How Stories Drive the Stock Market - The New York Times
As the saying goes, the stock market has helpfully predicted nine of the last five recessions.
In January of 2016, broad measures of US stocks dipped about 8% in two weeks. Yet in those two weeks, 8% of taxis did not disappear, 8% of iPhones were not destroyed, 8% of TV shows were not cancelled, and 8% of houses did not burn down . Even 8% of stock traders did not quit, though we might have wished they had.
Clearly the market reflects not the economy but what we all think about the economy. Despite the fact that the economy is not terribly volatile, the market clearly indicates that we all seem to think it is.
There are two reasons for this with one interesting consequence. First, the market is easy. We change our minds all the time at zero cost. It takes years to build a semiconductor plant, but just seconds to buy up some shares of a tech company that has one. You’d need an army of lawyers to unwind the complex financial arrangements of a typical bank, but you can dump the bank’s shares from a coffee shop using your phone.
Second, the market is human. The real economy checks our frailties of cognition. It takes time to change things in the real economy, and often requires us to work with other people. It’s hard to be impulsive about anything that requires weekly program reviews with a team. With markets, however, we’ve accidentally created a system that amplifies rather than countervails our cognitive flaws.
The result is a global mosh pit of money, each investor drugged and flailing, clutching your job in one hand, your dad’s retirement savings in the other, and bashing into each other in a futile attempt to feel something–anything–that might fill the emptiness from which only death offers escape.
But if you happen to be sober, head to the stairs and look over the balcony at the consequence of this carnage, the heaving mass of humanity below you, unpredictable, dangerous. Yet somehow hypnotic… undulating… moving together… almost predictably.
To a beat.
**
The best and worst advice in investing is to buy low and sell high. It is tautological–the definition of profitability. Yet just try it. Take $100 of your own hard-earned cash and open an account. Then proceed to follow those simplest of instructions. Buy on the downbeat and sell on the upbeat.
The attempt will turn you into someone you will not like. You will check stock prices every few minutes, doubt yourself, say “fuck it” and try to ignore it all, get angry at yourself for ignoring it all, wonder what could have been or been avoided, lose sleep, and be irritable to loved ones. (How come the E-Trade baby never seemed to go through any of this?) If you keep going, it will wreak havoc with your emotions, your identity, your own estimation of your intelligence, your relationships, your patriotism, and your belief in a brighter future for humanity and the planet. We’ve built a machine, the markets, that expertly unravels every shred of intelligence we’ve ascribed to the human departure from apes, and one need only engage with it in the most trivial way to be forever changed, like touching an orb and glimpsing hell.
Now imagine going through all that not with $100 but with your retirement savings, your kids college money, or (as is the fashion in the US) with your health care money. Because that’s exactly what you’re doing. Right now. Whether you thought you were or not.
**
Beyond certain basics, the value of most stores of wealth in an economy is determined by the future earnings that wealth produces. Yet the future earnings are themselves a product of that same economy. The economy produces wealth and wealth is what the economy produces. The cyclical reasoning is annoying but reveals the jeopardy in which we find ourselves: every store of wealth is nothing more than a specifically shaped claim on a slice of the economy, and if that slice fares poorly, the value of the wealth you derive from it is diminished.
We tend not to think this way, devising various techniques for “opting out” of economic risk. Trading stocks is risky, we tell ourselves, so let’s keep it all in bonds. This is because we confuse variability with risk. Let’s try a few to demonstrate.
It’s easy to see that buying a share of a company’s stock provides you a claim to that company’s future profits, and exposes you to its future losses. What about something safer, like government bonds? Are you still “betting”? Well, for the bond to maintain its value you need tax receipts to hold steady (funds that come from the economy), government finances to remain sound (funds spent into the economy), monetary policy to preserve the value of the currency (stabilizing prices in the economy), and trade and foreign exchange to preserve the buying power of the country as a whole (interactions between national economies). Properly understood, it becomes clear we haven’t opted out of much of anything. Everyone who loaded up on Canada Savings bonds in the last few years might as well have taken a leveraged long on West Texas Intermediate Crude Oil futures. Don’t know what a leveraged long on West Texas Intermediate Crude Oil futures is? You should, you just put a few of them in little Timmy’s college fund.
