The Stock Market Fantasy Some Investors Just Can't Seem to Shake
In medieval Europe, fortune telling was big business. Those who claimed psychic ability would often peer into molten wax to divine the future. That changed when Dutch traders introduced the continent to the wonders of tea, and the practice of "reading the tea leaves was born."
Fortune tellers would gaze into the intricate leaf patterns. A heart shaped pattern might mean a marriage. A house shape could mean success. For many people, it was no less valid than science.
These days, we more properly regard the practice as a harmless, pseudo-scientific diversion. Yet many of us still employ the same approach when it comes to our investments.
You don't have to be Warren Buffett to recognize causes for concern in today's market. Stock valuations are soaring. The U.S. economy is delivering mixed results. An interest rate hike could hinder short-term performance. Our bull market has reached historic length. How much longer can it run?
It raises the eternal question: Why not pull out now and let the market take its lumps? Then simply jump back in and ride that escalator to the top?
It seems so easy. It appears to make perfect sense, logically. Yet it's one of the most enduring fantasies that many investors can't seem to shake.
Many times to their own detriment.
What's wrong with this strategy?
Nothing -- if you can actually pull it off. Yet investors would be wise to tread very carefully. Will you be able to predict when stocks finally plummet? Congratulations! Yet you're only one-third of the way home. Now you'll need to predict when the market will bottom out. After that, you'll need to accurately predict when the recovery begins. You'll have to negotiate your way through every false alarm, false bottom, mini-rally and pseudo-recovery along the way.
Your odds of doing this successfully? Exceptionally low. Yet it doesn't seem like it should be so hard, right? That because we can easily identify peaks and valleys in hindsight. Predicting them, however, is largely a fantasy. You might as well be reading tea leaves.
Remember when the dot com bubble drove the stock market to stratospheric heights in the 1990s? Things were so overheated that gnomic Fed Chairman Alan Greenspan felt compelled to issue his famous warning about "irrational exuberance."
That phrase sent a chill down investors' spines. Worries about a bubble were already present. Now the world's foremost sage had verbalized everyone's worst fears.
The markets reacted immediately. The Tokyo market, still open at the time of the speech, tumbled three-percent. The long-awaited bubble had burst.
Yet it hadn't, actually. The crash wouldn't really start in earnest for several more years. Any investor who jumped out early paid the price.
This tells us two important things. First, timing the market based on prevailing conditions is a fool's errand. Second, despite the troubling market signs mentioned above, we might be still years away from a correction. There's no way to know. If you get out now, the cost could be substantial.
It's also critical to remember that markets don't move straight up and down. They fluctuate. The idea that an investor can jump in and out at the appropriate time is just a fantasy.
Plan for action
Forget about sitting on the sidelines for a ripe opportunity. Instead, consider this far more realistic prescription for success.
- Create a portfolio that properly manages your appetite for risk.
- If you're convinced a correction is looming, let your allocation reflect your concern.
- Invest in low-cost index funds and other smart plays.
- Get out of your own way. Statistics have shown investors do better with a more passive, long-term approach.
- Realize that earnings and fundamentals will become more important as the market slows down.
- Stick primarily with the U.S. stock market. Mixed results aside this year, it's still the strongest economy around.
- Consider high-quality bonds as a hedge against a market drop.
Forget about reading the tea leaves or timing the market. Stick with what has always worked, and your portfolio will look much better.