The Ignorant Investor
Ignorance Can't Stand in the Way of My OpinionMonday, June 27, 2005
Desire, Not Fundamentals, Driving the Housing Boom
Reading the New York Times business section today, I came across the statistic that total returns on REITs have averaged around 20% annually over the last five years. Those are massively impressive gains, and it's worth looking at what's driving them.
Now mentally you have to take yourself all the way back to the year 2000. You think about what homes were built of then (wood, mostly), and you think about where they were built (small plots of cleared land), and you ask yourself: what's changed in this product since then? We haven't seen any great technological improvements in house construction. A house in 2005 is pretty much built the same way as a house in 2000, or, for that matter, as a house in 1985. Walls, a roof, a front door. Bedrooms, a kitchen, bathrooms. Same old, same old. Compare that with the changes in information technology that drove the stock market boom in the late '90s; bubble it may have been, but underneath it was a fundamental change in the way business worked.
So if the technology of home construction didn't change, perhaps this boom is driven by a lack of inventory? No, it doesn't seem like it. As far as I remember, back in 2000 people there weren't too many people wandering homeless across the landscape or living in tents. If we look at rentals, today they're still about where they were 5 years ago, so housing as a whole can't be undergoing some kind of shortage. From the standpoint of having a roof over your head, there's no difference between a roof you own and one you don't. A housing shortage would lead to both skyrocketing home prices and rents. So the rise in home prices can't have been caused by a desperate need to secure shelter.
Instead, I'd say that booming home sales are being driven by the mere desire to own one's home rather than rent it, a desire that appears to be fueled not only by cheap credit and tax breaks (besides the deduction for mortgage interest, within generous limits capital gains from a home's sale aren't taxed at all), but by the expectation that the investment in a home results in a significant short term gain. After all, for the many people in this country who expect to 'trade up' homes every few years, the expectation of gain over the long term can't be a factor in their decision making.
What this indicates to me, even in my ignorance, is that expectations have been built into the market that cannot be sustained. Credit is not always cheap, capital gains are often a wish, and the expectation of rising values is merely psychological. Kick anyone of these props out from under home prices, and the other two will fall in turn.
Now mentally you have to take yourself all the way back to the year 2000. You think about what homes were built of then (wood, mostly), and you think about where they were built (small plots of cleared land), and you ask yourself: what's changed in this product since then? We haven't seen any great technological improvements in house construction. A house in 2005 is pretty much built the same way as a house in 2000, or, for that matter, as a house in 1985. Walls, a roof, a front door. Bedrooms, a kitchen, bathrooms. Same old, same old. Compare that with the changes in information technology that drove the stock market boom in the late '90s; bubble it may have been, but underneath it was a fundamental change in the way business worked.
So if the technology of home construction didn't change, perhaps this boom is driven by a lack of inventory? No, it doesn't seem like it. As far as I remember, back in 2000 people there weren't too many people wandering homeless across the landscape or living in tents. If we look at rentals, today they're still about where they were 5 years ago, so housing as a whole can't be undergoing some kind of shortage. From the standpoint of having a roof over your head, there's no difference between a roof you own and one you don't. A housing shortage would lead to both skyrocketing home prices and rents. So the rise in home prices can't have been caused by a desperate need to secure shelter.
Instead, I'd say that booming home sales are being driven by the mere desire to own one's home rather than rent it, a desire that appears to be fueled not only by cheap credit and tax breaks (besides the deduction for mortgage interest, within generous limits capital gains from a home's sale aren't taxed at all), but by the expectation that the investment in a home results in a significant short term gain. After all, for the many people in this country who expect to 'trade up' homes every few years, the expectation of gain over the long term can't be a factor in their decision making.
What this indicates to me, even in my ignorance, is that expectations have been built into the market that cannot be sustained. Credit is not always cheap, capital gains are often a wish, and the expectation of rising values is merely psychological. Kick anyone of these props out from under home prices, and the other two will fall in turn.
Thursday, June 23, 2005
The Pessimistic Angle
Bill Gross of PIMCO is a very well respected bond fund manager. According to the Wall Street Journal, in a recent speech on the future investing climate. . .