What about cash under the mattress? This turns out to be worse than bonds since you incur all the same risks of government solvency, price stability, and currency viability without the prospect of earned interest.
What about every conspiracy theorist’s favorite store of wealth, gold? The industrial applications of gold are limited relative to supply. So the value of your gold is very much exactly what others are willing to pay for it to use, as you did, as a store of wealth. This willingness to pay varies widely: if you had a gold necklace, would you rather sell it in London’s Hatton Garden or the Bakaara Market in Mogadishu, Somalia? Even with a global market, you’re making a bet on the relative optimism or pessimism of the global economy at the time when you need to unload your gold, as well as a bet that no new backstop store of wealth will be arbitrarily chosen to replace gold in the interim. The economy you sell it into decides its value, both the where of it and the when. (Before you ask, Bitcoin suffers the same risks and demonstrates the frailty of the replacement bet.)
The net of it is that the only way not to make a bet on some slice of the economy or other is to not have any wealth.
**
That economic bets are inevitable is liberating in its own way. In the past we might have agonized over whether to “get into” the market and “how much” to invest. In reality we were always fully invested, we just invested some of it in cash, with all its own risks. So let’s resolve this up front: if you have any wealth at all you are fully invested, and permanently so. Starting with your very first dollar, a bet has been made (whether you made it or not) on the stability or growth of some oddly shaped slice of the economy, and the future value of that dollar and all others like it depends on myriad events that may strengthen or weaken that slice.
So if you must take a bet, what bets should you take? First, it is extremely difficult to justify holding any wealth at all in cash, gold or Bitcoin. This is worth its own discussion, but the crib sheet answer is don’t do it. Cash is an instrument of transaction, not a store of wealth. You should free up enough cash to fulfill your transaction needs for a convenient period of time (say a quarter) and no more than that. There are ample highly liquid low cost income-generating securities that are great cash alternatives, like bond funds or combination bond/dividend income funds. Even if you just buy government treasuries directly (backed by the same people that guarantee your cash bank deposits anyway), you’ll likely come out ahead. The holding cost of gold eats into the asset, and Bitcoin is deflationary by design making it unlikely to ever become a serious currency contender for any significant portion of the economy.
Second, make investments automatic with monthly paycheck deductions or automatic transfers. Have those investments split between a total stock market fund (like Vanguard Total World Stock) and a total bond market fund (like Vanguard Total Bond Market Fund) so that your portfolio maintains a target split. The target stock/bond split should start at 90%/10% when you’re in your 20s, 75%/25% in your 30s, 50%/50% in your 40s, 30%/70% in your 50s, and 10%/90% in your 60s. The numbers don’t have to line up perfectly, the idea is to link risk with age. You can also have this done automatically for you using, for example, one of the Vanguard Target Retirement 20XX funds (linking risk to age is smart for any kind of investing, so don’t get thrown by the mention of retirement in the fund name).
The above describes the primary lever by which you tune your portfolio, as well as the many levers by which you will not tune you portfolio. We are not making a bet on any particular company, sector, geography, or currency. We are simply allocating our investments to collect the prevailing risk premium on offer in the market at any given time: the more risk you take on, as you can do when you’re younger, the more you are paid for it.
I should mention here that very few people need to go past this point. If you’re saving automatically, investing the funds in low-cost securities, taking broad market risk early in life when you can and shifting to broad conservative investments later on, you are doing probabilistically as good as anyone can without supernatural powers or engaging in insider trading.
Still reading? Ok clearly you want more. This dimension, of risk+return vs. safety+stability also happens to be the dimension along which the beat appears in the mosh pit. When reading all the analysis of bank failures and industrial growth and liquidity crises, what you’re discerning is movement in the underlying market-wide risk premium: in times of panic, those who can take on risk are paid handsomely; in times of plenty, risk pays little and is probably best left to others.
