Investing in Stocks is Counterintuitive

“Many things about investing are counterintuitive. Low-quality assets can be safer than high-quality assets. Things get richer as they become more highly respected (and thus appreciate). There can be more risk in thinking you know something than in accepting that you don’t.” – Howard Marks

“Investing is the only business I know that when things go on sale, people run out of the store” – Mark Yusko

The stock market is the one area in life where you feel better when the prices go up. Whether it’s gas, groceries, clothing, or technology we want them all to go on sale. But with stocks it’s different. We feel the need to run away when they get cut in half and the urge to buy more when they double in price.

Warren Buffet once said, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” This makes perfect sense in theory but is very hard to put into practice.

In Microeconomics 101, I was taught about simple supply and demand curves. As the price of a good rises, the quantity demanded for that good falls. As the price of a good falls, the quantity demanded rises.

In other words, people want more of something as prices fall and less as prices rise. This seems fairly obvious even to those of us that aren’t economists.  At least in a rational world.

Unfortunately for investors, when stocks rise the value of our portfolio goes up and as they fall we see our accounts drop in value. We only focus on our current wealth not our future self. This dichotomy is what causes most investors the biggest problems.

We’re nervous when stocks fall but confident when stocks rise because we see it as things getting better or worse based on the level of the market.

As prices rise, greed begins to seep in and we feel like we are entitled to ever higher returns. We assume they should be a given. Then when stocks are falling it seems like the losses will never end. It’s always feels like the entire financial system will collapse every time we see a few down days in a row.

The psychology of market participants becomes much more positive when markets are rising. It’s almost a self-fulfilling prophecy. And as things go down the psychology turns more and more negative.

We are constantly performing a balancing act between the fear of losing money and the fear of missing out on an opportunity to make more money.

VALUATIONS MATTER
It doesn’t feel this way but as stocks increase in value and become more expensive your future returns decline as valuations rise. And as stocks decrease in value your future returns go up as valuations fall.

The price you pay for an investment will end up being the biggest determinant of your future returns.

The better returns have been in the recent past, the lower they are likely to be in the future because valuations are getting more expensive as stocks rise.

This isn’t to say that stocks can’t continue to go up or down simply because they are over or undervalued. We all know that isn’t true. It just means it’s difficult for stocks to trade above or below average forever because mean reversion eventually kicks in.

Unfortunately, investors don’t start talking about an investment theme until it has started to perform well. You don’t hear about stocks on the news until they hit all-time highs. The same goes for bonds, gold or pretty much any asset class or sub-strategy you can think of.

IT’S ALL RELATIVE
Another counterintuitive aspect of the stock market is that it generally does better when things are going from horrible to bad than it does when things are going from good to great.

The markets trade on more of a relative basis than in absolute terms. It’s the reason there are such large snapback rallies at the bottoms when things seem like they will never get better and all it takes it one piece of not-as-bad-as-yesterday news to turn things around.

Or why Apple couldn’t continue to rise forever even though they continued to show phenomenal growth when compared to other businesses. They were still growing, but at a much slower rate than the market had seen previously or expected in the future.

This is especially true when trying to make heads or tails of the economic picture. The economy doesn’t necessarily have much correlation to the stock market over the short to intermediate term. But it can be very difficult to become comfortable investing in the financial markets when the economy is tanking or just muddling through like the current state of affairs.

In fact, the best year ever for US stock market returns was in 1933, when the unemployment rate was at around 25%. How many investors do you think had the guts to invest in the stock market in the midst of the Great Depression?

You should get more excited about increased volatility in the markets. Use them to your advantage.  Bad news and declining markets are actually good for you if you are still saving. You will earn higher returns on the cash you deploy into falling markets.

Stocks have entered a bear market about every 4 years on average.  Remember this the next time stocks drop and you start to feel nervous.  You should be happy when they go on sale.

Now onto the best of what I’ve been reading this week:

[widgets_on_pages]

Download PDF

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.