A Brief Primer on the Markets

[billroper]

Well, the Dow Jones has just dropped 10% across the last two days following the election. I heard the financial reporter on WBBM-AM this morning saying that it was because people thought that Obama would not be in office soon enough to implement his economic plan. Now, that's fascinating logic. I could equally easily say that it's because the markets recognize that Obama will soon be in office to implement his economic plan which has included things like raising the capital gains tax rate in the interest of fairness, regardless of its impact on government revenues. (That may or may not be part of his economic plan now, as these things are subject to change.)

But that would be equally specious reasoning. In the short run, it's not necessarily easy to figure out why the market is doing a particular thing, only that it is doing it and that it reflects some belief that the value of the shares traded is either higher or lower than it was before. And you need to recognize that there is a buyer and a seller in each of these transactions, so for everyone who is deciding to sell a share at a given price, there's someone else who is willing to buy it.

I used to work with a fellow named Gregg Jarrell, who had been the chief economist at the SEC. He was, in a masterpiece of timing, scheduled to give a speech the day after Black Monday back in 1987 when the stock market shed about 22% of its value in one day.

Gregg stepped to the podium and said two words: "Efficient markets."

He brought down the house.

See, here's the thing you need to remember. The markets set prices efficiently in the long run. From day to day, they're as subject to irrational behavior as, well, any one of us are as individuals. They're also subject to short run manipulation. You may have missed the story the other day where Volkswagen was briefly the largest company in the world by market capitalization. It turns out that a lot of people had shorted the stock figuring "It's an automaker. They're going down." They then got squeezed by a run up in the underlying stock and lost their shirts, because they had to be able to get shares in order to get the heck out of their short positions.

It turns out that Porsche managed to get control of enough of VW's shares that there were twice as many shares shorted as were actually available in the market. Oops. Poor short sellers.

It's not enough to be right. You've got to have enough cash to ride out those periods in the market when everyone else is convinced that you're wrong.

Take, for another example, oil prices. I frequently said that I thought that oil was unsustainably high and that I thought the natural price was somewhere around $70 a barrel. Now, admittedly we've had some really lousy economic news that's helped drive the price down, but look at where we're hanging right now. $60.77 a barrel. Down from $147 a barrel. Boy, I could have made a fortune.

If I'd only known when I was going to be right. We were never really that short on oil, but we were certainly getting squeezed. We're not that long on oil right now either, but the squeeze is done. For now.

Sure, I could have made a bet in the commodities market that oil was going down at any time. But could I make a bet that was timed correctly? Not without getting lucky.

Trying to time the market is a good way to lose money. If you sell stocks when the market is going down, you might miss the bottom of the market, which would be good. You also might miss the recovery. This is why, should you have a stack of money to invest (Right now? Have a stack of money? What'd you do, win the lottery?), the best thing to do is to invest some of it now, and some of it six months from now, and some more of it a year from now, and so on. You might miss some gains going up, but you're also unlikely to put all of it in at the top of the market, which would suck a whole lot.

In the long run, the best place to put money is into equities. This assumes that you're investing for the long run, because -- in the short run! -- you can lose a lot of money. But if you have the time to wait it out, you'll on average be better off by buying stocks than by keeping your money in the bank.

This is why investment planners tell you to reduce the amount of equities in your retirement accounts as you approach retirement age. If you're going to need the money soon, equities are not a safe place to be. You want the money in something more stable.

The risk of an investment is related (in at least one dimension) to how much the return on that investment tends to fluctuate in the short run. If you're willing to absorb more risk, you can get a higher long run return.

You just have to be sure that you can survive until the long run arrives. Because, to quote Keynes, "In the long run, we are all dead."

So if you have the chance to do so, keep putting money away in your retirement plan. And if you've got a good bit of time until you retire, put it in equities.

That's what I'm still doing. And it's what I've done with Katie and Julie's college funds.

That's my money going where my mouth is.

Comments

[stevemb.livejournal.com]

"I heard the financial reporter on WBBM-AM this morning saying that it was because people thought that Obama would not be in office soon enough to implement his economic plan."

A financial reporter who doesn't understand that markets don't suddenly react to long-anticipated events is like a sports reporter who doesn't remember how many strikes it takes to put a batter out. Sheesh.

[jdonat.livejournal.com]

My 401k has lost a bunch in the last quarter.. I'm not retiring soon, so it's just a blip.
Until you need it, it really doesn't matter that much. I'm increasing my percentage into my 401k and Fujitsu is also increasing their match. Rare, in these times.

As far as the capital gains tax goes -from 15% to 20 isn't bad... and I don't know about you, but I don't 'have' any capital gains right now. ;)

[drsulak.livejournal.com]

I suspect if you didn't know there was an election, you would be unable to tell anything about the election or who got elected. For a reporter to claim it's because someone was elected is dopey. The market is going to vacillate until folks are convinced a majority of the economic surprises are over.

And yes, keep investing for long term. The market is low now. That being said, nothing prevents it from going lower in the short or medium term. Or staying essentially flat for a couple years.

Me, I'm keeping my 401K contributions steady...

[mia-mcdavid.livejournal.com]

I realized with a start somewhere around the second week of the market collapse that our house must be highly unusual since we had neither discussed nor even considered selling our stocks. We're both ex-bankers.....

