The mistake that the Buy-and-Holders made in thinking that market timing is not 100 percent required for every investor is the worst mistake ever made in the history of personal finance. Market timing is price discipline. No market can function without price discipline.
Take market timing out of the picture and sooner or later you are going to have a bull market. Have a bull market and you are going to have a bear market. Have a bear market and you are going to have an economic crisis, It’s all connected.
Market Timing Is Necessary
So it’s worth devoting some effort to trying to understand why the people who developed Buy-and-Hold believed that market timing might not be necessary. These were smart people. All of the other ideas associated with the Buy-and-Hold strategy have checked out.
Why did they get this one so terribly wrong? Surely they didn’t wake up one morning and think: “Gee, price discipline is essential in every market that has ever existed, wouldn’t it be a fun idea to see what would happen to the stock market if we told people that it is not necessary in this one?”
It was the idea that the market is efficient that threw them. And, while there is today a good bit of research showing that the market is not efficient, that was not so in the 1960s, when the Buy-and-Hold concept was being developed. All these people had to go by was theory.
And, while the theoretical case for concluding that market timing was required was strong even then, in fairness to our Buy-and-Hold friends, the case for concluding that it was not was at least somewhat reasonable as well.
The case for believing that the market is efficient (and that thus market timing is not required) is that investors all want to achieve good long-term results. It is their retirement money that is at stake.
For so long as investors make decisions in accord with their self-interest, stock prices should be set properly and timing should not be required. All of that really does follow logically.
What Robert Shiller showed is that what follows logically simply is not so. There is a good reason why the title of his book is Irrational Exuberance. Investors do NOT act in their self interest, according to Shiller’s research findings.
They push stock prices higher than the price that is justified by the economic realities. They hurt themselves by doing so. They cause themselves to suffer failed retirements. They cause economic distortions and in time economic collapses.
The worst of the economic collapses exacerbate political frictions. Irrational exuberance is no joke.
Why do stock investors do this terrible thing? Investing irrationally is all downside and no upside. Why go there?
Why do alcoholics drink themselves out of their jobs and out of their marriages and out of their health? Why do gambling addicts give up their paychecks to the owners of casinos who care not a whit for them? Why do men and women get romantically involved with partners who all their friends could tell them are no good for them?
Stock Investing Is Emotional
Humans are emotional creatures. The human has been referred to as the rational animal. We are capable of rationality. That’s why it was possible for the Buy-and-Holders to be taken in.
The tricky thing is that, while we are capable of rationality, we are all capable of amazing acts of irrationality. We are known to engage in greatly destructive acts of emotionalism.
I see the study of how the emotions affect decisions about stock investing to be the undiscovered continent of this discipline. We need to talk about it and explore it much more than we do today if we are to achieve a full understanding of the forces we are up against in trying to make the market more efficient than it is today.
Ask most people how investors are emotional and they will point to the greed that makes them want to enjoy excessive gains and the fear that makes them want to avoid suffering excessive losses. But fear and greed are really only a small part of the story.
When people invest, they are taking on a responsibility to provide for their future and the future of their loved ones. So, once they come to believe that their portfolio has achieved a certain value, they have a very hard time accepting that the gains they are counting on are not real.
Investors form an emotional attachment to bull market gains. That’s why bull markets are so hard to reverse. That’s why in time bull markets always become runaway bull markets.
We’re not greedheads. It’s not that we want more dollar bills and we come to believe all sorts of crazy things as a result of our desire to come into possession of more of them.
It’s that we care about being able to send our sons and daughters to college and to acquire some security for us and our spouse in our old age and to be able to achieve enough financial independence to make generous contributions to our favorite charities.
It’s not a story of dollar bills. It’s a story of human hopes and dreams. I believe that we can get a better handle on our investor emotionalism and limit the creation of irrational exuberance to a fraction of what it is today.
But for so long as we are humans we will be drawn to the creation of it. Investors are emotional because the dreams that we hope someday to be able to finance with our portfolios matter.
Rob’s bio is here.