Mr. Gross laid out a gloomier view of the U.S. economy than he has presented recently in his closely-read monthly commentaries. Of late Mr. Gross has professed a mostly neutral stance, pointing to an equally-matched tug of war between inflationary forces like lower interest rates and rising prices for assets like real estate and disinflationary forces like the rising use of cheap overseas labor and the aging of the U.S. population. (Disinflation refers to a reduction in the rate of inflation.)
The article goes on to say that forces that Gross believe fueled modest inflation, like fiscal policy and rising real-estate values, have now waned. So Gross sees inflation dropping to as low as 1% from its current level of about 2.5%. The result will be lower corporate profits, stock-price appreciation and fixed-income yields, which may in turn lead to a recession and/or a slowdown in the real estate market that's helped to drive the economy forward.
The upshot: Mr. Gross believes investors should prepare for an environment over the next three to five years where stocks, bonds and real estate plod along, producing average annual returns of 4% to 5%.
Gross says he's reduced his fund's holdings of TIPS- though not abandoned them- as the prospect of high inflation has receded. This is obviously a good plan if inflation doesn't rear back up. If.
The kicker is here, which I'm a little proud to say matched my own thoughts from a month or two back:
Mr. Gross's advice for investors and financial planners is to cut their investment costs to the bone to capture as much of the middling returns as possible.
Wednesday, June 22, 2005
The Push-Up Indicator
The New York Times ran a piece in today's paper headlined "Foreign Makers, Settled in South, Pace Car Industry" that described the ongoing trend of foreign auto makers setting up assembly plants in the American south and the nature of the work force they're finding there.
This passage gives you a sense of just how desperate people are to get a solid, middle-class job with a big company in these times of economic growth:
Come to think of it, this piece has given me a new test for gauging the state of the labor market in America. Just find out how many pushups Toyota is demanding during a job interview. The higher the number, the more desperate the workers are.
This passage gives you a sense of just how desperate people are to get a solid, middle-class job with a big company in these times of economic growth:
Reading this, I can't believe that the labor market be as tight as the unemployment numbers indicate when people will work for nothing for five weeks in the hope of getting a half-decent job on an assembly line.The process of getting a job at Toyota is rigorous, meant to weed out those not meant for the repetitive, sometimes hot work inside the plant, which sits on 200 acres surrounded by cotton fields.
After interviews, job seekers had to complete five weeks of pre-employment training at a center, which is run and paid for by the state, across the road from Alabama A&M University. The drill included exercises to see if they could work on teams and hours spent on a practice assembly line. None of the applicants were paid. Anyone who was late or missed a training session was instantly cut.
The few successful applicants went through nine weeks more training inside the engine plant, including two hours a day in a fully equipped gym where they ran on treadmills and lifted weights to build endurance.
Come to think of it, this piece has given me a new test for gauging the state of the labor market in America. Just find out how many pushups Toyota is demanding during a job interview. The higher the number, the more desperate the workers are.
Tuesday, June 21, 2005
The Contrarian Impulse
If there is a single aspect to investing that I have yet to feel comfortable with, it is the ability to take the contrarian course.
There is nothing inherently special about being contrarian. Usually when we think of somebody as 'contrary' in nature, it isn't a compliment. A contrarian is somebody who doesn't want to do something we all want to do just because we all want to do it. As with the devil's advocate or the person who stops listening to some indie band because the band 'got commercial', the contrarian is usually someone who everyone wouldn't mind seeing run down by a runaway truck.
So I admit it, I'm not predisposed towards going against the crowd. For example, if the market has favored a particular sector long enough that I start hearing things like, "Small cap funds have murdered the S&P index funds over the past five years", the first thing that pops into my mind is that I should buy a fund investing in small cap stocks because they've done so well lately. I can't help that. That's a pavlovian response, but it's probably totally wrong.
We know that over the long term, small cap stocks and the S&P have had roughly similar returns (yes, small caps have generally outperformed the S&P, but only by a relatively small amount). So if the S&P's return for the past five years is running at 1-2%, and returns for small caps in the same period are running at 50%, what does that say about the future growth of either?
Seems like the returns on each would have to even out eventually. Either the S&P would be due for a significant jump, or the small caps would be due for a significant fall, or there'd be a combination of both movements to bring the two closer together. That's the nature of the regression to the mean. After all, I can remember a time when the S&P was murdering small cap funds in the 'olden days' before 2000. Totally killing them. And what happened then? The S&P tanked and stayed locked in a range while the small caps ran free.
