Daniel Crosby is a a psychologist and an expert in behavioral finance. We asked him to give us his thoughts on the recent shenanigans of the stock markets. You can follow Dr. Crosby on Twitter: @incblot.
Are stocks expensive right now?
In a word, “yes.”
The expensiveness of a stock is determined, not by the absolute price, but by the price you pay for every dollar of sales, earnings, book value or other commonly used measures. To try and paint a more complete picture, I combined three widely used valuation metrics and converted them into percentile ranks going back to 1971. This composite measure currently has stock valuations in the 79th percentile relative to history, even after the downside volatility of early this week. That’s not as ridiculous as it was circa Dot Com Boom but it’s certainly no bargain either.
Oh good, I’ll shop other asset classes then. Buy low, sell high, you know?!
Bad news: fixed income, stocks and real estate are all very expensive compared to their historical averages at this point. Asset classes tend to be mean reverting over time, meaning that what is performing well today will tend not to perform as well in the medium term. Stocks have averaged 10%/year returns over long periods of time but have produced nearly 17% returns since the Great Recession. While that has been a nice boost, it probably means to expect less predictability and more heartache from just about every asset class in the medium term.
Fine then, I’ll do what Glenn Beck says and hoard gold and silver.
I wouldn’t advise it. The risk-adjusted returns on precious metals are pretty crummy over long periods of time, no matter what your favorite conservative radio pundit is paid to say. If you’re the type of Mormon that has a three-year supply of Bishop’s Storehouse wheat and you insist on it, I would stick to buying physical metals (e.g., actual gold bars) and not gold ETFs or other forms of “paper metal.”
So, what should I be doing?
Do Look for Positivity – Despite what political pundits and that guy who always bears his testimony would have you believe, this is not an unusually scary time to be alive. Although you’d never know it from Sunday School, the economy is growing (slowly) and most quality of life statistics (e.g., crime, drug use, teen pregnancy) have been headed in the right direction for years! Markets always have and always will climb a wall of worry, rewarding those who stay the course and punishing those who succumb to fear.
Warren Buffett expressed this beautifully when he said,
In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.
Such it has ever been, thus will it ever be.
Do Take Responsibility – Pop quiz! Which of the following do you think is most predictive of financial performance – a. market timing b. investment returns c. financial behavior? Ask most any man or woman on the street and they are likely to tell you that timing and returns are the biggest drivers of financial performance, but the research tells another story. In fact, the research says that you – that’s right – you, are the best friend and the worst enemy of your own portfolio.
Over the last 20 years, the market has returned roughly 8.25% per annum, but the average retail investor has kept just over 4% of those gains because of poor investment behavior. What happens in world financial markets in the coming years is absolutely out of your control. But your ability to follow a plan, diversify across asset classes and maintain your composure are squarely within your power. At times when market moves can feel haphazard, it helps to remember who is really in charge.
Do Work with a Professional – Odds are that when you chose your financial advisor, you selected her because of her academic pedigree, years of experience or a sound investment philosophy. Ironically, what you likely overlooked entirely is the largest value she adds – managing your behavior. Studies from sources as diverse as Aon Hewitt, Vanguard and Morningstar put the value added from working with an advisor at 2 to 3% per year. Compound that effect over a lifetime and the power of financial advice quickly becomes evident.
Vanguard suggests that the benefit of working with an advisor is “lumpy”, that is, the effects of working with an advisor are most pronounced during periods of volatility (like today). They go so far as to break out the impact of the various services provided by an advisor, and while asset management accounts for less than half of one percent, behavioral coaching accounts for fully half of the value provided by working with a professional. Today is the day your financial advisor earns her keep. Don’t be afraid to reach out to your advisor during times of fear and seek her reassurance and advice. After all, she’s saving you more money by holding your hand than by managing your money.
What should I not be doing?
Don’t lose your sense of history – The average intrayear drawdown over the past 35 years has been just over 14%. The market ended the year higher on 27 of those 35 years. A relatively placid six years has lulled investors into a false reality, but nothing that we have experienced this year is out of the ordinary by historical measures.
Don’t equate risk with volatility – Repeat after me, “volatility does not equal risk.” Risk is the likelihood that you will not have the money you need at the time you need it to live the life you want to live. Nothing more, nothing less. Paper losses are not “risk” and neither are the gyrations of a volatile market.
Don’t focus on the minute to minute – Despite the enormous wealth creating power of the market, looking at it too closely can be terrifying. A daily look at portfolio values means you see a loss 46.7% of the time, whereas a yearly look shows a loss a mere 27.6% of the time. Limited looking leads to increased feelings of security and improved decision-making.
Don’t forget how markets work – Do you know why stocks outperform other asset classes by about 5% on a volatility-adjusted basis? Because they can be scary at times, that’s why! Long term investors have been handsomely rewarded by equity markets, but those rewards come at the price of bravery during periods short-term uncertainty. The relationship between risk and reward is real; choose peace of mind or a shot at meaningful wealth-compounding because you can’t have both.
Don’t give in to action bias – At most times and in most situations, increased effort leads to improved outcomes. Want to lose weight? Start running! Want to learn a new skill set? Go back to school. Investing is that rare world where doing less actually gets you more. James O’Shaughnessy of “What Works on Wall Street” fame relates an illustrative story of a study done at Fidelity. When they surveyed their accounts to see which had done best, they uncovered something counterintuitive. The best-performing accounts were those that had been forgotten entirely. In the immortal words of Jack Bogle, “don’t do something, just stand there!”
This is a less-than-ideal time to be an investor, but some principles of building wealth are timeless. Over time, people who diversify across asset classes and countries, manage their behavior and minimize transaction costs will do well.