A young person who is new to driving eventually does something a little dangerous. She drives a bit too fast or stays on the road after it begins snowing or engages in a conversation on a cell phone or elects to drive home after consuming a beer. It’s human nature to want to test the limits. Usually, the eventual result is a scare. And usually the scare convinces the new driver to play it more safe in the future.
We test the limits when it comes to investing in overpriced stocks too. The new investor is reluctant to own stocks when prices are high. It sounds risky. But most of us don’t like to be away from stocks for too long. So, if prices remain high for a time, we get over our initial discomfort and learn to buy stocks for the long run. We assure ourselves that timing never works and try to ignore valuations.
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High prices eventually cause pain, however. What then?
Price crashes cause investors to pull back. The Bogleheads Forum is packed with Buy-and-Holders. The vast majority of people who post there believes that it is foolish to time the market. Most stuck to that philosophy when prices dropped hard during the 2008 economic crisis. But a good number were frightened enough to reconsider. I am highly confident that there were many who lowered their stock allocations but who didn’t say so publicly because to do so would be a violation of a key Buy-and-Hold dogma.
My question is -- Are the investors who lived through the 2008 crash more confident in their Buy-and-Hold strategy today as a result or less so?
Prices never dropped too much below fair-value levels in early 2009. And they did not remain at those levels for long at all. So the Buy-and-Hold strategy worked out well in that case. Investors who lowered their stock allocations regretted it when prices went back up and then remained at high levels because they felt forced to buy back the stocks they had sold at higher prices.
It was a scary experience. If is hard to understand how that much stock market value could be lost in so short an amount of time. All investors are of course aware that crashes happen. But most of us think of them much in the way we think of heart attacks -- they are something that happens to the other guy. Investors experience feelings of panic when a large portion of their accumulated wealth of a lifetime disappears into thin air no matter how many times they have told themselves that it is a mistake to time the market.
So, on the one hand, investors who lived through the 2008 crash were chastened by it and are probably more concerned today about the possibility of a stock crash than they were before the 2008 crash took place. On the other hand, Buy-and-Hold worked. That reality should have given them added confidence that sticking to their Buy-and-Hold strategy in the wake of the next crash will pay off once again.
I obviously cannot see into investors’ minds. But my belief is that living through crashes ultimately causes investors to feel more panic during subsequent crashes. I say that because all bull markets come to an end. Bull markets could not end if most investors stuck with Buy-and-Hold strategies. Something causes most of us to at some point lose confidence. I suspect that it is a feeling that many years of gains could be forsaken in a short amount of time that eventually causes investors to abandon the Buy-and-Hold ship.
But I also believe that crashes in which a Buy-and-Hold strategy pays off cause investors’ confidence that the strategy will work in the future to increase. Prior to the 2008 crash, many investors believed in Buy-and-Hold because they were told by experts that they should follow the strategy. Seeing with their own eyes how the strategy can pay off must have made a big impression. It is a far more powerful experience to live through something rather than just to read about it in books.
So, in the early days of the next crash, there will be competing waves of emotion pushing investors in opposite directions. One inner voice will be saying that this crash will turn out like the last one and that the thing to do is not to panic and sell.. Another will be saying that the good result obtained in 2008 will be jeopardized if this crash does not turn out like the last one, if this crash turns out to be the one that sends prices lower and that keeps prices at those low levels for a far longer stretch of time.
It can be a good thing when a young driver experiences a near crash experience. All of the lectures that he has heard about the dangers of speeding can have little effect compared to one real-life encounter with near-hospitalization or near-death. A driver who is scared straight can learn a lesson that sticks with him for many years.
Or, if he does not experience any serious pain, he can conclude that the warnings of what happens from following unsafe driving experiences are exaggerated and he can up the bet until he gets himself in real trouble.
I believe that there is an undercurrent of worry about stock prices today that was not present in the days prior to the 2008 crash. I believe that that crash put a fear into people that did not result in panic selling at the time but which may contribute to feelings of panic the next time we see a sudden price drop.
But this is speculation. I do not know. I do not believe that it is possible to know what is going on in investors’ minds except in the most surface sense.
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