[I'm off this week, enjoying the waning days of summer and catching up on a few things I promised to finish before September. In the meantime, please enjoy this example of that great American summer tradition, reruns. This post originally ran April 7, 2009.]
Not long after you convince yourself that buy-and-hold is the best way to invest in the stock market, you start to get doubts. Sure, owning a well diversified portfolio of stocks through thick and thin is the best way to capture the high long-term average returns that you expect, but couldn’t you do a little better? Couldn’t you sell your stocks when the market is particularly high and maybe double down when it is particularly cheap? How hard could that be?
Pretty darn hard, it turns out. Only in the clarity of hindsight are those market peaks and bottoms obvious. The towering heights that the market reached in the spring of 2000 and fall of 2007 now look like great places to exit only because we know what happened next. Yes, stocks in 2000 were by many measures more expensive than they had ever been in the past, but saying that everybody should have therefore known to sell is unfair, because stocks had been unprecedentedly expensive in each of the four or five years prior to 2000 as well.
Spotting the low points when they happen is no easier. After its disastrous September, the market was by many objective measures very cheap in the fourth quarter of last year. And then it went down a lot more.
But even if you did have a useful objective measure that would tell you when the market was too expensive or cheap, actually using it would be a lot harder than it sounds in the abstract. See that dip on the chart above in early March? That’s when the market hit its low for the year so far. It is also when I published this post, making the strong case that the market was then really cheap. Since that day the S&P is up about 25%.
Did I act on my judgment that the market was a bargain, invest big and reap a much needed profit? Are you kidding? Read the post again. I had thought it was too cheap months before, only to watch it get more cheap every week. I didn’t understand why it had gotten so low, and so had no reason to believe it wouldn’t go lower.
When I was just starting out in the professional investing world, one of the senior guys in the office took me aside and said something like “Frank, what you gotta understand about the market is that it’s really all psychology.” This guy made roughly a hundred times as much money as I did, so I nodded and smiled, all the while thinking to myself something like “what a pompous and empty platitude.” It only took me about ten years to understand the wisdom he was trying to pass on to me. It’s not just that stock prices move up and down because of the irrational behavior of other investors. It’s that making money in the market is hard because of your own irrational behavior.
It has been said that the four most dangerous words in investing are “this time is different.” When the market is very cheap it is nearly impossible to convince yourself that it is a good time to buy, even if in hindsight every other time it was that cheap it had been a great time to buy. Because when push comes to shove you are sure that this time is different. You worry that this time the world really is coming to an end, that capitalism is dead, and that your kids better start studying Chinese if they ever want to get a job. Then the market goes up, the dust settles, and you feel like an idiot.
That it is very difficult to buy at the bottom and sell at the top is not mere coincidence. You are just like everybody else, irrationally scared at the lows and foolishly confident at the highs. Widespread fear and confidence is why the market was low and high to begin with.
Which is why you should cast away your doubts about buy-and-hold.