Now, buying into an index that's been lagging another index is counterintuitive for us ignorant investors. That the S&P was once king of the hill isn't something we take into account. In fact, the phrase 'what have you done for us lately' springs instantly to our minds. Small caps are winners, we think. Big caps suck.
But since the market is a race that never ends, it's always worth considering whether that lagging index- be it big caps, techs, Euro-stocks- may be ripe for a good run no matter what everyone else thinks. When we buy the indexes that are out of favor, chances are we're buying them cheap. And buying cheap is always a good thing.
There is nothing inherently special about being contrarian. Usually when we think of somebody as 'contrary' in nature, it isn't a compliment. A contrarian is somebody who doesn't want to do something we all want to do just because we all want to do it. As with the devil's advocate or the person who stops listening to some indie band because the band 'got commercial', the contrarian is usually someone who everyone wouldn't mind seeing run down by a runaway truck.
So I admit it, I'm not predisposed towards going against the crowd. For example, if the market has favored a particular sector long enough that I start hearing things like, "Small cap funds have murdered the S&P index funds over the past five years", the first thing that pops into my mind is that I should buy a fund investing in small cap stocks because they've done so well lately. I can't help that. That's a pavlovian response, but it's probably totally wrong.
We know that over the long term, small cap stocks and the S&P have had roughly similar returns (yes, small caps have generally outperformed the S&P, but only by a relatively small amount). So if the S&P's return for the past five years is running at 1-2%, and returns for small caps in the same period are running at 50%, what does that say about the future growth of either?
Seems like the returns on each would have to even out eventually. Either the S&P would be due for a significant jump, or the small caps would be due for a significant fall, or there'd be a combination of both movements to bring the two closer together. That's the nature of the regression to the mean. After all, I can remember a time when the S&P was murdering small cap funds in the 'olden days' before 2000. Totally killing them. And what happened then? The S&P tanked and stayed locked in a range while the small caps ran free.
Now, buying into an index that's been lagging another index is counterintuitive for us ignorant investors. That the S&P was once king of the hill isn't something we take into account. In fact, the phrase 'what have you done for us lately' springs instantly to our minds. Small caps are winners, we think. Big caps suck.
But since the market is a race that never ends, it's always worth considering whether that lagging index- be it big caps, techs, Euro-stocks- may be ripe for a good run no matter what everyone else thinks. When we buy the indexes that are out of favor, chances are we're buying them cheap. And buying cheap is always a good thing.
Monday, June 20, 2005
The Headline That Strikes Fear Into Mine Heart
Fannie Sees Higher Odds Of Regional Housing Busts, or so says the Wall Street Journal about a study that will soon be released by Home-lender giant Fannie Mae.
This is why.
The report, presented to a group of home builders in Washington last month but not yet released publicly, finds conditions in many parts of the country "mirror past conditions that preceded regional housing busts." Among other things, it cites increases in the number of riskier loans, including ones that allow buyers to delay repaying the principal or that aren't backed by full documentation of the borrower's income and assets.
In other words, we've got an increased percentage of borrowers who have to walk further out on the financial plank to afford the skyrocketing costs of homes. The driving force behind this is increased competition between private lenders that has led to a lowering of credit standards on loans that are getting bigger and bigger, on average. Isn't that comforting?
But the kicker is down at the bottom of the article:
Now, I bought into the market back in 1999 and benefitted from the home-buying hysteria that swept the nation over the past few years. But I've never counted the paper value of my increased equity as an asset in making up my own personal balance sheet.The report says lending patterns of the past year are similar in some ways to those of the late 1980s, shortly before prices fell in parts of the U.S., including Southern California and New England.
This is why.
Sometimes An Investor's Knuckles Must be White
There's a lot of talk on various blogs and the business media about the future direction of the S&P 500 and the rest of the stock market. This is isn't unusual. There's always lots of talk about that. Yet there seems to be more doom and gloom than usual. More economists and famous investors, Buffet among them, who seem to think that the combination of reckless fiscal policy by the government, a massive current account deficit (essentially a measurement of how much the world's capital the U.S. economy is absorbing . . . I think), and a potential bubble in the housing market is driving the U.S. economy. Since all three are unsustainable over the long term, the story goes, the economy is heading for some serious whitewater over the next year or two, which would drive down stock prices. The movements could be made more volatile by the effect of itchy trigger fingers of hedge fund and mutual fund managers who collectively control vast positions of stock market wealth. Doom, baby. Doom.
