Rich Examines Stock Market Mythology, Philosophy, Psychology, and Risk

To whom it may concern:  I’m on record saying that I think we’re in the midst of another stock market bubble. My bubble claim was a while ago, and I’ve missed out on some gains. Moreover, I acknowledge that stocks could go much, much higher from here. They could also go much lower. I’m ok with either outcome. The measure of smart investing, to me, is not actually the outcome, because outcomes can range from very lucky (winning the lottery) to very unlucky (a market crash). I’d say the measure of smart investing is the process — the ability to think clearly about risk in the context of one’s goals. 

My goal in this post is not to convince anyone to invest like I do. I admit I’m a contrarian generally — I like to zig when others zag. It’s not for everyone. So my goal in this post is to take a closer look at the  current conventional wisdom when it comes to stock market investing, and to explain along the way where my take differs. I would describe the current “passive indexing” wisdom in 3 parts, like this: 

  1. MYTHOLOGY: The stock market always goes up in the long run.
  2. PHILOSOPHY: Therefore, one should continually invest in stocks, at any price.
  3. PSYCHOLOGY: When the market goes down, don’t panic! Keep calm, remember #1, and keep doing #2.

Let’s take these in turn.

(1) MYTHOLOGY: Stocks always go up

The stock market always goes up in the long run. Definitions are important here. Proponents will clarify that the stock market in the good ol’ USA always goes up — not the Japanese or Burmese markets. Moreover, we’re not talking individual stocks. It’s the US index that always goes up, because an index is self-cleansing: it will kick out companies that fail (e.g. Enron) and bring in companies that succeed (e.g. Facebook). Therefore, as the narrative goes, a US stock index fund is likely the best investment as long as one can hold on over the long haul, through the ups and downs.

Why do I call this mythology? Well first let me say that a myth does not need to be a false claim. Another definition is that it’s a story, a narrative, to explain a phenomenon. My discomfort here, and the reason I call this mythology, is due to the words “always” and “long run.” While US stocks have indeed risen to this point, and spectacularly so since the 1990s, saying they will forever continue to rise does veer into the realm of magical thinking. Think about the claim: “This investment will always go up.” It’s just a little too certain for my taste, even if it works out that way for a very long time.

I’ve read that if one doesn’t believe stocks will always go up, then one is a doomsdayer. The only way the US stock market index will stop going up is if the economic world comes to an end. But for me, there is a middle ground between the end of the world and a good investment.  Which brings us to “long run,” the purported time period that makes this work.

Whether or not the “long run” idea is true, I’m not sure it’s useful. As a human I expect to live around 80 years. I might have 30 years of really good earning years and during that time I want my investments to be working for me. That’s my “useful long run.” Do US stock investments always go up over 30 years? Probably. From 1980-2010 they went up a ton. From 1915-1945 not so much. It depends when you put the money in and when you need the money, and if you never need the money or never need to sell an investment, you probably can invest in a savings account and be fine.

Overall, I admit that the first point doesn’t bother me too much. It’s a theory based on a fact, which is that US stocks have, in fact, gone up over the long run. Fair enough. A more important point in my mind is: How do we know if our personal useful long runs will be good times to invest in stocks or not? On to point 2.

(2)  PHILOSOPHY: Buy stocks at any price

Here’s where it gets hairy for me. I’m going to tackle an objection right off the bat and that is: “Hey, no one ever said at any price.”

Au contraire.

It’s my perception, based on point 1, that there are many advocates of stock investing at any price. After all, even if there’s a bubble and stocks go down, they will eventually go back up. Right? I’m not trying to misrepresent a view, but this is what I think is going on.

Here’s a question to ponder. If someone gave you the chance to buy shares at the peak of the tech bubble, would you do it? If so … why? Would you buy shares at two times the peak of the tech bubble? Three times?

Perhaps some would say: “Well, not any price. The tech bubble was obvious, for example. I would’ve sold something.”

Hmmm. Then I would ask, where are we now in terms of prices?

The chart below is a measure of valuations. If you are buying shares right now, you are, in fact, buying at the peak of the tech bubble.

Click on image to enlarge. Credit: www.hussmanfunds.com.

So, the mantra that one should ignore prices is, I think, not about an objective analysis of valuations. It’s a philosophy. There is no other asset I can think of where one would say that price does not matter, and further that something is worth buying on a continual and regular basis even when clearly overpriced.

One last point on this. If you are in the current conventional wisdom camp, I will call foul if you argue that stocks are not overpriced. Why? Not because I know I’m right. I might not be. I will call foul because passive indexing is not tied to valuations at all. In other words, once you enter the debate over valuations, you admit that valuations might matter, and you are outside the realm of passive indexing. The whole point of passive indexing is that you don’t time the market based on valuations or any other metric.

