The Car is Parked, But the Motor is Still Running

With the stock market currently standing some 30% above its March low (still a bear market rally, really?), my thoughts turn to those investors who sold their stocks anytime before then and still hold cash. Selling stocks because the market is going down is a classic investment “tactic” driven more by emotion than cogitation. Hey, I’ll admit that I’ve done it, and I suspect a lot of other people have done it too. To be fair, it’s not really our fault, at least according to Jason Zweig in his book, Your Money and Your Brain: How the New Science of Neuroecononics Can Help Make You Rich. It’s our brain’s fault!

His research suggests that when we start losing money in the market, the feral, animalistic and primitive portion of our grey matter grabs the steering wheel and starts driving with somewhat reckless abandon. This response is neurologically similar to what we feel when in real (not just financial) danger. It’s the classic “fight or flight” adrenaline rush. Often in those moments of stress, our ability to think clearly, carefully weigh options and calmly deliberate on possible outcomes goes out the window. We feel we must do something, and selling is the only thing that seems to make sense.

So now here we are, holding on to our cash and watching the market move up. How do we feel about that? On the one hand, maybe we find some comfort knowing that our asset values are no longer going down. On the other hand, perhaps we are wondering if we really missed the boat. This is when the rational part of our brain takes over and starts to make sense of what happened and what to do now. For investors who need their assets to grow in order to achieve long-term financial objectives, stocks and bonds must be an important part of the portfolio.

Ultimately, the decision to raise cash and sit on the sidelines is two decisions; the other one being when to get back into the market. Do you get back in now? Wait until it goes even higher? Or do you wait for a pull back? How much of a pull back is enough? Do you wait for the “other shoe” to drop and buy at a much lower level? What happens if the market never goes back to where you sold? Ah, such are the dilemmas faced by those who try to time the market. The rational part of the brain may understand at some level that timing the market is impossible, but all this good wisdom is forgotten when the feral brain takes over.

I am seeing a large amount of press lately about how “buy and hold” investment strategies no long work. Given the results of this strategy over the last 10 years, some of this press seems reasonable. However, the conclusion that active trading strategies are the only way to make money in the markets going forward seems misguided. Into this debate steps Stephen Mauzy and his excellent article “Trading Paces” (which can be found in the latest issue of CFA Institute Magazine). In this piece, he reminds us that successful traders are as rare as Kansas surfers. One great quote: “You may call one top or one bottom [in your trading] or you might call two. Getting it right requires many excellent decisions in buying and selling. But I don’t know anyone who is able to constantly produce exceptional after-tax results with trading strategies.”

He references another study in which investment professionals were asked to provide 30-day forecasts for 20 stocks and estimate the size of their own errors. It turns out that the professionals were able to make successful predictions only 40% of the time – less than what a simple coin toss could do. This is not to suggest that investment professionals do not provide valuable services, I truly believe that they do. But they may not be all that great at predicting near-term market or stock movements. And, if the professional is not adept at making short-term predictions, what chance does the non-professional really have?

You may be saying to yourself, “That’s all fine and dandy, but what do I do with my cash NOW?” Well, my advice now would be the same as in March, December, September or even last July – buy cheap stocks trading well below their intrinsic value. Over time, cheap stocks (if identified and measured properly) will usually move upward toward their fair value. Nothing is guaranteed, but the time-tested value investment approach, so well explained by Graham and Dodd and so well practiced by Warren Buffett, John Neff and a host of others, is still my favorite way to make money with stocks. There are many great values out there right now, and I am happy to buy and own them.