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Understanding Swings in Psychology Is the Key to Understanding Stock Investing

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The stock market is nuts. It really is. Prices go up crazy amounts for crazy reasons. And prices go down crazy amounts for crazy reasons.

That scares us humans. Most of us have our retirement money invested in stocks. To cope with the fear, we cover our eyes at all the craziness. We tell ourselves that investors are rational and that the market is efficient.

The Stock Market Always Comes Back

It really doesn’t matter so much when prices go down crazy amounts for crazy reasons, we assure ourselves. The stock market always comes back in time. Just hang in there. Buy and Hold. Tune out the noise.

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The stock market really does always come back. That much is so. The market is not so unhinged from reality that prices never return to where they should be. But I don’t think that that justifies tuning out the noise.

It justifies not treating the noise as something real. I can go that far. But we need to take the noise into account. If the crazy noise causes stock prices to rise to two times the fair value of the market, there is no longer any clear correlation between the number on the bottom line of our portfolio statement and the true and lasting value of our account.

That can’t be good. We need to know how much wealth we have accumulated over the years. Without that information, our efforts to engage in financial planning become futile.

Another way to say it is to say that we need to tune out the noise in a real way. We really do not want to pay attention to the craziness. But if we treat the nominal portfolio numbers as real, we are paying attention to it.

Truly tuning out the noise requires discounting the nominal portfolio numbers for the amount of irrational exuberance contained in them. At a time when the CAPE value is at two times the fair-value CAPE number, we need to divide the nominal portfolio value by two to gain a good sense of where we really stand re our retirement planning efforts.

Ignoring the craziness of the market makes it worse. It is by coping with the craziness of the market that we get it under control.

Eventually, we do always get it under control. As the Buy-and-Holders constantly remind us, the market always does return to reasonable price levels. The question is, is the return to reasonable price levels going to be achieved through moderate efforts at market timing taking place all the time or through some massive price crash that inevitably takes place after we ignore the problem for many years? You can probably tell that I favor moderate efforts at market timing taking place all the time.

The Riskiness Of Stock Investing

The amazing thing about this approach to stock investing (I call it “Valuation-Informed Indexing”) is that it gives us – the stock investors affected by market gyrations – control over the market. When the only way that the market can get prices right is by crashing them, we sooner or later are surprised to see our retirement savings wiped out in a flash.

With regular market timing, that never happens. Our Get Rich Quick urge occasionally pushes prices up a bit too high. But then our rational side tells us to lower our stock allocation a bit and the sales pull prices back to where they should have been. Stock prices are self-regulating in a world in which most stock investors appreciate the need for regular market timing.

Market timing is rationality evidencing itself. That’s the beauty of it. The market is trying to find the right price, as all markets do. So long as investors are pursuing their self-interest, which requires them to maintain the risk profile that they have determined is right for them, the right price can be achieved and the market can lock it down to the benefit of all concerned.

When a large number of investors become unwilling to make the changes in their stock allocation needed to keep their risk profile constant in the face of changing stock valuations (which obviously affect the riskiness of stock investing), the market becomes unable to get prices right. Eventually, it crashes them for lack of any other way to get them right.

The Buy-and-Holders posit that it is economic developments that determine stock prices. If that were so, investors would be helpless in the face of forces beyond their control. But we can control our own psychology. Shiller’s finding that investor psychology is the dominant influence on stock prices was a highly liberating discovery.

Rob’s bio is here.