Why crazy people rule the market, and how you can profit from it

P.S. You’re crazy, too.

Way back in the 1960s, a University of Chicago doctoral student named Eugene Fama proposed a theory that would shape finance courses for the next three decades. He posited that stock and bond prices were “informationally efficient”. That is, that they reflected all known knowledge about the stocks at the time. When new information came available, the prices would instantly change to reflect that. There couldn’t be a “bargain” stock, because if there was a bargain, investors would have already recognized it and bid up the stock price.

Problem was, his theory never seemed to pan out in real life. Benjamin Graham, who’s considered to be the father of value investing, shrewdly observed that the theory “could have great practical importance if it coincided with reality.” How could stocks be worth 23% less at the end of the day than they were at the beginning, with no new information of significance coming out? (This happened in 1987 on Black Monday. It turned out that auto-trading computer algorithms triggered a panic.)

The answer to this riddle: Humans are not rational beings. *gasp*

When stock prices plummeted their first 10% on Black Monday, investors felt a deep, depressing pit in their stomachs that made them want to sell and stop the pain. They had no freaking clue why prices had dropped, but they knew how it made them feel. Afraid. They weren’t going to be the suckers who held on as the market continued to tank.

Since the 1990s, most economists have recognized this. There’s a burgeoning field called “behavioral economics” that’s trying to explain how our own zaniness affects markets. The theory goes something like this…

If your physics teacher taught investing…

Think of the stock market like a pendulum. The bearing (the fixed point where the string attaches) is the rational value of the market based on all known information, per Fama’s theory. So when the bob is completely still and hangs straight down, stocks are priced exactly where they should be. When emotions start causing the weight to swing to the left or right, the price will climb higher or slide lower. The weight can go only so high until gravity pulls it back down.

To be a good investor, you have to recognize when the market’s price has swung to the optimistic side and when it’s swung to pessimism. Get caught up in the euphoria or depression of the crowd, and you’re not going to be able to place the bearing where it should be.

1. Find which way your pendulum’s swinging.

The catch is, you have a pendulum too.

Look at the statements for your 401(k), IRA, stock portfolio and your other accounts. Add up the damage. Think about how it might affect your retirement, your savings for your kid’s college, your boat fund *cough*…close your eyes and let your mind run with it. Now open them, and write down exactly how you feel.

This is what I saw: My portfolio is barely up over the past 12 months. But it could be up a lot higher. My bond holdings, which haven’t risen nearly at the pace of stocks, are dragging my whole portfolio down. My mutual funds, none of which include the hot, emerging markets sector, were mostly among the worst performing funds in my 401(k) plan.

I wrote: “I feel like I did when I got my first ‘NS’ on an elementary school test.” For those who don’t remember that far back, that stands for “Not Satisfactory.” It made me feel depressed, inadequate, hopeless. Elementary schools won’t tell you that you’re mediocre. You’re either an “S” or an “NS”. And contrary to their purpose, an “NS” didn’t make me want to work harder. It made we want to give up.

A lot of the personal finance press advocates ignoring your 401(k) balance, turning off the TV, and investing like it never happened. Thing is…you’re not an idiot. You can’t exist nowadays without knowing that the market’s on a tear or in the tank. You can’t deny your emotions. So spell them out. Now you know which way your pendulum’s swinging, and you can stop it from leading you down the wrong path.

2. Make the pendulum hold still.

If you add weight to the bob of a pendulum, it becomes much harder to swing.

It’s extremely difficult to know exactly where the market “should” be priced. But an easy-to-use tool can give you an idea.

First, take a look at the market’s price-to-earnings ratio. This roughly measures how much money you have to pay for every dollar of a company’s earnings. You can find the ratio in the Excel spreadsheet linked from Yale economist Robert Shiller’s website.

Anything above 16, means the market is swinging toward optimism. Anything below, means the market is pessimistic.

If you did this exercise in March 2008, you’d have probably felt pretty crummy about the market. But with the market’s P/E ratio at around 13, it was actually a pretty good time to buy. And as you know, the market’s had an incredible run since.

Right now, with the market up more than 50%, you might feel good about the market again. Guess what? The market’s P/E is back up to 20. That’s not the highest it’s ever been, but let that weight bring your expectations back down.

3. Put your pendulum in the closet.

It’s tempting to take the value of a P/E too far. You might want to invest more than normal in stocks when the P/E is low and invest less when it’s high.

But the fact is that investors let their emotions run away with them for really long periods of time. While 16 is the market average, the S&P’s P/E actually spent more than 10 years above the average in the 1990s before coming back down. That led a lot of investors to assume that the average P/E was no longer valid. Boy, were they wrong.

Could you have stuck it out for a decade while thousands of investors told you your reasoning was outdated? I couldn’t.

Instead, revoke your decision making privileges all together. Tell yourself: “You’re an irrational, market crazy who will likely lose money every time he makes a decision.” And don’t let that crazy guy make decisions anymore.

How can you do that? First, settle on being average. Invest in low-cost index funds like those offered by Vanguard or Fidelity that simply track the market’s performance. Both companies also offer age-based asset allocation funds, that will put a certain amount of your money in stocks and bonds depending on your age and risk tolerance. That way, you won’t have to decide when the market’s over or under priced.

Second, you can settle on dollar-cost averaging. Put a certain amount of money into your investments every month, and stick to that amount no matter what the market does. Most brokerages or mutual fund companies will even let you do this automatically, without you ever having to touch it.

Getting a “C” might feel mediocre, but it sure beats an “NS.”

Further reading:

The New Yorker’s John Cassidy recently conducted an illuminating interview with Fama about the economic crisis and how that reflects on his theory. He’s still clinging to that same hypothesis he invented decades ago.

Tagged as: behavioral finance, dollar cost averaging, index funds