Fear Greed & Logic

When the stock market goes up we’re all “isn’t life grand” and “we’re so smart”. When the stock market falls a lot, the world is coming to an end and we MUST know why. It’s hard to understand why AT&T was worth $38 a share on Last Wednesday and $35.60 today. The simple answer is that the perceived value of the stock has gone down for some simple reason, higher interest rates, weaker economy or new technology. The real answer is that the markets are driven by fear and greed. Logic is the fulcrum for these two emotions.

 

In finance class we learned that the value of a stock is equal to the net present value of the future cash flows that it will generate. The problem is that no one knows what that will really be for any given stock or stocks in general. In a rational world stocks would fluctuate up and down as people’s perceived value of that amount changes. In reality stock prices are driven largely by the fear that the investor will lose their investment and the hope that they will turn their investment into a much larger amount of money. Over time the rational value of a stock is found by the markets, but much of the time emotion is embedded in the price.

Financial advisors will push bonds because their value and income is known. If you buy a $10,000 bond with a 2% yield and a 10 year maturity you expect to get $200 annually in interest and $10,000 back in 10 years. As long as the issuing entity remains solvent that’s a reasonable expectation. Equity is higher risk, dividends can change, business can falter and management can make stupid mistakes that cause the business to lose value. All of these factors will impact bond holders, but not as much as stock holders. All of these factors weigh in on the fear and greed of the stockholders.

If you invested $10,000 in the 10 year bond on 2/8/2008 with a 2% yield you would have $12,000 today if you held the interest in cash. A similar investment in an S&P 500 benchmark mutual fund would be worth $19,397 today. At the low point after the market crash in 2009 that S&P fund would have been worth $5,133. The unfortunate reality is that with a drop like that, many investors decided that selling was the right decision because further losses were likely. They were wrong.

Stocks are not for those of us that hate risk. But we need to realize that avoiding that risk has a price. In the case of my example that price is over $7,000. Taking the risk has a price as well. If an investor lost their faith in the markets and sold at the bottom, that cost would have been just under $6,000. There are two lessons here. First, investing in stocks means that the value of your investment will fluctuate a lot and you need to be able to sleep with those swings. Second, money that you need in the near future should not be invested in stocks because of the fluctuations. It shouldn’t be invested in long term bonds for the same reason.