Paralysis and other effects of distrust

by Pop on January 28, 2010

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Or, why sometimes, we shouldn’t follow our instincts.

“Fool me once, shame on you. Fool me twice, shame on me.” Heard that one before? That’s what I felt the second time I was told by a cell phone rep that my contract hadn’t been extended, when in fact it had been. I’m not falling for that, “Sure we can tweak your plan this way, no problem!” trick again. But thing is, that kind of kick in the head isn’t just something you reason through. Getting shafted by something more than once starts to build psychological barriers even when they aren’t healthy.

Take the stock market. This time last year, economists at the University of Chicago School of Business and Northwestern launched the Financial Trust Index, which purports to measure how much we trust various financial institutions. Basically, they survey 1,000 Americans and asked them questions like “How much do you trust brokers on a scale of 1 to 5?” A score of 5 meant you trusted them completely, where a score of 1 meant you don’t trust them at all. Both brokers and the stock market received scores near 2—the worst of any other institution.

Americans were also asked how likely they thought it was that the stock market would drop by more than 30% in the next 12 months. In December 08, 56% of Americans thought it was “likely”. By June, after the market had started a full-on recovery, only 40% thought it was likely.

Well, the stock market’s run up another 20% since the end of June. So by now, we’ve all got to be really confident in stocks again, right?

Nope. In December, the economists asked the question again, and 41% of Americans still think the market’s likely to drop 30% in the next year.

What’s going on?

It turns out, we’re treating the market like a customer service rep, who’s lied to us a couple times. Twice in the last decade—in 2002 and 2008—the market’s erased a huge percentage of our wealth. And as a result, we’re not getting back in, even as the market rises without us. In 2009, which saw the quickest stock market recovery in decades, investors actually put more money into bond funds than stock funds. We keep hearing that investors chase returns, right? Apparently not when there’s been a fundamental disruption of their trust in the market.

Sometimes, this can be healthy. I don’t get off the phone without getting an order or service number from customer service reps. But in this case, I think investors are doing themselves a huge disservice. There’s nothing to “trust” or to not trust in the stock market. It is what it is—a long-term bet on the future of global business.

If you find your stomach turning when you think about adding money to a stock fund, keep these points in mind.

1. Whether it went up or down, the market’s price history doesn’t matter.

The market’s up more than 50% from the bottom. That might be making you feel that you’ve already missed the biggest gains. You could be waiting for another dramatic fall, at which point you’ll jump in. But let’s take a look at that logic for a minute.

Pretend I was selling a Rolex watch for $30. You’re a watch expert. So you know it’s real and think it might really be worth $3,000. But before you got the cash out of your wallet, some other guy jumped in and took the deal. Now he’s re-selling it for $1,000. You’re thinking, “Damn. I really missed out on that one,” when you should really be saying “Wow, there’s still a great deal to be had here.” If you hadn’t seen the first deal, when the watch was an extreme bargain, you might not even be hesitating to buy the watch.

That’s kind of where we are right now. Yes, you missed out when the S&P 500 sat at 666 in March 2009. But that doesn’t really matter now. What does matter is the market’s current price.

2. If you’re buying for the long-run, the market’s always a deal.

I find valuing the market to be an exhausting process. There are lots of ways you can go about it—looking at normalized price-to-earnings ratios, price-to-book ratios, etc. And at the end of the day, you’re rarely left with a lot of confidence in your conclusion. That’s why market timers tend to underperform the market as a whole by more than two percentage points.

But one thing I am confident in, is that over very long periods of time, you earn more money by owning American businesses than by keeping your money in cash. And that’s basically what you’re doing by investing in the stock market. You’re buying a small piece of the earnings power of the American economy. Unless you think there’s been some permanent disruption that will continue to exist until you retire, which for me is more than 30 years, you’re asking for trouble by not buying now.

I’m not the only guy who thinks this. Even one of the greatest value managers of all time, Warren Buffett, says so. His company is buying railroad Burlington Northern, and Buffett’s made a point of saying that he doesn’t think he’s getting a bargain on the company. He just thinks that Burlington is going to be a great company long-term and is willing to pay a premium to get a piece of it.

3. You weren’t “fooled” anyway.

Even though it felt like the market screwed you twice in the last decade, if you were simply dollar-cost averaging in a 401k or IRA, and re-balancing, you made money in the last 10 years. Money Magazine has a graphic on this in their current issue, which isn’t online. Starting with a 60/40 stock/bond portfolio, someone who began with $100,000 invested, added $1,000 per month, and rebalanced annually finished the decade with $290,000–for a 3.8% annualized return. (A lump sum in the S&P 500 would have lost you 1.1% per year.)

So the somewhat anticlimactic bottom line? You weren’t tricked. Even if you were, it doesn’t matter. And even if it mattered, it doesn’t matter so much that you should stop investing. However, if you are making a change to your cell phone plan, make sure you get the rep’s name.


{ 2 comments… read them below or add one }

Jackie February 1, 2010 at 10:16 am

Love the Rolex analogy, and I suspect you’re right about the trust thing. Personally I just invest each month and try to keep a long term perspective. I look for companies with beliefs and/or charts that I like.

Ryan @ Planting Dollars February 5, 2010 at 6:44 pm

Great explanation of the relative value of the market and how it should be perceived. Looking long term 20-30 years out without even considering touching your money for retirement would be ideal for everyone especially when applying the rationale you highlighted in #2. So the world of business goes, so the stock market goes. If you think the business world is going to end, don’t invest in stocks!

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