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AT THE RISK OF CAUSING readers to think too much on a Saturday morning, let me start by offering a pair of seemingly contradictory statements:
My contention: There’s a payoff to be had from grappling with these two apparent contradictions—a payoff that takes the form of greater calm in the face of market turmoil and improved long-run portfolio performance.
Measuring up. Many HumbleDollar readers, and perhaps most, are fans of indexing, and with good reason. We all know how difficult it is to pick winning stocks and to forecast the financial markets’ short-term direction. Statistics tell us that even professional money managers struggle to outwit the markets, especially once their investment costs are factored in.
Beating the market, of course, would be far easier if we could figure out what stocks were truly worth. But as I’ve come to realize after almost four decades of writing about investing, valuation metrics like price-earnings ratios, book value and dividend yield give only a rough idea of what stocks are truly worth, and they certainly aren’t a reliable guide to short-term performance.
Why aren’t these market yardsticks more helpful? There’s a host of reasons. Stocks’ fair value rises when interest rates fall, and it falls when rates climb. Investors’ appetite for risk has grown over time, and that means typical stock valuations have also trended higher. Valuing corporations based on the assets they own has become trickier as companies focus on building intangible assets like brand names and intellectual property. Meanwhile, valuation measures that look at earnings have drifted upward as the market has come to be dominated by fast-growing technology firms.
Because it’s so difficult to figure out whether stocks are cheap or pricey, outperforming the market averages is mighty tough and few manage it over the long haul. Indeed, the most sensible assumption is that the financial markets are efficient, meaning they accurately reflect all publicly available information, and that the best strategy is to settle on a prudent stock-bond mix and then build our desired portfolio using low-cost broad market index funds.
Going nuts. Investors tend to anthropomorphize the stock market, ascribing human qualities to its unpredictable behavior. For instance, if the market rockets higher and then lower, we might call it crazy. If it moves against us, we might depict the market as punishing us. Even the great Benjamin Graham anthropomorphized the market, with his famous analogy of Mr. Market, whose erratic behavior might allow us to make money at his expense.
But in truth, the market’s action reflects not the behavior of a single, unhinged individual, but rather the decisions of millions of investors, all buying and selling based on their best judgment of what stocks are worth. While some of these folks may be acting foolishly, most investors are reasonably rational and hence stocks tend to be reasonably valued. The financial markets are indeed efficient—most of the time.
That said, it seems that, every so often, a significant number of investors go collectively nuts, causing stocks to become unmoored from their intrinsic value. I don’t want to suggest this is a common occurrence and that stocks are often wildly mispriced. Still, it’s clear that it does indeed happen.
Think back to the 2021 craziness over special purpose acquisition companies, cryptocurrencies, net fungible tokens, and meme stocks like AMC and GameStop. Or think about the pricing of dot-com companies in 1999 and early 2000. Markets may be efficient when individuals make judgments in isolation. But when large numbers of investors act as a herd, with folks egging each other on, market efficiency can break down and share prices can lose touch with reality.
Behaving yourself. What does this mean for more sensible investors? Even if you think particular stocks are at unsustainable prices, I would caution against betting that they’ll fall back to earth. Shorting stocks is a dangerous game—because the potential losses are unlimited.
So, what should sensible investors do? At a minimum, I think it’s helpful to be aware of this herd behavior, so you aren’t tempted to join in. Eventually, fundamental value will win out, dragging foolishly priced investments back to earth, and you don’t want to get caught up in the carnage.
Instead, if there’s any opportunity for sensible investors, I think it comes during broad market declines. When the news is relentlessly bad, your neighbors are talking about cashing out their 401(k) and the TV talking heads are certain the market decline has further to go, there’s a chance we’re seeing herd behavior—and this is the moment when you want to rebalance your portfolio, buying stocks so you get your holdings back up to your target portfolio percentage. At such moments of collective madness—think early 2009 or early 2020—you might even consider overweighting stocks, something I’ve done during market declines.
But even if you aren’t inclined to buy, I’d encourage you to lean against the wind, at least emotionally. We may not know the precise fundamental value for stocks. But we know they do have fundamental value, and that value changes far more slowly than share prices. When financial markets seem nuts, we should keep this fundamental value in mind—and know there’s more to stocks’ value than just the latest price quote.
Think about the past year, with all the fretting over inflation, recession, a government debt default and the dollar losing its reserve currency status. If you paid too much attention to the handwringing, it would be easy to lose your nerve and make panicky decisions. And even if you stood your ground, there’s a good chance you found yourself worrying needlessly.
