#1 of 8 Investing Questions You Need Answered — When Stocks Prices Go Down, Where Does the Money Go?
The money disappears. It goes “poof!”
Many middle-class investors do not understand this. They understand that money used to purchase lottery tickets can go “poof!” But putting money into stocks isn’t gambling. It’s, it’s, it’s — investing!
Right?
That’s sort of right and sort of not right. Stock prices are to a large extent determined by economic realities. The thing you own when you own a share of stock is a share of a corporate enterprise. A corporate enterprise is comprised of patents and machinery and property and goodwill and things like that. Those sorts of things have real value. Your ownership of things like that can never go “poof!”
It’s not only economic realities that determine stock prices, however. Stock prices are also determined by investing emotions. When investors become excited about stocks, they bid prices up to fantastic levels. When their emotions return to earth, they bid prices back down to the levels suggested by the things of real economic value owned by the underlying corporate enterprises, or sometimes even lower.
If you buy stocks at reasonable prices, you are not gambling because your money is being used to acquire a share in things of real economic value. If you buy stocks at times when prices are what they are today (this article was posted in September 2007), half of your money is being used to acquire a share in things of real economic value and half of your money is being used to acquire cotton candy that can be blown away with a change in the wind. Buying stocks today is half investing and half gambling.
The bad news is that half of the value of a stock purchase made today really can go “poof!” The good news is that only half of the value of a stock purchase made today can go “poof!” Once prices drop by 50 percent, all of your remaining money will be going to the purchase of a share in a real economic enterprise and you can be realistically assured of obtaining a strong long-term return on that portion of the money you invested.
#2 of 8 Investing Questions You Need Answered — What Do People Mean When They Say That Stocks Always Do Well in the Long Run?
They mean that, if you are willing to wait 30 years, you are almost sure to obtain a good return on your stock investment.
Please take a look at The Stock-Return Predictor (see tab at left). At today’s prices, the most likely 10-year annualized real return is less than 1 percent. You can beat that by putting your money in certificates of deposit. Go out 30 years, however, and the most likely 10-year annualized real return for a purchase of the S&P index is over 5 percent. That’s a highly appealing return.
Many investing “experts” engage in trickery by suggesting that it is always a good idea to invest in stocks “for the long run.” Few middle-class investors can afford to wait 30 years to see their stock investments beat the returns that they could have obtained by investing in far safer asset classes. Most would be better off lowering their stock allocations at times of extremely high prices and then increasing them again when prices came down and stocks again offered a compelling long-term value proposition.
It is not in a strict sense untrue to say that stocks do well “in the long run,” however. After the passage of 30 years, stocks really do always do well (or at least it can be said that U.S. stocks always have ). The trickery is in the suggestion that the odds favor stocks purchased at today’s prices doing well at the end of 5 years or 10 years or 15 years or 20 years. Purchasing stocks today with the thought that they might do well over those sorts of time-periods (which most of us think of as “the long run”) is a long-shot bet.
#3 of 8 Investing Questions You Need Answered — Why Doesn’t the Price You Pay for Stocks Affect the Value Proposition Obtained from Them?
There is no asset you can buy for which the price paid does not matter. The price paid matters when purchasing bananas. The price paid matters when purchasing cars. The price paid matters when purchasing houses.
So why doesn’t the price paid matter when purchasing stocks?
It does. There is a lot of trickery engaged in on this question too.
”Experts” are able to make arguments seeming to show that price doesn’t matter when purchasing stocks by focusing on short-term results. It is the emotions of investors that are the primary factor in determining stock prices in the short term. Emotions are unpredictable. Even though stocks are a poor buy today, it is possible that investor emotions will send stock prices far higher over the next year or two or three.
In the long run, though, it is the economic realities that are the primary factor in setting stock prices. When you purchase stocks at reasonable prices, you can be virtually assured that you will obtain a strong return in the long term (10 years or more). When you purchase stocks at the prices that apply today, you can be virtually assured that you will not obtain a strong return in the long run.
Prices matter when buying stocks, just as they matter when buying any other asset available for sale on Planet Earth. There is no need to abandon your common sense when deciding on an investment strategy.