As Warren Buffett said, “be bold with others are cautious, and be cautious when others are bold,” the non-tautological version of “buy low, sell high.”
So how do you do it? Let’s begin with some house cleaning.
First, deal with complexity by eliminating it. A young single person or couple should have no more accounts than they can count on one hand: a checking account, a few retirement accounts (RRSP, 401k), and a general savings account (preferably at a low-cost brokerage and mostly invested in index ETFs). If you have children or aging parents, you may permit yourself accounts countable on two hands: an educational account (RESP, 529), and a health account (HSA).
Second, cost efficiency. Access to financial markets is not like access to public parks. Not everyone can get there and the gatekeepers extract their toll. So get access as cheaply as possible. Be especially wary of costs that compound (high interest debt), costs you don’t see regularly (auto-deducted fees as opposed to manually paid bills) or costs that are continuous (monthly account fees). Some fall into more than one category, the expense ratios of mutual funds being perhaps the most costly aspect of the average person’s savings. Don’t worry as much about transaction costs; you won’t be doing many of those. Paying $10/transaction instead of $1 might waste $36 per year (with one transaction per quarter), but saving 0.5% MER by getting access to ETFs will save you $500 per year on a $100k portfolio. In Canada, online brokers and the big banks are converging towards lower fee levels that are not great by global standards but much than what was available even a few years ago. InvestorLine and iTrade are good places to start, QuestTrade has slightly lower fees on some securities but more of a learning curve. There are good options in the US: Vanguard has good service and excellent funds, Interactive Brokers can be insanely cheap but has a learning curve and requires safeguards to keep from shooting yourself in the foot. Once you open such an account, calibrate your expectations: you will do nothing interesting in the account except buy stuff for the first 20 years of your career, you don’t need real-time or Level 2 data or access to research reports or market intelligence; you will not trade in a way that requires anything more than the free delayed quotes available on Yahoo Finance. You will not use limit or stop orders so don’t worry about any added fees for those. The add-ons and doo-dads are pure profit to brokers so expect the hard sell but don’t fall for it.
Third, tune your mental radio to a different station: less Jim Cramer and more Eduardo Porter, less Fox Business’ Cavuto and more The Economist’s Free exchange, less Paul Ryan and more Paul Krugman. Junk news kills the mind faster than junk food kills the body. But beyond who to listen to, change what you hear when you do. You’re not listening for the articulate analysis of some mechanistic economic process; even from someone admirably qualified. Such pronouncements are rarely more than speculation. Remember that the market, that orb from hell, is the summation of human frailty effortlessly unleashed by technology upon the financial world. Listen for how the tone of commentary changes, month after month, year after year. Compare it to what you heard when you were younger, at key points of collective ecstasy or panic. The specific issues (like the Greek crisis of 2010) may come and go, but it samples and remixes hits that sound familiar (like the Argentinian crisis of 1998, the Southeast Asian crisis in 1997, the Mexican peso crisis of 1994, …). The cast of characters is always fresher, younger, better dressed and thrashing about with the latest styles of dance. But ignore the mosh pit and listen for the beat. Buy on the downbeat, sell on the upbeat. Carefully. Rationally. Efficiently. And with a perspective borne of a study of decades worth of human frailty communicated in violent market reaction and its attendant breathless commentary.
If we are going to make an economic bet, we might as well do so with our eyes open, and at least investigate the bets we have been making by default. Turns out a lot of these are pretty lousy and we can do a great deal better with only a little rational thought.
Lastly, resist the temptation of youth to try to convince everyone they’re wrong. Instead try to profit from the fact that they are, that they will sell you cheap what is precious and will later buy dear what you acquired cheap. Doing so requires a constitution that deviates in fundamental ways from the norm.
In finance, it turns out, it pays to be different.