My advice: Get into the habit of telling yourself it isn’t as bad as the headlines suggest and that this too shall pass. Indeed, even if we fear “it’s different this time,” it’s rational to bet otherwise. How so? An imploding world hurts everybody, no matter how they’re invested, but a recovering world only rewards those brave enough to stay the course.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X (Twitter) @ClementsMoney and on Facebook, and check out his earlier articles.
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I spent 40+ years in the investment business and had to deal with fearful clients in every downturn.
When market got bad, the phones would inevitably start ringing, bringing messages from clients: “Is this going to last?”, “How bad will it get?”, “Shouldn’t we be doing something?”, “Should we sell everything and wait until the market gets better?” The last question was always the most dreaded as it inevitably lead to a too-technical discussion of the perils of market timing, or worse, that their portfolio was “outperforming on the downside.”
We tried hard to keep our clients invested, but there was always one or two clients who insisted that we liquidate their portfolios. Needless to say, having gone to cash, it was equally hard to get them to reinvest when market conditions improved for fear of further losses.
In managing my own money, I have relied exclusively on a very few funds in order to achieve my desired asset allocation and diversification. I also try hard to not constantly check my account balances and not make unnecessary trades as markets are falling. Nevertheless, its one thing to give advice and quite another to take our own advice.
Wrt Jonathan’s article I do like to speculate a little (with small amounts!) and I am always watching for opportunities where the market’s herd mentality is getting overly pessimistic or optimistic; ie: stupid, especially with individual stocks, sometimes with indexes such as SPY.
I agree strongly with a comment (slightly paraphrased) by John Bogle, he said he allocated his assets so he could “sleep soundly at night” regardless of market fluctuations.
We all should know by now when it comes to the direction of stocks or bonds, NOBODY KNOWS ANYTHING!!!
Thanks for your words of wisdom, Jonathan. Happy holidays!
I’m entering the last full year of my “delay period” where I am living primarily off my retirement savings prior to turning on Social Security at 70. It came time for me to rebalance this fall in order to replenish the cash buffer I have been living on since 2017 when I retired. This could be referred to as re-balancing since what I did to replenish the cash buffer was sell the 5% of my equity holdings that were above my target allocation of 60%. What always confuses me is all the different opinions out there about when to rebalance. Since I don’t believe I can time the market my decision as to when to rebalance is primarily based on when I need to replenish my cash, although if the market is tanking, I would likely hold off for bit (and having a generous cash buffer does help with that), but this year I did not hesitate to sell and market has been going up so fast that I am already back up over a 61% equity allocation.
Several decades ago, long before I knew anything about investing (perhaps I still know very little, but I do at least know a lot more than I did 40 years ago), I had a daily car commute in which I happened to listen to WCBS AM radio in New York, where they have business news twice per hour.
Each day, they would have a short blurb from some broker or fund manager or other expert who would give their opinion on which way the market was likely to move in the coming weeks or months.
I noticed that the expert of the day might give a prediction that might well be completely at odds from the prediction of the expert the previous day.
Not knowing anything about investing, I remember having thus clearly been “taught” one specific lesson: In investing, no one knows anything about the future. So how could I possibly best the “experts” who it seemed could not agree on anything?
I could not.
So all I could do, as implied in your piece here, is to look at history and try to be right a lot of the time and not so wrong on some big things that it messes everything up. That’s just twisted way of saying:
1) save,
2) think long term,
3) use indexes,
4) try to understand taxes (in-as-much as anyone can).
All I can say is it worked for me and my wife – we are comfortably retired. Like many, I made a few mistakes in the first couple decades, none terrible, but noteworthy in the lessons they taught. If, starting when I was just out of college, I had done what I have been doing the last few decades, the results would be even sweeter than they are now; an extra 10-15 years of compounded returns on a decent sized portfolio is huge.
100% on #4!
Not only do taxes influence the type of assets you hold in either taxable or non-taxable accounts, it also influences your re-balancing tactics.
Controlling our behavior is paramount to fund selection. We have all made some form of timing mistakes. As Bole said from Day 1, ‘STAY THE COURSE”. Long term Equities win by a big margin over bonds long term; like 2 to 1
Error 😳
During the COVID market crash I adopted the following plan. When the market hit correction level I increased my stock position 1%. When it hit bull territory I increased my stock position 2%, then increased increasing my stock position by an higher 1% position with every 5% drop. My final buy was nearly at the bottom but with this philosophy I didn’t have to determine what that level would be. Then I reversed course using the same market levels on the way up. I made some decent money because I am not a greedy investor. Why did I do this? I am an invested long term and firmly believe that the markets. Will build my wealth over time. BTW when the S and P hits a new high I will sell 1% of my stock portfolio and buy short term treasury bonds. When it drops into a correction or bull I will rinse and repeat!
Your third sentence – didn’t you mean “bear”, not “bull”?
