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The Stock Market: Gains, Pains, and Panics

A fear that, if prices fall, they will continue falling is not justified by history but by panic Published at Mind Matters

Let’s push an imaginary rewind button on the stock market. We’ll go back five years to April 14, 2015. The S&P 500 is at 2096, up 80% over the previous decade. That works out to a 5.6% annual average price increase. Add in dividends and investors enjoyed an average annual return above 7% over the preceding five years.

Now, suppose the market were to go up a steady 6.3% over the next five years, with the S&P 500 beginning at 2096 on April 14, 2015, and finishing at 2842 (which it did) on April 14, 2020. Add in dividends, and stockholders would have enjoyed a satisfying average annual return close to 8%. Investors would have been pleased by this serenely profitable market. They certainly would not have fled the stock market, vowing never to return.

Of course, this alternative history is not at all what happened. Instead, over the past five years, the market went up more than 60%, and then fell a breathtaking 34% before rebounding more than 25%.

Oh what a difference! Instead of a peaceful stroll, it was a nauseating roller coaster ride. Many investors panicked after the price collapse, sold everything, and vowed to give up on stocks — at least until the market returned to “normal” — as if there ever is a normal in the stock market.

An investor who sells a stock after its price falls from $100 to $50 and plans to buy the stock back after the price returns to $100, is locking in a 50% loss. This behavior makes little or no sense but human psychology isn’t always rational. I know financial advisers who refuse phone calls after a market dip because they are trying to protect their clients from the consequences of their hysteria. One manager of a large college endowment made up excuses — I’m traveling to Europe, I’m traveling to Asia — to avoid meeting with the university’s Board after the 23% market crash on October 22, 1987. He knew that they wanted him to liquidate the university’s stock portfolio. I also know financial advisers and investment managers who sell after prices go down and buy after prices go back up.

The uncomfortable truth is that it is impossible to predict short-term movements in stock prices. J. P. Morgan was exactly right when he said that, “The market will go up and it will go down, but not necessarily in that order.” A fear that, if prices fall, they will continue falling is not justified by history but by panic. If anything, the historical evidence is that, because investors overreact to news — good or bad — large price movements in either direction — up or down — tend to be followed by price reversals.

The hysterical reaction of many investors to stock prices soaring and then collapsing reflects a well-documented human trait known as loss aversion. For many people, the pain from watching their wealth fall by 10% is a lot sharper than is the pleasure from having their wealth increase by 10%. Thus, making money and then losing it feels much worse than not making any money at all. In fact, some studies indicate that losses are twice as painful as equivalent gains are pleasing. Making $10,000 and losing $5,000 balance out. Making $10,000, $100,000, or $1,000,000 in the stock market and then losing it is traumatic.

Here is a simple mental experiment. Yes, please do try this at home. Suppose you have $100,000 and are offered an opportunity to pay $4,000 for a 50% chance of winning $10,000. Would you take the wager? Many people would.

But suppose the wager is posed this way: You have $106,000 and can pay $6,000 to avoid a gamble that has a 50% chance of losing $10,000. Would you take the wager? Many people who would take the first gamble would avoid the second gamble — even though the possible outcomes are identical: a safe $100,000 versus equally likely chances at $106,000 and $96,000. People react differently when the gamble is framed as a possible loss than when it is framed as a possible gain — because they fear losses more than they welcome gains.

In the roller coaster we call the stock market, the average investor makes money in the long run because companies earn profits, pay dividends, and grow with the economy. Nonetheless, some people are so paralyzed by the fear of losing money that they put it in bank accounts paying little more than would dollar bills buried in the backyard. For those investors who do venture into the stock market, some dismiss the gains as “just on paper,” hardly worth celebrating, while losses are considered real and must be mourned. This way of thinking explains why gains followed by equal losses are much, much worse than nothing. If Apple rises from $230 to $320 and then falls back to $230, it feels terrifying.

So, instead of fixating on the past two months, let’s think about where the market will go next.

I don’t know what will happen tomorrow or next week or next month — and neither does anyone else. But I do know that, in addition to loss aversion, another human foible is overreaction to things that, in the long run, really aren’t all that important. As Keynes wrote: “day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and nonsignificant character, tend to have an altogether excessive, and even absurd, influence on the [stock] market.” This is why stock prices fluctuate wildly and tend to regress. Good news causes prices to go up too much, and then retreat. Bad news causes prices to go down too much, and then recover.

When I managed a club soccer team, I used to say that the wins and losses are seldom as important as they seem at the time. The same is true of stocks. The latest breaking news is seldom as important as it seems at the time and has little or nothing to do with the long-run returns from stocks.

The S&P500 dividend yield is currently 2%, while the 10-year Treasury rate is less than 1%, and the 30-year rate is 1.4%. As Warren Buffett observed, stocks are just disguised bonds — with the important difference that bond coupons are fixed while stock dividends will increase. Since the coupons on Treasury bonds are fixed, a long-term investment in Treasury bonds will give an annual return of less than 2%. In contrast, I am confident that the US economy, earnings, and dividends will be much higher 10, 20, and 30 years from now than they are today. If they are, a long-term investment in stocks will give a return that is much, much higher than Treasury bonds. If the US economy is not far larger in the coming decades than it is today, then we will all have a lot more to worry about than our stock portfolios.

Stocks paying dividends that will grow over time are currently a much better long-term investment than Treasury bonds — even if there are ups and downs along the way.

Investors: calm down and enjoy the ride.

Also by Gary Smith:

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