#4 of 8 Investing Questions You Need Answered — Why Is Buy-and-Hold Such a Powerful a Strategy?
Many of today’s “experts” endorse the idea of adopting a buy-and-hold strategy without understanding why buy-and-hold is so powerful. It is essential that the investor seeking to pull off a buy-and-hold approach successfully understand why buy-and-hold works.
Buy-and-hold works because using a buy-and-hold strategy causes the investor to focus on the right things — the economic realities that determine long-term results, not the emotional cotton candy that determines short-term results. The media is focused on the cotton candy. 80 percent of what you read about investing tells you about what happened yesterday or what is happening today or what some people think is going to happen tomorrow. None of that junk helps you become an effective investor. It is not just a waste of time. It is dangerous to your hopes of obtaining a good return on your investment dollars.
It’s dangerous because it gets you interested in the gambling aspects of the investing experience. No one knows what is going to happen in the short term because the short term is determined by investor emotions. You need to tune that stuff out. The power of buy-and-hold is that it turns your focus to the long-term and it is in the long-term that purchasing stocks stops being gambling and becomes investing.
Most middle-class investors are today in a transition phase from being short-term gamblers to being long-term investors. We have learned in recent years that we should be focused on the long-term and that we should follow buy-and-hold strategies. However, few “experts” provide us the tools needed to focus on the long-term in a meaningful way. To focus on the long term, you need tools like The Stock-Return Predictor, tools that give you the information needed to form reasonable assessments of how your stock investment is likely to perform over the long term.
The good thing about buy-and-hold is that it takes your mind away from the short-term nonsense that is the focus of most media coverage of investing issues. The bad thing about what most “experts” tell us about buy-and-hold today is that it tunes out the long-term realities too. When prices fall as they are likely to fall in coming years, middle-class investors are going to be shocked and the shock is going to cause most to abandon their buy-and-hold strategies. Effective buy-and-hold strategies are valuation-informed buy-and-hold strategies.
The power of buy-and-hold is that it encourages a tuning out of the short-term nonsense. There is no power in avoiding knowledge of the long-term economic realities too. That aspect of the conventional approach to buy-and-hold is an unfortunate consequence of the fact that buy-and-hold was developed during the longest and strongest bull market in the history of the U.S. market.
#5 of 8 Investing Questions You Need Answered — Why Doesn’t Timing Work?
Most middle-class investors “know” that timing doesn’t work. Few know why.
If you don’t know the answer to the “Why?” question, you don’t really understand how timing relates to stock investing. You need to understand this before putting money at risk investing in stocks.
Timing doesn’t work because in the short-term it is investor emotions that determine stock prices. Say that you take note that stocks are absurdly overpriced. Does it follow that you can predict where prices are headed and thereby take advantage of your insight? It does not. Stock prices are determined by emotions. Emotions are not rational. There is nothing to stop absurdly high prices from heading to even more absurdly high levels. Timing doesn’t work because of the way stock prices are determined.
It is in the short term only that stock prices are determined by emotion. In the long term, stock prices are determined by the economic realities. In the long-term, stock prices are to a large extent predictable. In the long-term, timing works.
A good way of testing whether an investing “expert” knows what he or she is talking about is asking him or her why timing does not work. If all that the expert can say is “well, it just doesn’t,” it is fair to conclude that this particular expert is merely repeating what he heard from someone else and lacks a strong personal understanding of how stock investing works. You need to be wary of any advice offered by such an “expert.”
#6 of 8 Investing Questions You Need Answered — What Makes Someone a True Investing Expert?
It’s not popularity. It’s not managing lots of money. It’s not going to school to take courses with the word “investing” in the title and obtaining passing grades.
The same media that focuses its attention on the causes of the day-to-day price swings also blows the call as to what sorts of qualifications are needed to make someone an investing “expert.” The media looks at obvious credentials such as whether the person studied investing, whether he manages lots of money, and whether her views are frequently quoted. It is fair to say that these things are positive signs, but possession of these sorts of credentials are not sufficient to make someone a true investing expert.