Opps, u r correct
I now believe in the accumulation phase 100% equities is the way to go. Over 30 and 40 year periods stocks always beat bonds. Pre-retirement hold 5 years of safe assets in fixed income vehicles. READ Simple Wealth by Nick Murray
During the first half of my accumulation phase, I believed in 100% fixed income and aggressive savings. It worked well, especially in the interest rate environment of the late 1980s and the nineties. Half-way towards my savings goal, I felt secure enough to invest in equities, with an eye towards quality, dividends, and value. That has worked well, too.
In retrospect and for simplicity, I should have held index funds. Instead, I purchased individual stocks with caution and generally hewed to buy and hold and dividend reinvestment plans. Luck struck with long ago investments in a few stellar out-performers (AAPL, MSFT, BRK). Had it not been for these, I doubt I would have beat the market.
There’s no intrinsic value.
Index funds only work when a substantial group of investors believe they can beat the market.
I think it is safe to that there will always be a large number of investors who think they can beat the market. In fact, the widespread love of gambling indicates that many investors will take a chance on hitting the investment jackpot even when they know the odds are against them.
Thanks for the article Jonathan. It feels like herd mentality right now driving prices up. I am 63 right now and have been on the sidelines relative to owning stocks (20/80) for a long time. I keep seeing all the retirement videos and articles telling us we should be 60% or 100% stocks even in retirement otherwise inflation will decimate our savings over time. I understand the thinking behind it but it is very hard to invest in stocks right now at these price levels. I think a greater than 10% negative correction to my savings would cause significant mental anguish. It is hard to know how get more exposed to stocks.
I feel exactly the same – also the same age and similar stock allocation (25%). I believe a 1/3 allocation to stocks is right for us long-term, so I’ve been dollar cost averaging into a total market fund this year. With valuations this high it sure is difficult to pull the trigger every few months!
I don’t have a crystal ball. But as best I can tell, investors aren’t wildly enthused about stocks or bonds right now, which I find comforting.
Thanks. My savings are mostly in FZDXX and a few various stocks I picked up over the years. I did just pick up some of those iShares TIPS Bond ETF to fund the years from 65-70 prior to social security so I should just invest the rest in stocks but it seems so high right now. I should probably set a VTI stock price that I would purchase at and then either get in at that level or start the monthly purchase process at that level. The question is what is that number? 10% below current? 🙂 Thanks again.
We had a bear market in 2020 and another in 2022, and we’re just over 14 months into the current market recovery. History suggests this rally has further to go. If you want to allocate more to stocks, I’d settle on an investment plan that doesn’t hinge on a 10% market drop — or you could find yourself sitting on the sidelines for quite a bit longer.
Excellent advice. Thank you for sharing this with us.
I’m not a financial analyst. I wonder sometimes, why everybody isn’t completely invested in index funds. But because stock and bond prices do rise and fall, it’s obvious not all investors agrees with me (and as you say, most Humble Dollar readers). I don’t know anyone who invests solely in stocks and actively trades. If everyone was like me, I think the price of index funds would only move at a glacial pace and would, over time, asymptotically approach Jonathan’s fundamental value.
Through my tax practice I’ve known quite a few active traders, and all but a couple have gotten crushed. Of the two that have consistently done well, I find it interesting that both are retired engineers. They’re most always in the right place at the right time. I wonder if this is just a coincidence or perhaps because of the analytical nature of engineers in general.
I think more like you Jeff; slow and steady is good enough for me.
@ Jeff Bond,
Index funds are my largest holding but my individual holding in Apple Stock FAR exceeded the return of any index fund. That includes Index funds that count Apple amongst it’s holdings.
While nothing has beaten Apple, I have other individual stock holdings that have also beaten the index funds.
As long as investor can beat index funds, many will allocate a portion of their portfolio to High quality stocks.
I’m not against the funds, I’m just noting why everybody isn’t exclusively invested in them.
I haven’t been a big index fund investor until the after the 2020 crash ( retired 9 years ago at age 57) but, like you, AAPL (and ABBV) have been my biggest stock holdings over the years and have far exceeded any index funds returns (factoring in ABBV’s 4% dividend payout each quarter). I may get more index funds heavy as I get older but solid, dividend paying stocks have been my bread and butter over the last 40 years.
That’s why I have a gambling account which I limit to $1k per buy. I can feel like a genius when I look at Broadcom (up 2x) or scratch my head at Pfizer (sold at a loss).
Over those two years I’ve beat VTI. But two years is not enough data. Especially with the unusual behavior of energy stocks in 2021.
We do need active investors, with all their buying and selling, to ensure the markets are efficient and hence prices reflect fundamental value. Those of us who index are effectively mooching off their hard work and trading costs.
Just call me Minnie …
(Cab Calloway reference)