Or not. At least, that's the view of a whole bunch of other economists, Alan "Yoda" Greenspan among them, who see a few relatively minor issues that won't detract from the overall health of the economy. These folk see low inflation, manageable growth, improving conditions.
So who do we in the ignorant investing community believe?
I'm not an economist. I don't know anything about account deficits, the business cycle, capital flows, derivatives, or the Federal Reserve that isn't contained in the average 500-word article from Businessweek. When experts disagree, I don't have any reservoir of knowledge of my own to judge whose analysis is on target. So I just don't know who is right here.
Then again, it doesn't seem like anyone else does, either. The best description of the field of market prognostications is that nobody ever agrees, even though the possibilities are so limited. After all, the market can only do one of three things from here: go up, go down, and stay the same. Of those three, only the second is the kind of thing that bothers investors very much.
But if you do put money into the market now, there is the chance that the market will go down. This is a risk that is unavoidable. You can never put money into the market with the certainty that it's protected from loss. On the other hand, you can never keep money out of the market and still expect to make solid gains. So there isn't any way to avoid the occasional, or even frequent, white knuckle moment that comes from investing.
And keeping money completely out of equities isn't much of an option, either. Even when he's tame, Mr. Inflation eats away at cash piles like . . . well, you can come up with your own metaphor. But he must be beaten soundly, and the only way to do that is invest in stocks and bonds that provide the prospect of returns that outpace inflation.
There's no other way than to risk at least some capital. To hop aboard the roller coaster and accept that sometimes your knuckles are going to be white.
Or not. At least, that's the view of a whole bunch of other economists, Alan "Yoda" Greenspan among them, who see a few relatively minor issues that won't detract from the overall health of the economy. These folk see low inflation, manageable growth, improving conditions.
So who do we in the ignorant investing community believe?
I'm not an economist. I don't know anything about account deficits, the business cycle, capital flows, derivatives, or the Federal Reserve that isn't contained in the average 500-word article from Businessweek. When experts disagree, I don't have any reservoir of knowledge of my own to judge whose analysis is on target. So I just don't know who is right here.
Then again, it doesn't seem like anyone else does, either. The best description of the field of market prognostications is that nobody ever agrees, even though the possibilities are so limited. After all, the market can only do one of three things from here: go up, go down, and stay the same. Of those three, only the second is the kind of thing that bothers investors very much.
But if you do put money into the market now, there is the chance that the market will go down. This is a risk that is unavoidable. You can never put money into the market with the certainty that it's protected from loss. On the other hand, you can never keep money out of the market and still expect to make solid gains. So there isn't any way to avoid the occasional, or even frequent, white knuckle moment that comes from investing.
And keeping money completely out of equities isn't much of an option, either. Even when he's tame, Mr. Inflation eats away at cash piles like . . . well, you can come up with your own metaphor. But he must be beaten soundly, and the only way to do that is invest in stocks and bonds that provide the prospect of returns that outpace inflation.
There's no other way than to risk at least some capital. To hop aboard the roller coaster and accept that sometimes your knuckles are going to be white.
Friday, June 17, 2005
If Only Harry Potter Managed Money
Trying to simplify the process of investing down to its bare bones, it occurred to me that there are a limited number of ways the average person can make money with a little capital:
1) You can buy an asset of some kind- a home, a painting, coins, gold bars, bare land, a patent or copyright- and either wait for it to appreciate in value or allow someone else to use it for a fee. Usually this appreciation results from the demand for the asset outstripping the supply, or because someone has figured out a way for someone to use the asset to make more money.
2) You can lend money to someone for a period of time in exchange for a fixed fee or a fee that rises and falls based on some external event, like a rise in the going rate of interest.
3) You can buy a share of someone else's business, having virtually no say over how the business is run but taking a share of the profits and having a miniscule stake in the assets the company.
4) You can use the money to set up your own business.
That's it, as far as I can see. Nothing magical or extraordinary there. Taking any one of these four routes involves risk, and people have managed to both make and lose a lot of money doing all of them.
