Irrational Discouragement

In a 1996 speech, Alan Greenspan, then chairman of  the Federal Reserve, used the idea “Irrational Exuberance” to describe the dot.com bubble.  He was right about the exuberance and as it turned out, largely right about the irrational part, too.

Nearly 20 years later we have a situation developing where the term may again be reasonable.  Royal Bank of Scotland economists offered this cheery advice to their clients.

“Sell everything except high quality bonds. This is about return of capital, not return on capital. In a crowded hall, exit doors are small.”

In my view this part of the advice that says, “Panic is not a great idea, but when you must panic, panic first.”  The question is about whether you “must panic.”

The bank estimates that equities could fall 20% this year.  The bank could be right, but it is important to notice several things about what that means.

  1. It is an index idea.  Not all securities will fall 20%.  Some will go up.
  2. It is a two decision strategy.  Selling is one end, but when do you repurchase?  It is hard to know when the low is happening.
  3. A strong business is pretty much the same business at $40 per share as it was at $50.  (down 20%) Recall that the market sets prices for securities, it has little to do with businesses in the short run.
  4. Price setting mechanisms are emotionally driven.  Daily market results display strong kurtosis.  The results are a little like a bell curve but taller and thinner and with bumps on the left and right side. (Heavy tails) Right side (high returns) indicate greed, while left side (losses) indicate fear.  Emotional price setting makes mistakes.

The RBS ideas, while possibly correct, indicate “Irrational discouragement”  If we can jump out 25 years and look at the results curve for major indexes, a 20% drop in 2016 will be nearly invisible.  Go look for 1987 when the market dropped more than 20% in one day.  There was cursing and gnashing of teeth then, too. Even 2008 and 2009 seem to be minor adjustments when viewed in a 100 year chart.

See MacroTrends here

dow-jones-100-year-historical-chart-2016-01-13-macrotrends

People have trouble assessing the meaning and addressing what to do when faced with commentary like that from RBS.  The result – Fear!  That is largely their own fault.  If they have a reasonable long term view of their investment plan, fluctuations are just noise.  If their time frame is too short, they have fear and fear is a poor counselor.

I think disposing of securities of not so sound businesses may be prudent.  The idea would be to hold more cash to use in the inevitable buying opportunity to follow.  To be successful there, you will need to know two things:

  1. How to value businesses
  2. How the market prices securities.

If you knew those two things now, you would be feeling less trepidation about current events.  Learn more or hire someone to help you.

Thanks to Sipho Nzimande in Johannesburg for the idea.

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Contact: don@moneyfyi.com 

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