[wick-deer.livejournal.com]

I think that, when all the dust settles, one of the lessons from the market meltdown will be that the system as a whole had way too much leverage. People had gotten so wound up with "sophisticated" transactions, that they forgot the basics like assessing risk and being adequately capitalized for the risks that were being taken.

[madfilkentist]

Commentators can always explain something after the fact. Give them an event which is totally contrary to what actually happened, and they'll come up with a logical explanation of why it had to happen.

[singingpatient.livejournal.com]

it's been amusing watching analysts trying to explain the wild swings of late. some days, there are just no reasons for big drops- or big gains. In a time of extreme volatility, it's like trying to explain the every move of someone who's bipolar.

[patoadam]

I'm concerned about the possibility of a long, L-shaped recovery. I went to cash in my IRA and 401(k) in July and August, 2007. See Sequoia Capital's opinion.

For those who haven't sold yet, is it too late? I don't know.

[weirdsister.livejournal.com]

There has been talk amongst liberals in Congress about nationalizing 401ks. Have you heard anything about this, and what is your opinion?

[rmeidaking.livejournal.com]

Right now, the vast majority of investors are just standing pat, and so there's quite a bit of volatility, but not much volume. People selling right now are either trying to lock in a "loss" position for the year, or they desperately need the money.

As Warren Buffet keeps pointing out, this is a good time to buy the quality stocks. The trick is in figuring out which ones *are* the quality stocks... Shearson Lehmann Bros. would have been recommended a year ago, after all.

[daddy-guido.livejournal.com]

This brings to mind an interesting conversation I had a while ago. I was looking at a "play" account that i have - a sepIRA with a few thousand bucks in it. I use it to play crazy hunches, such that if I lose the whole fund, it doesn't really affect my life, because it's not worth pulling the money out with penalties and all, and it lets me do crazy market shit on a small scale.

Anyway, I tend to buy stocks that meet 2 criteria - 1. undervalued (IMHO) and 2. pay dividends like clockwork.

When looking at the numbers on the screen, and of course there was this huge line declining to the right. A co-worker wandered by and said "wow, you lost a lot of money"
"no, i haven't" i said. "but the line, and the numbers in red, etc" sputtered the co-worker.

"but I haven't lost anything IN REALITY" I said.
I then explained that although the market price on the shares I own are lower than when i bought them, i had no plans to sell them today, or anytime in the near future. This is because although the stock price is lower, the dividends being paid are roughly the same for most of the stocks. I then pointed out that by using the funds generated by the dividens, i could buy MORE shares of the stocks at these depressed levels, thus generating MORE dividends, and that eventually, left long enough, the shares would generate enough dividend income to pay for themselves.

Thus eventually, free shares of stock that continue to provide income, all in an account that doesn't tax me until/unless i sell the shares and withdraw the cash. Which cannot happen for at least 25 years. In point of fact, some of these shares are currently paying dividends generating as much as a 50% return at their current price, which means shares bought TODAY, assuming continuing dividends at the same rate, WILL PAY FOR THEMSELVES IN TWO FREAKIN YEARS.

The co-worker walked away muttering about crazy financial schemes. But for those of us who have a lot of time before retirement, and trhe means to do any kind of investing in tax deferred accounts.... this may someday look like the Golden Years in retrospect.

[(Anonymous)]

Perhaps it's time to give Social Security myths a rest, since the myth-makers are leaving office shortly. The notion that Social Security is headed for a "demographic meltdown" ignores the fact that the 1981 changes were put in place precisely because of Baby Boom demographics. What has happened since is that the gains from increased productivity have been distributed very unevenly through the economy. The median wage, after inflation, has stagnated.

There is no practical reason Social Security cannot be returned to long-term balance. Four years ago, the actuaries at SSA were busy vetting a number of plans from Congressmen and Senators. Several would work with roughly equal amounts of pain. One would have been to double the income cap on paying into the Trust Fund, skip the cost of living increase one year, then skip the annual increase again once in the next five years. The shortage seems to be in political will.

How the Trust Fund works is not mysterious. Saying its investment in Treasury bills "has long since been spent" is just stating the obvious. The entire national debt has long since been spent. So has the bond revenue for every highway and school building in sight. That does not make the holders of T-bills or municipal bonds think their investments are imaginary.

The notion that the money won't be repaid to SSA for disbursement assumes the United States will renege on its debt. Should that happen, there would be worse things to worry about.

The mechanism for investment of the Trust Fund is simple. SSA invests in Treasury securities that are almost the same as T-bills. The chief difference is that the securities held by the Trust Fund are never traded on the open market. Given the national debt is a certain size, the Treasury can either auction off T-bills, and pay interest to the market, or sell the special securities to the Trust Fund, and pay about the same amount of interest.

If Roper and the people born on the same date are paying in $1 million to Social Security, the Trust Fund buys that much more in Treasury securities this month, and the Treasury sells that much less in T-bills on the open market. Conversely, when Roper and those who share his birthday are due $1 million in benefits this month, the Trust Fund cashes in that amount of securities, and the Treasury sells that much more on the open market. The size of the national debt and the size of payments for debt service stay the same.

Someone could take the extreme position that all money these days is imaginary. Ron Paul and the gold bugs have gotten a lot of mileage out of that. Really, though, what is money but a shared, consensual hallucination? Should we not be putting our efforts into maintaining the illusion?