I don't know why this is important to note. It's probably obvious to everyone but me. But I like to make lists, particularly when there's so much written about investing out there in books, websites, magazines, the newspapers. Whatever the idea is, it's just a variation of one of these four approaches, and so is unlikely to have any magical properties to turn a little money into a lot of money fast.
Unless I've missed something. Which is very possible given my ignorance.
1) You can buy an asset of some kind- a home, a painting, coins, gold bars, bare land, a patent or copyright- and either wait for it to appreciate in value or allow someone else to use it for a fee. Usually this appreciation results from the demand for the asset outstripping the supply, or because someone has figured out a way for someone to use the asset to make more money.
2) You can lend money to someone for a period of time in exchange for a fixed fee or a fee that rises and falls based on some external event, like a rise in the going rate of interest.
3) You can buy a share of someone else's business, having virtually no say over how the business is run but taking a share of the profits and having a miniscule stake in the assets the company.
4) You can use the money to set up your own business.
That's it, as far as I can see. Nothing magical or extraordinary there. Taking any one of these four routes involves risk, and people have managed to both make and lose a lot of money doing all of them.
I don't know why this is important to note. It's probably obvious to everyone but me. But I like to make lists, particularly when there's so much written about investing out there in books, websites, magazines, the newspapers. Whatever the idea is, it's just a variation of one of these four approaches, and so is unlikely to have any magical properties to turn a little money into a lot of money fast.
Unless I've missed something. Which is very possible given my ignorance.
Thursday, June 16, 2005
Your Broker Loves You Bold
E-trade appears to have a preferred client in mind judging by the company's new TV ads.
As the screen shows shots of a series of well-trimmed men and women in various settings- some white, some black, some asian, and each of them is sitting in front of, or striding about, a computer screen surrounded by the trappings of the modern office or well-appointed home. As they consider whether to buy stocks on E-Trade, a man's deep voice triumphs the spirit of investing, E-trade style:
Be more bold, he intones. Be more powerful . . . Be . . . More!*
Now there's no doubt that investing in equities requires a certain amount of boldness. And claiming that buying 100 or so shares of IBM will turn one into a rutting reservoir of power is seems like a reach. But would it have hurt the company's message to suggest its customers also be . . . more prudent . . be more careful . . . be . . . Skeptical!
Why, yes. Yes, it would. Because although research has indicated that frequent trading and the resulting turnover is hell on returns (it's like riding a bike and trailing a big, fat parachute behind you), E-Trade makes its money by making trades for its clients. Less trading=Less Profits, and what company is going to use advertising to hurt its bottom line?
Whether or not trading a lot eats away at hard-won gains in a customer's portfolio isn't a problem that concerns them. For E-trade and other brokers, they're never going to see a trade they don't like, and their advertising reflects that.
So you can be sure they like bold investors. Ignorant ones, too.
*The quote may not be exact- I'm working off memory here.
As the screen shows shots of a series of well-trimmed men and women in various settings- some white, some black, some asian, and each of them is sitting in front of, or striding about, a computer screen surrounded by the trappings of the modern office or well-appointed home. As they consider whether to buy stocks on E-Trade, a man's deep voice triumphs the spirit of investing, E-trade style:
Be more bold, he intones. Be more powerful . . . Be . . . More!*
Now there's no doubt that investing in equities requires a certain amount of boldness. And claiming that buying 100 or so shares of IBM will turn one into a rutting reservoir of power is seems like a reach. But would it have hurt the company's message to suggest its customers also be . . . more prudent . . be more careful . . . be . . . Skeptical!
Why, yes. Yes, it would. Because although research has indicated that frequent trading and the resulting turnover is hell on returns (it's like riding a bike and trailing a big, fat parachute behind you), E-Trade makes its money by making trades for its clients. Less trading=Less Profits, and what company is going to use advertising to hurt its bottom line?
Whether or not trading a lot eats away at hard-won gains in a customer's portfolio isn't a problem that concerns them. For E-trade and other brokers, they're never going to see a trade they don't like, and their advertising reflects that.
So you can be sure they like bold investors. Ignorant ones, too.
*The quote may not be exact- I'm working off memory here.
Wednesday, June 15, 2005
A House May Not Make You Rich
In his June 12 column, "How Houses Eat Money", Wall Street Journal writer Jonathan Clements examines whether his home has provided the kind of investment returns we've all come to expect from the red hot real estate market.