And that, basically, is where I can’t go. When I see valuations near historic peaks, I take note.

(3) PSYCHOLOGY: Don’t panic!

When stocks go down, and go down fast, a common reaction in financial media is to declare that no one should panic. I completely agree, one should avoid doing something irrational with one’s money.

But after avoiding panic, then what? The conventional answer is: do nothing.

And that’s another area where the logic escapes me.

“Don’t panic!” is the first step in reacting to a problem, but it’s not the only step. If you see a train coming at you, it’s great that you don’t panic, but then you should think about getting out of the way.

Here’s another analogy. Let’s say your goal is to sail a boat across the ocean. You know that if you go slow and maintain the boat and watch for rocks, you will almost certainly make it. You could also go very fast, but a function of going very fast is that your risk of crashing increases. It’s up to you — is it more important that you reach your goal safely or quickly? Should you pick one speed and stick to it or adjust along the way?

Now let’s say you were going very fast in a slight fog and you hit a rock. The first thing you tell yourself is: “Don’t panic!”  Rightfully so, because if you panic you might oversteer the boat right into a much bigger rock, or you might jump off the boat for no reason.

However,  it would be quite strange if not panicking was your only response. You wouldn’t then close your eyes and say, “I’m sure the ship will be fine, rocks don’t matter, full speed ahead!” No, you would check for damage, open your eyes wider, and make sure your current path is sustainable. In other words, the point of staying calm isn’t to deny all risk; the point of staying calm is to assess risk more thoughtfully and make sound decisions. After all, the goal is to get across the ocean.

It’s not a perfect analogy, but it sums up my view toward stocks when valuations are as high as they are right now and take a steep drop. The market has been going fast, and it hit a rock. Now is precisely the time to take an honest look at one’s strategy.

To be clear, I’m not saying: PANIC! I’m just saying let’s think about why a drop like that happens. To be double clear, I’m not advocating that anyone sell all their stocks. What I’m saying is that it’s entirely logical to consider a change in strategy if the facts warrant a change in strategy. I would advocate that one should not put all their eggs in one basket, and at least entertain the idea of risk. In the conventional wisdom, it doesn’t appear to me that risk is given much due.

RISK AND RETIREMENT

So let me explain how I think about risk in personal terms. I feel very fortunate to have a high salary and be in a stable country, actually the richest country in the history of the world. I’m already quite lucky.

When it comes to retirement, my main goal is to be able to have enough flexibility to travel and be comfortable without resorting to Bingo as an income stream. I think we’ll need $1.5 to $2 Million in retirement accounts to do what we want to do. We have 15-20 years to get there. We also have pensions and other savings, so that number is purely a retirement account number.

There are many ways to look at risk, and at heart I’m a bit of a risk taker. That said, my retirement is not a place where I want a lot of risk. Mrs. R and I work hard, and I don’t want to leave much to chance on reaping the rewards in retirement. Here’s a long term chart of our retirement savings progress.

Click on image to enlarge.

By 2033 we’d have nearly $2 Million, meeting my goal. Through 2018, we’re on track. What’s more, this chart is based on very modest returns, as in 2.75% compounding. Currently I can earn 2.75% on very low risk treasuries.

The question for me is not how I might add risk to this and earn more, or how I might beat the market. The question is how do I meet my goal with near certainty? The answer to that, I think, is to earn at least 2.75% going forward. I know that treasuries can do that for me. Probably stocks could do that for me as well, but then again, if we are at the top of the tech bubble, my plan could hit a serious bump. If stocks have a bad 2-3 years (which I think they could, soon or within a few years), I would rather pounce on that as an investor rather than sweat it out as my retirement accounts lose 30-40-50%.

This may seem overly cautious. I think of it this way.

Let’s say you lived in an uncertain world and a wizard said if you take very little risk you have a 95% chance of having a life without money problems, and you’ll have $2MM in just 15 years. Lots of people have money problems so that sounds like a good deal.

Now let’s say another wizard said you could take more risk and have an 80% chance of having $3MM instead. Well, that’s great! Then again, you don’t need $3MM, and you now have a 1 in 5 chance of some problems. I don’t think that sounds so great.

Back to the boat analogy. Would you rather be on a fast boat with an 80% chance of making it or a slower boat with a 95% chance of making it?

That’s where I’m at with this. When I see clear skies, perhaps I’ll speed up. For now, I’ll take the slow sturdy boat.

(Penny if you’re lurking around out there, I think you have a different view on risk in life and I’d be happy to hear it! We’ve been quite busy lately but hope to catch up soon … )

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