None are anywhere near the scale of last year’s stimulus package, but each could have an incremental impact.  And, while noting that the Fed does not possess unlimited power to regulate economic growth, Chairman Bernanke nonetheless observed that the central bank still has policy options in its toolkit and made clear its commitment to using any and all of them to keep the recovery on track.

One of the things holding down the pace of recovery is the “savings binge” that consumers have engaged in as they work to pay down the excessive debt levels acquired during the real estate boom.  Businesses, likewise, are holding back on new hiring and fixed investments that could create a much needed boost.

While the “animal spirits,” as John Maynard Keynes termed business sentiment, have left American business people in a pessimistic mood, sentiment can change suddenly, dramatically, unpredictably. In this vein, it’s worth noting that American businesses are now sitting on a record $1.6 trillion in cash reserves, the deployment of which would cause a dramatic shift in direction for the economy.  Consumer and investor sentiment is likewise subject to unpredictable swings.  In the long run, I suspect that one counts out the American consumer at one’s peril.  Today, in fact, it was reported that consumer spending had risen in July, after four months of decline.

The real point of enumerating the foregoing pluses and minuses is this: I don’t know what’s going to come next for the economy.  No one does.  No one you see speaking on TV and no one you see quoted in newspapers or magazines knows what’s coming next.  There is sometimes an illusion of prescience, created by the fact that every possible outcome is being predicted by someone, every minute of every day.  As we look back at how events have unfolded, inevitably someone will have “called it right.”  That in itself isn’t particularly impressive.  What would be more so is if the same person got it just right again and again and again.  There’s not much evidence for that.

Of course, if someone did possess perfect foresight, they would never diversify.  Diversification is only a reasonable strategy in the absence of such prescience.

So, coming back to my opening question:

How are we to know what to do when times are so scary?  The answer, prosaic as it may sound, is to show up with a plan from the start.  And then stick to it (scuba divers like to say “plan your dive and dive your plan;” a good motto for our financial affairs as well). There’s a reason this is so hard to do, however.  As I’ve noted in prior writings, neuroeconomists have established that the prospect of financial loss activates the part of our brain called the amygdala. The amygdala is where our “fight or flight” responses live, so, naturally, when this part of our brain lights up, we feel the urgent need to DO SOMETHING!  This is certainly a functional response when one is being physically attacked, but far less so when it involves one’s portfolio.  As long as there are sufficient cash reserves to serve as an emergency fund, and as long as there are sufficient stable bond reserves to meet spending needs in retirement for five or six years, there really is no reason to take action when it appears that the economy might be hitting a bump in the road.

So, the motto should be: Plan Your Life and Live Your Plan.  And the next time the doomsayers are splashed across the front page of your newspaper, put it down and take the dog for a walk.  You’ll both feel better for it. And as Roger Lowenstein, pointed out in Friday’s New York Times (Taking Stock): “it is generally more lucrative to sell prophecies of doom than to act on them.”

The Yeske Buie Team