Market Mania: The Wild Ride Continues!

Still afraid to peek at your 401(k) balances? Still shell-shocked from the Dow’s plummet from 14,000 in October 2007 to 6,500 in March 2009?

Well, it may not be time to pop the champagne bottles just yet, but you can open your eyes now. This week, the Dow closed above 9,000. There are still plenty of losses to recoup, but for wounded investors everywhere, it’s indeed a sizable recovery.

The Return of Buy and Hold

But what does this mean to you? Are you ready to plunge your life savings back into the stock market? Ready to rejoin the wild ride?

Interestingly, many financial advisors believe that you never should have cashed out at all. John Bogle, the founder and retired CEO of Vanguard Group, continues to believe that long term investors should purchase broadly diversified, low cost, passively managed, index based mutual funds and simply hold them through the peaks and valleys of market movements.  And many investors apparently agree with him, considering that Vanguard (along with American Century Funds & Fidelity Investments) consistently ranks in the top three mutual fund companies in America based on assets under management.

The problem with buy and hold strategies, of course, is that it’s mighty difficult to simply sit back and watch half of our life savings vanish as the Dow collapses from 14,000 to 6,500 in a mere 17 months. After a collapse of that size, we might need to hold onto our investments for an extremely long time to recoup our losses. The Dow, for instance, didn’t return to its Roaring ’20s pre-Depression high until the early 1950s; that’s more than two decades of losses! And today, the Dow is still 10% below the 10,000 level that it first achieved over a decade ago.

The Logic of Momentum Investing

Momentum investors take a fundamentally different approach to their craft. They believe that investors should buy stocks that are rising in the hope that they will continue to do so. Even if their stocks only continue their ascent a little while longer, momentum investors still hope to “ride the rise” and cash out on top.

Can momentum investors also “ride a fall” and make money on stocks that are dropping? Of course they can! They use a technique called short selling, which requires them to agree to sell a stock for today’s price at some future date. They don’t even need to own the stock today, as long as they agree to borrow or buy it in time to sell it at the agreed upon date. So, if a stock is selling for $10 today and an investor agrees to sell it for $10 next week, he could earn a 25% return in one day if the stock’s market value drops to $8 next week. He could simply buy it for $8 in the market that morning and meet his obligation to sell it for $10 that afternoon!

But why would any purchaser lock into a private transaction price of $10 if the market price will only be $8 at the time of purchase? It’s because the purchaser, in this situation, is convinced that the market price will increase over that week. And if the purchaser is correct – if, for instance, the stock is actually selling for $12 instead of $8 at the transaction date – the momentum investor has no choice but to buy it for $12 that morning and sell it for $10 that afternoon, incurring an onerous 17% loss in a day. Conversely, the purchaser can buy it for $10 that afternoon and “flip” it by selling it for $12 immediately thereafter, earning a tidy 20% return in one hour!

In this case, both buyers and sellers in short sales transactions are momentum investors; they simply disagree on the direction that the market is about to follow. One believes that the market is about to rise, and the other believes that it is about to fall, so they both try their best to take advantage of what they consider to be the other’s mistaken belief.

Economists vs. Psychologists: Whom to Follow?

So who’s correct? Whom should you follow? The buy and holders or the momentum investors?

In a sense, the way you answer that question depends on the academic field you respect more: economics vs. psychology. Economists tend to be buy and holders, while psychologists tend to be momentum investors.

That’s because economists tend to believe that humans are rational creatures, and that market fluctuations are merely temporary blips. They believe that stock prices generally reflect the underlying value of the companies that they represent, and as long as the majority of companies in the broad economy grow over time, their values will grow as well.

On the other hand, psychologists tend to believe that humans are full of emotional biases, and that irrational market fluctuations can last for very long periods of time. They believe that stock prices can be driven far from their underlying values during economic bubbles or depressions, and that such manic movements are likely to continue occurring throughout human history.

Is there a compromise position between rational economists who believe in efficient markets, and social psychologists who believe otherwise? Yes, there is! It’s occupied by a pair of fields called behavioral economics and behavioral finance … but that’s a topic for another day.