I wrote a piece with the same title four months ago, but this one will be different, because I want to focus on individuals, and less on institutions. During the bull phase of market moves, people are willing to take chances. That can take several forms:
- Being willing to buy speculative companies
- Lengthening the time horizon: buy-and-hold.
- Committing to debt, or even just lessening cash reserves, to own assets like houses, cars, second homes, boats, furniture, etc.
- Being willing to buy illiquid assets like art, private equity, hedge funds, etc.
This applies to institutions as well, because they also give into the boom-bust cycle. They are willing to speculate in good times, and seek safety in bad times.
But for individuals, time horizons sum up asset behavior whether it is investing or buying consumer durables. Willingness to part with cash lengthens time horizons. Those with short time horizons hang onto cash. But often the same people change from having a long time horizon to a short time horizon and vice-versa, and at the wrong times.
The delicious perversity of markets — they incline you to do the wrong thing at the wrong time. Have I been taken by this? Yes, but not as much as many, because I don’t trade much.
Optimism creates long time horizons; it simplifies thinking. “Let the market pay your people.” “Cash is trash.”
Pessimism creates short time horizons; it simplifies thinking.”I’m going to stick with my money market fund.” “I will keep my savings in gold.” “I will buy long Treasuries because I want cash flows that are certain out in the future.”
Time horizons are a symptom of the bull/bear cycle. During bull phases, people commit capital for long time periods. During Bear phases, periods shorten to the degree that many hold only cash.
To some academics this will seem unreasonable. People are rational, aren’t they? They don’t regularly make bad decisions, do they? Sorry, but with economics, the answers are no and no. The assumption that people are rational is not proven. A far better assumption is that people try to justify themselves, whether they succeed or not. Winners proclaim their brilliance. Losers blame the umpire.
Yes, people regularly make bad decisions, and those brighter than them sporadically benefit. It is hard to buy at the bottom, but a few do. It is hard to sell at the top but a few do. Note: those “few” are not the same people, because native bullishness or bearishness overcomes. No one consistently gets out at the top, and in at the bottom. But many get out at the bottom, and in at the top. That is the way the markets work.
You might argue that this increases inequality and is not fair. I’m sorry, but this is fair because people misjudge the underlying businesses, and they don’t keep adequate cash around as a margin of safety. The equity market is only for those who keep an adequate reserve of safe assets around. It is too dangerous for anyone else.
Stocks do not reward people year after year. It comes in fits and spurts. That is as it should be, and get used to it. Those who don’t have long time horizons should reduce the amount of stocks they hold, unless valuations are low, and that’s not true now.
This is a time to be cautious, and reduce exposure to risky assets. Given the global troubles, be wary, because little things like Cyprus could prove as small as subprime, which was declared “well-contained” by someone who didn’t know which end was up, and still does not.
By David Merkel, CFA of Aleph Blog