It is risky to ride a bicycle blindfolded. It is risky to walk over broken glass barefoot. It is risky to drink a hot beverage without checking its temperature. These foolish risks are one-sided in that they have a downside, but no real upside.
Buying stock is different. In the stock market, risk simply means uncertainty — not knowing which way stock prices will go next. The risk is two-sided, in that things may turn out worse than expected, but they may also turn out better.
How do investors weigh the upside and downside risks? Most investors are risk-averse. They are not interested in a stock that has a 50% chance of going up 20% and a 50% chance of going down 20%. They want stocks that, on average, have positive returns. In fact, studies of loss aversion suggest that the pain of a prospective loss is typically twice as powerful as the pleasure of a possible gain — most people would not buy a stock with a 50% chance of a 20% loss unless there was a 50% chance of a 40% gain.
Loss aversion can cause investors to make ultra-conservative decisions. I know one investor who has had $1 million dollars sitting in a bank earning essentially nothing for 10 years because he fears that if he buys stocks, prices might go down. He would have more than $2 million now if he hadn’t been so paralyzed by loss aversion.
We see widespread evidence of loss aversion in the stock market these days, with investors and analysts fretting that, with the S&P 500 (.SPX) at or near record levels, and double its level six years ago, a crash is inevitable. Many have pulled out of the market because they fear losing money more than they fear not making money. The pain of a prospective loss is much more powerful than the possible pleasure from a potential gain. Better to give up the possibility of a 30% gain than to risk a 20% loss.
Others have pulled out of the market because they are waiting for prices to collapse so that they can buy stocks at bargain prices. It is a good idea to buy stock at low prices, but it is seldom a good idea to try to time the market, sitting on cash while waiting for bargains to materialize.
The risk for investors who are holding cash, either because they fear a crash or because they want to take advantage of a crash, is that the stock market may go a lot higher before it goes down significantly. They are paying too much attention to downside risk and too little to upside risk.
Those who predict a crash of 20% or more are surely right in that there will be one, but as veteran market observer Ed Yardeni has said of stock market prognosticators: “If you give a number, don’t give a date.” Yes, the stock market will go down 20%, but nobody knows when this will happen. It could be this week, next year, or five years from now.
The upside risk is that the market may go up 50% or more before it goes down 20%. Investors who have been holding cash will, as they hoped, then be able to buy stocks at prices that are 20% lower than right before the crash, but these “bargain” prices will be much higher than what prices were when they exited the market. Selling at 100, and buying back after prices fall from 150 to 120, is not formula for success.
There is a lot less stock-market risk in the long-run than in the short-run, because one of the most important characteristics of U. S. stock returns is that they are mean reverting. How could it be otherwise? If the stock market drops 20%, 30%, 50%, or even more, it will have to come back — unless the U. S. economy collapses permanently.
Suppose that the U. S. economy and corporate earnings grow by 5% a year for the next 30 years. If so, earnings will be more than four times higher than they are now. Even if U.S. stock prices fall 20% or more along the way, they will surely be much higher 30 years from now than they are today. High-quality stocks currently have dividend yields of around 2%, while 30-year U.S. Treasury rates are around 3%. How could 30-year bonds yielding 3% possibly be a better investment than stocks with 2% dividend yields and substantial price appreciation over the next 30 years? They can’t.
We can be confident that U.S. stock prices will fall at some unpredictable point in time, but we can be equally confident that stock prices will recover and that stocks will beat bonds over the next 10, 20 or 30 years, or we will have a lot more to worry about than our portfolios. If you are bullish on the American economy, you should be bullish on the U. S. stock market.
Over the past 30 years, the S&P 500 has given investors some wild ups and downs (upside risk and downside risk), but anyone who bought stocks in the past should be happy that they decided to do so. Yes, investors haunted by loss aversion have sometimes been unnerved. Yes, investors trying to time the market could have done even better if they had nimbly jumped in and out of the market before every wiggle and jiggle. But the reality is that short-term losses in the stock market are inevitable, perfect timing is impossible, and the stock market has been and will continue to be rewarding in the long run.
Remember the aphorism, “The perfect is the enemy of good.” Hindsight always reveals losses that occurred and identifies the optimal times to have been in and out of the stock market, but foresight is always cloudy, with a 50% chance of rain. Chasing after a perfect timing of each and every up and down in the market is a futile exercise that will almost surely underperform a solid strategy of buying stocks for the long run.
Being in the market now is risky, but there is upside risk as well as downside risk. May of 2018 may turn out, in retrospect, to have been an unfortunate time to buy stocks, but it also may turn out to have been better than holding cash while waiting for a crash of unknown magnitude on an unknown date. What is certain is that U. S. stocks will do well in the long run and you don’t want to be left behind.
|For more news you can use to help guide your financial life, visit our Insights page.|