Why Won't We Learn?

Here’s a mini-rant to start the week. The lead article in the Wall Street Journal today makes two observations well worth calling out. First, the stock market is hitting two-year highs and, second, investors are feeling “more bullish than they have in years.” The article also points out that the market’s “fear gauge” is at its lowest level since April. I guess that’s three observations, but who’s counting?

To be fair, investors may feel less fearful because they see the market value of their current investments rising. That’s a good thing in so far as it goes, but ignores other critical investor considerations like:

1. Capital markets become more risky as asset valuations rise, not less risky, all other things being equal. Therefore, rational investors will become more risk averse, not less, as markets move higher. Risk averse behavior manifests itself in profit-taking, which collectively, investors are unquestionably bad at doing. Who wants to take chips off the table with the markets moving up every day? Wrong! That’s exactly the time to take chips off the table and reinvest in cheaper, out-of-favor asset classes.

2. Each new dollar invested will now buy less (i.e., fewer shares, bonds, etc) not more than it would have previously. Somehow we manage to overlook this simple but critically important factor; even those engaged in asset-accumulation stages of life. We’re willing to pay anything as long as asset prices subsequently move higher. Unfortunately, they often don’t.

3. Income yields (e.g., dividends, interest) decline as asset prices rise and vice-versa, all other things being equal. However, few investors do this simple math and they are worse off because of it. Ignorance is bliss, I suppose.

No wonder then that most individual investors buy-high and sell-low and relatively few make real, permanent money in the capital markets outside of their corporate retirement plans (where mutual fund managers typically do the trading). If you’re a private investor who’s not prepared to embrace these and other important investing concepts, I urge you to find a competent professional to help you. What you don’t know can and will hurt you.

Private Investors Beat A Path -- In The Wrong Direction

The recently-ended 3rd quarter was one for the record books. The Dow Jones Industrial Average gained +10.4% during the three-month period and had its strongest September performance since 1939 (+7.7%). That’s an astounding 71 years! September is traditionally the market’s worst month from a performance perspective. The Nasdaq Composite Index did even better than the Dow, up +12.3%, followed by the Russell 2000 Index, +10.9%, and the S&P 500 Index, +10.7%.

The record-breaking rally occurred even though market data show that private investors are fleeing stocks in favor of bonds and gold. Money flows in and out of stock mutual funds were negative every month since May. Conversely, bond fund money flows have been strongly positive all year. These money inflows & outflows are explained by the many media reports trumpeting economic and political uncertainty. Taken together, they dominated the headlines and caused many private investors to abandon their strategic stock allocations for perceived safe havens. History has shown, and the 3rd quarter demonstrated again, that this almost never turns out for the better because it invariably leads private investors to sell-low and buy-high.

Have you substantially changed your investment asset allocations lately? If so, what was your #1 motivating factor?