April 28, 2015

Investing is Counter Emotional

By: Stephen A. Jarislowsky

Buy low / sell high is logical.  Sell low / buy high is highly emotional.  As emotions in humans are stronger than rational thinking, one can expect them to sell when stocks are down and buy when stocks are high.  High markets breed confidence, low markets lead to fear – exactly the reverse from good investing and this explains why many investors lose money on stocks, despite the fact that long-term stock markets rise.  I recommend that those who cannot control their emotions would do well to avoid stock markets.

This hardly means that you should buy a specific stock just because it sold down.  Many stocks become “fashionable”; many are pushed up by so-called “momentum” buying.  A stock does not become cheap by going down, only cheaper than before.  But when a quality stock based on sound investment research is temporarily cheap, it becomes a buy not a sell, even if it could sell yet cheaper as fearful “investors” continue to sell.

The best of all times is when the whole market is underpriced.  If 15 times earnings for the entire market is the average norm long term, which is around where the market’s at now, then anything lower is cheap long term and vice versa. Even if you’re not normally buying at the low of the market but at 17 to 18 times earnings, in due time it will sell higher.  However, at over 20 times earnings, you may conclude from history that the market is expensive and overpriced.

If and when we enter into high inflation, stocks will sell off to reflect rising interest rates in the economy.  In high inflation, stocks should logically rise long term, but higher interest rates will make bonds look good, as yields are “higher”. As a result, on “yield” alone, bonds look “cheaper” than “less yielding” stocks.  However, stocks are actually helped by inflation long term as they benefit from a falling real value of their companies’ debts in addition to the nominal higher prices of their sales, which means that the real equity will rise faster than inflation in the long term.  The debt, by becoming worth less in real term, gives positive leverage to the equity.  But because stocks decline initially (as explained above), as dividend yields increase, the lower stock values appear to be worth more. This in turn should raise stock prices, reducing real value as normally low interest rates go with low inflation.

The ideal market to buy in is one like 1932 or 2009 when the world panicked, investors dumped their stocks and markets crashed, adding to yet greater fear.  Logic tells you that confidence always returns in time, and that in time prices must go up as people overcome their fear and rush again into rising stocks.  So 1932 and 2009 were scary times, but in retrospect, they were logically the time to buy as price risk was at a low point.  If you can overcome your fear and realize that you are buying cheap, it will work out, even if you are buying blindly and emotionally rather than rationally. If you’re really not sure, getting help from a professional might be your best decision.

Investment requires many counter- emotional, rational decisions based on fact and taking advantage of the fear and greed of others.  True crashes like in 2008 are rare but any major market break leading to average or below average market levels provides opportunities and vice versa.

Descartes should have said:  I think; therefore I make money in up and down markets.

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