"The market can stay irrational longer than you can stay solvent." ~ John Maynard Keynes
When the investor herd is irrational, where does that leave the rational investor? Perhaps broke. But there is hope for rationality!
The good news is that, in capital markets and in life, irrationality tends to be a short-term phenomenon, while rationality ultimately defines (and eventually wins in) the long term.
For a rational investor to survive and thrive in an irrational market, there are a few universal truths to remember and practice.
Here's what to keep in mind:
Rationality is Not Always in Opposition to Irrationality
Yes, an investor can do well to buy when the herd is selling and to sell when the herd is buying. But there's also something to be said for doing nothing. Passively investing in an S&P 500 index fund would have resulted in a 34% decline from the February peak to the March low. But holding from from April through June would have resulted in a 29% gain. Going against the crowd in March was smart; going against the crowd in April, May and June was not.
Irrationality Can Work in Both Directions
A rational investor could make a solid argument that stock prices are now irrationally high. With new Covid-19 cases hitting records daily, businesses going bankrupt, and unemployment still at 11% (higher than the average rate during the Great Recession), how can investors continue to push prices higher from here? One word: irrationality. Would this justify selling stocks now? Not so fast.
Go back to the featured Keynes quote at the top of this blog post: "The market can stay irrational longer than you stay solvent." Irrationality can work in both directions. The investor herd sold stocks at a record pace in March but they bid up prices in April and May, notching in the largest 50-day gain in the history of the stock market. Stocks then added to those gains in June and early July.
Never Assume 'the Judges' Are Rational
An analogy that works here is John Maynard Keynes' "beauty contest." Keynes noted that the best investment strategy isn’t to pick the faces that are your personal favorites. It's to select those that you think others will think "prettiest."
Perhaps even better, Keynes said, move to the “third degree” and pick the faces you think that others think that still others think are prettiest. Similarly in speculative markets, he said, you win not by picking the soundest investment, but by picking the investment that others, who are playing the same game, will soon bid up higher. Adding to his analogy: the "others" may or may not be rational.
Fear and Greed are Not Qualities of the Rational Investor
Let's return in our minds to March 2020. One could make an argument that the biggest one-month decline in stock market history, based on fear and speculation and with almost no consideration for fundamentals, was irrational. Yet, the rational investor could have done well to buy progressively as the market declined. This is not greed; it's the absence of fear.
Equal and opposite, as the market has reached what appears to be irrationally high levels, what would make an investor sell? If, after careful consideration, you find that it's fear or greed motivating you to sell now, give this more consideration. If the market falls significantly in the short term, do you have the cash on hand to buy more? Does it make as much or more sense to rebalance? Are you a long-term investor? Or do you need to start making withdrawals from your investment accounts in less than 10 years?
Bottom Line
When markets are irrational, you can either do something or you can do nothing. When the market is irrational on the downside, you can buy or do nothing. When the market is irrational on the upside, you can sell or do nothing. For most people, especially long-term investors, doing nothing is best.
If you find that it's difficult to think and act rationally with regard to your own money, another alternative is to hire someone else to manage it for you. This is not a solicitation; it's just another facet of rationality.
Kent Thune is a philosopher who happens to be a Certified Financial Planner (TM) and owner of Atlantic Capital Investments, LLC, a registered investment advisory firm located in Hilton Head Island, SC. Mr. Thune is also a freelance writer published on multiple investing and finance websites, including MarketWatch, Yahoo Finance, Kiplinger.com, InvestorPlace.com, The Balance, and The Motley Fool.
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