Clements bought his New Jersey home back in 1992 for $165,000, and since then he's seen its value rise up to somewhere in the $500,000 range, giving him a paper profit of about 200%.
But, he notes, in calculating the value of his investment he couldn't stop there. He'd also have to include expenses. In his case, about $130,000 over the years in rather mundane and ordinary improvements to the house like a new roof, new boiler, screened in porch, new kitchen (keep in mind, the purchase price of his house was probably discounted because it needed work). These improvements improve the value of the house, he says, but not to the tune of $130,000 because nobody pays full price for what is now a 'used' kitchen or a 10-year old roof.
Then comes interest and real estate taxes: $171,000. Although these are tax deductible, he notes that he would have taken a standard deduction even without owning the house, leading to about $24,000 in federal-tax benefits from these two items. Subtracted from $171,000 means total cost was about $147,000.
The money quote is here, as he counts up the damage:
For a start, freedom from rent, the cost of which he didn't mention and which is impossible to gauge without knowing the value of local house rentals between 1992 and 2005. In constant 2005 dollars, assuming the equivalent of $1,500 to $2,000 per month to rent a house each month would mean he would have spent between $18,000 to $24,000 per year over the same time period (or $234,000-$312,000 in total if I'm figuring it right). This imprecisely determined figure may be far higher, and as it is the sum isn't too far from what he actually paid for housing.
He could count his equity, of course, as an asset. However, the same amount he paid towards equity each month could have been put into an investment account that probably would have grown to equal or better his current equity.
Still, as anyone who has ever been in a rental knows, he never had to worry about the landlord raising the rent, and that's no small reward.
Clements bought his New Jersey home back in 1992 for $165,000, and since then he's seen its value rise up to somewhere in the $500,000 range, giving him a paper profit of about 200%.
But, he notes, in calculating the value of his investment he couldn't stop there. He'd also have to include expenses. In his case, about $130,000 over the years in rather mundane and ordinary improvements to the house like a new roof, new boiler, screened in porch, new kitchen (keep in mind, the purchase price of his house was probably discounted because it needed work). These improvements improve the value of the house, he says, but not to the tune of $130,000 because nobody pays full price for what is now a 'used' kitchen or a 10-year old roof.
Then comes interest and real estate taxes: $171,000. Although these are tax deductible, he notes that he would have taken a standard deduction even without owning the house, leading to about $24,000 in federal-tax benefits from these two items. Subtracted from $171,000 means total cost was about $147,000.
The money quote is here, as he counts up the damage:
Combine that with my $165,000 purchase price and the $130,000 in home improvements, and I am up to $442,000 -- not much below my home's $500,000 current value. The picture would be even uglier if I counted my initial closing costs, routine maintenance expenses and annual homeowner's insurance, to say nothing of the innumerable hours of my own time that I have sunk into the place. And while I have no intention of selling, that day will come. Imagine I sold today, paying a 5% real-estate commission. After enriching the brokers involved, I would net $475,000, perilously close to my total cost.What did he get in exchange for spending all this money?
For a start, freedom from rent, the cost of which he didn't mention and which is impossible to gauge without knowing the value of local house rentals between 1992 and 2005. In constant 2005 dollars, assuming the equivalent of $1,500 to $2,000 per month to rent a house each month would mean he would have spent between $18,000 to $24,000 per year over the same time period (or $234,000-$312,000 in total if I'm figuring it right). This imprecisely determined figure may be far higher, and as it is the sum isn't too far from what he actually paid for housing.
He could count his equity, of course, as an asset. However, the same amount he paid towards equity each month could have been put into an investment account that probably would have grown to equal or better his current equity.
Still, as anyone who has ever been in a rental knows, he never had to worry about the landlord raising the rent, and that's no small reward.
Monday, June 13, 2005
I am an ignorant investor
It seems worthwhile to begin a blog about ignorant investing (the only financially-related subject with which I am familiar) with a post about just how poorly the average individual does in the role of portfolio manager.
In a post on Sunday on his market-oriented blog The Big Picture, Barry Ritholtz, the chief market strategist for Maxim Group, linked to the results of a study that found that:
Ritholtz links these low returns to a tendency among individual investors to allow the dominance of emotion over rationality. They succumb to a herd mentality that makes them buy stocks only when everyone else is buying, he says, and sell stocks only when everyone else is selling theirs. The result is a de facto trading strategy that can be aptly summarized as "buy high, sell low." Obviously, that's not the easiest way to make money.
