Cognitive Investing

Many individual investors panicked during the 2008 market meltdown and have maintained a siege mentality ever since.  Reasons to be afraid are abundant: European crises, debt monsters, and a dysfunctional Congress are just a few of the more obvious ones.  But the stock market has seemingly ignored these negatives and has erratically rallied for four years and is now at more than twice the value of its low point during the crash.

These nervous investors who have watched from the sidelines are now asking whether they should get back into the stock market.  It seems safer than it has been in a while, because memories of the crash are slowly fading with each passing month.  They are watching others who either did not sell during the plunge, or those who bought stocks since the crash profit rather handsomely.  On the one hand, they don’t want to miss out if we are truly in a new bull market.  On the other hand, they are afraid that they missed the boat and another market crash is imminent.  So they are asking, is it time to get back in the market?

There are numerous ways to answer this question.  I will expound on several of them.

The correct time to get back in was four years ago.  This is a pretty safe statement that I can say with confidence, since hindsight is 20/20.  The problem is that foresight is blind, so no one really knows how the future will unfold.  There are many opinions, of course, and if you care to research what various pundits and forecasters have to say, you will find that there is a wide variety of opinions, ranging from “now is a great time to buy” all the way to “now is a horrible time to buy.”  I would venture a guess to say that if you were able to sample all investors, the opinions would be pretty balanced. After all, that is what prices indicate: that the pressures to buy and sell are roughly equal with prices at current levels.  If pressures to buy and sell are unequal, then prices adjust to restore this balance.

Approaching the problem by asking the opinions of others and expecting to arrive at a firm conclusion is an exercise in futility.  You will never know with total confidence and even if you did know, in several months, you would be faced with a similar issue of whether you should get in, stay in, or get out, depending on what you did before.  To resolve this dilemma, you must change your approach, understanding the inherent uncertainty of the landscape.  Trying to solve the unsolvable is not the key to success.

The problem with this mental approach is that it oversimplifies the investor’s choice to a single yes/no question.  As Chip and Dan Heath discuss in their forthcoming book, Decisive: How to Make Better Choices in Life and Work, when faced with a dilemma posed as a single yes/no question, it frequently helps to widen your options.  Instead of a single question of whether to get in or not, I would expand this list by adding a few related questions.

1. What are the consequences of staying in the whole time?
2. What are the consequences of staying out the whole time?
3. How likely is it that anyone can choose entry and exit points that will be better than either of the first two options?
4. Is the stock market something to “get in and out of?

These questions are easier to answer.  The consequences of staying in the whole time are that stock market investors will experience a wild ride of ups and downs.  Over long periods of time, the ups have usually outnumbered the downs.  The investor who remains out of the market the whole time will not suffer any losses along the way, but he also won’t participate in any of the gains.  So the investor who remains in the market the whole time is most likely going to outperform the investor who stays out the whole time, when measured over longer, multi-year time periods, if history is any guide.  There will certainly be shorter periods when the staying-out investor will do better, but investing should be thought of as a marathon, not a series of sprints.

The answer to whether anyone can accurately choose optimum times to jump in and get out has been well tested over many years.  Virtually no one has figured out how to do this, even though some claim to be able to.  If anyone really know a method of doing this with great accuracy, I can guarantee that they will not be selling you this information at $12.95 per month (if you sign up today).

So the answer to question four is that the stock market is not something to get in and out of.  It is a way to accumulate wealth over long periods of time.  The benefits accrue to the patient and those who have the fortitude to power through the inevitable downturns without panicking.

Another way to answer the original question by widening the available options is to frame the question as a dial instead of a switch.  A switch has two positions: on and off.  A dial spans a spectrum from fully off to fully on and has many intermediate values that frequently work better than either extreme.  So instead of trying to ascertain whether now is the time to get back in, one could ask, “what percentage of my available funds should be invested in the stock market?”  Considering options like investing 25% or 50% or 75% would temper the effects of making an all-or-nothing decision that could turn out poorly.  A very nervous investor could invest 10% of her available funds and at least have a small exposure to the market if the rally continues.  A bold investor could invest 90% of his funds and still retain a small portion of available cash for further investment at lower prices if his timing turns out to be poor.

Because the stock market can be extremely volatile at times and enduring the downturns can be trying, tempering these effects by investing only a portion of one’s funds can reduce the temptation to panic during the worst of the downturns and sell at what might later turn out to be the most inopportune time. So for many investors the answer is: yes, it is time to get back into the market if you aren’t invested, but you should only invest up to your own comfort level.

The more important lesson is that when faced with a yes/no question, think again to see if more options are available.  The best answer might be something besides absolutely yes or absolutely no.