The key to investing success is focusing on the long run. Those managing large amounts of money often cannot focus on the long run. The strategies that work in the long run are often the opposite of those that work in the short term. Fund managers posting poor short-term results are likely to lose their jobs. Those managing large sums are often compromised. The price paid for following effective long-term strategies is too high for them to do what their understanding of how stocks work tells them to do.
And those who speak openly about how stocks are likely to perform in the long term are rarely popular. Dallas Morning News Columnist Scott Burns gave the game away when he noted in a column from July 2005 that the reason why few reporters have told their readers about the Retire Early Community’s safe withdrawal rate findings of recent years is that: “It is information most don’t want to hear.” Investing “experts” and investing journalists don’t see it as their job to tell you what you need to hear. They see it as their job to tell you what you want to hear. There’s a difference.
The true “experts” are those who can provide you with clear and understandable and sensible answers to the eight questions listed in this article. These questions are basic. Anyone purporting to be an investing expert who cannot address them effectively is most likely trying to sell you something. Investor beware.
#7 of 8 Investing Questions You Need Answered — Why Are Most Middle-Class Investors So Confused About How Stock Investing Really Works?
Most middle-class investors are busy people. They have money they need to invest and the time they can put into the project of figuring out what they need to do is limited. They turn to shortcut methods for figuring out what to do that work in most other life endeavors but that produce poor long-term results in the investing field.
If you were trying to pick a restaurant and didn’t have much time to do research, you might just conclude that a busy restaurant probably serves good food. Otherwise, why would it be so busy? It doesn’t work that way with investing. Stocks become popular by going up in price. When stocks are high priced, they offer a poor long-term value proposition. The Stock Restaurant is a place that cycles from being a wonderful place to eat to being a horrible place to eat, and the times when it is most wonderful are the times when there are no lines.
Middle-class investors are not dumb and middle–class investors are not greedy. Middle-class investors are busy. Their time crunch causes them to accept explanations of how stock investing works that in a surface sense are plausible but which do not stand up to scrutiny. My advice to middle-class investors is to drill down on the basics. Insist on clear answers to the questions listed in this article. Do not put one penny at risk until you possess a sure enough grasp of the stock investing fundamentals to see what games are being played and to know how best to protect yourself from them.
Understanding the fundamentals does not take long. You can get by without knowing lots of detailed and technical stuff about how stock investing works. Not knowing the fundamentals can get you killed. You owe it to yourself to work the questions listed in this article until you are absolutely clear on them.
#8 of 8 Investing Questions You Need Answered — At What Price Level Do Stocks Represent a Good Buy?
If you don’t know the answer to this one, you are buying blind.
Stock prices fall 10 percent. You know what happens, don’t you? Some “expert” writes a column saying that now might be a good time to buy.
Dumb.
I would take that description up a notch and refer to it as “pathetically dumb” if it were not for the fact that so many fall for it. Bad advice that hurts lots of people is certainly dumb but perhaps not pathetically so. The advice described above is powerfully dumb (and I saw Jonathan Clements at The Wall Street Journal put it forward only a few weeks ago).
Would you fall for the claim that an absurd price that is a little less absurd that one than one applied earlier is a good deal if a fellow trying to sell you a car tried to persuade you of it? If you were looking for a car with a fair market value of $20,000 and you went to a dealer who quoted a price of $40,000, you would walk out. What if he called you the next week to tell you the good news that he was now willing to take 10 percent off and let you have the car for $36,000?
People who call themselves investing “experts” pull this one all the time. Stocks are today selling at a price double their fair value. A 10 percent price drop isn’t going to improve the long-term value proposition enough to make stocks an appealing buy. Again, please spend some time with The Stock-Return Predictor to learn what you need to know to know when stocks will be worth buying again.
It’s a nice thing for the stock-selling industry that most of us know so little about how to identify when stocks offer a strong long-term value proposition and when they do not. It’s not such a nice thing for us middle-class investors. Insist on clear answers to these eight questions before putting money on the table. Don’t take every investing expert to be your friend.