I don't know if Ritholtz has it right here. I'd like to say that I am as canny an investor as they come. Yet my own experience in investing has been governed by emotion, largely alternating between fear and greed. Envy, too, has occasionally put in an appearance.
For example, after the 2000 crash, I fixated on maintaining a huge position in cash. At the time I was worried about a serious market crash. Dow down to 4000 or so, economic meltdown. The works. This is what happens to an otherwise rational mind when it sees its portfolio lose 40-50% of its value in the course of a year or two. Fear takes over, and the result was that I missed out on the huge 2002 rally after the market touched its low in 2002.
Move forward a couple of years. Now that the S&P is running high again, I've become obsessed with the idea that I missed out on what turned out to be a sizable gain. My gut tells me that the market is going up more, and so now I'm more worried about missing out on gains than I am of losing capital.
Yet should I be listening to my gut?
My gut is no more able to pass judgment on the future course of the market than it is able to solve a complex math equation or write a light opera. Those are tasks for the brain. For an organ capable of weighing evidence, imagining possible movements in stock prices, and judging the probability of those outcomes occurring. In other words, the decision of whether to invest in the S&P or some other investment vehicle shouldn't go by instinct. It should be based on reason.
Now that certainly appeals to the highly trained, analytical side of my brain. But if people were entirely rational, no one would be afraid of flying, we wouldn't fall in love with someone we shouldn't, and very few jokes would be funny.
So when I hear on CNBC an analyst say something like "a lot of cash is waiting on the sidelines to leap into the market", I can't help but be lured by that sweet siren's call from the S&P . . . buy me . . . invest now . . . don't miss out . . .
In a post on Sunday on his market-oriented blog The Big Picture, Barry Ritholtz, the chief market strategist for Maxim Group, linked to the results of a study that found that:
“Individuals have historically underperformed the markets, earning just 2.6% vs. the S&P 500 gain of 12.2% between 1984 and the end of 2002. Research in the U.S. has shown that this dramatic underperformance comes as a direct result of client behaviour, or more specifically, the attempt to avoid bad performance while seeking out better returns.“http://bigpicture.typepad.com/.
Ritholtz links these low returns to a tendency among individual investors to allow the dominance of emotion over rationality. They succumb to a herd mentality that makes them buy stocks only when everyone else is buying, he says, and sell stocks only when everyone else is selling theirs. The result is a de facto trading strategy that can be aptly summarized as "buy high, sell low." Obviously, that's not the easiest way to make money.
I don't know if Ritholtz has it right here. I'd like to say that I am as canny an investor as they come. Yet my own experience in investing has been governed by emotion, largely alternating between fear and greed. Envy, too, has occasionally put in an appearance.
For example, after the 2000 crash, I fixated on maintaining a huge position in cash. At the time I was worried about a serious market crash. Dow down to 4000 or so, economic meltdown. The works. This is what happens to an otherwise rational mind when it sees its portfolio lose 40-50% of its value in the course of a year or two. Fear takes over, and the result was that I missed out on the huge 2002 rally after the market touched its low in 2002.
Move forward a couple of years. Now that the S&P is running high again, I've become obsessed with the idea that I missed out on what turned out to be a sizable gain. My gut tells me that the market is going up more, and so now I'm more worried about missing out on gains than I am of losing capital.
Yet should I be listening to my gut?
My gut is no more able to pass judgment on the future course of the market than it is able to solve a complex math equation or write a light opera. Those are tasks for the brain. For an organ capable of weighing evidence, imagining possible movements in stock prices, and judging the probability of those outcomes occurring. In other words, the decision of whether to invest in the S&P or some other investment vehicle shouldn't go by instinct. It should be based on reason.
Now that certainly appeals to the highly trained, analytical side of my brain. But if people were entirely rational, no one would be afraid of flying, we wouldn't fall in love with someone we shouldn't, and very few jokes would be funny.
So when I hear on CNBC an analyst say something like "a lot of cash is waiting on the sidelines to leap into the market", I can't help but be lured by that sweet siren's call from the S&P . . . buy me . . . invest now . . . don't miss out . . .
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