Being known as the money nerd among my friends, I'm often tapped upon to proffer wisdom on topics like investing.
Usually, I try to give some encouraging advice like, "You're smart enough to do it on your own," but such encouragement falls flat. "I recommend owning stocks and bonds, and I prefer funds to individual assets," is equally sleep inducing, and leaves me with little more than football to discuss at playoff parties (#KeepPounding).
It seems that people want me to perform like some stock picking wizard, but I haven't been admitted to Hogwarts, so I have no wizardry credentials. Additionally, I've made plenty of investing mistakes, I'm still learning about investing, and I'm not even a billionaire, so I'm uniquely unqualified to provide hot stock tips.
However, the people have asked, so I shall deliver. Today's investing advice is that the market can stay irrational longer than you can stay solvent. Want me to unpack that? Keep on reading.
The current state of the US Stock Market
Over the course of the last few months, we've seen the value of the S&P 500 (the 500 largest companies in the US) drop precipitously (around -11%). In fact, as of the moment I captured this screen shot, the S&P 500 was down -2.16% the previous day. Ouch!
Why is that? I have no earthly idea. Sometimes, such stock market drops can be tied to some fundamental weakness in the real economy (low consumer spending, war, etc.), but in this case, I am generally bullish that the US real GDP will grow in 2016, and most macroeconomists agree.
So it's fair to say that the stock market is dropping, and very few people can give you a fundamentally sound reason as to why.
It seems to me that the stock market is behaving irrationally.
What does the state of the US markets mean to me?
I guess this means that I'm facing a prime buying opportunity, and I should buy, buy, buy. Take out a mortgage on the house to buy more and more and more.
Or maybe this is a selling opportunity. I may have missed the peak, but if I sell now, I can miss out on all the downward motion as I swim in a pile of cash, and then put it all back in when the downfall subsides.
Here's the thing about irrational markets, I can't outsmart them. I'm not about to write a book peddling the idea that it's easy to profit from irrationality. It's not easy. Whether irrational exuberance (upswings in the market) or irrational depressions (downswings in the market), it's neither easy to predict how long the irrationality will persist, nor what direction it will move your portfolio.
Basically, for me, the change in the stock market means that I may have to rebalance my portfolio sooner than expected.
What if I had a different stock market strategy?
If I had a different stock market strategy, I may engage in a little more buy/sell action in order to keep in line with my portfolio goals. If I picked individual stocks, I may be keenly aware of buying opportunites for some stocks on my watch list.
This would be a perfectly fine, and I would likely see a more profitable strategy emerge in the long run. Such a strategy certainly adds risk, but also, when executed properly could lead to higher returns in the very long run.
Still, the focus for my buying and selling wouldn't be on market irrationality, but rather on my portfolio goals, and my specific portfolio strategy. I still wouldn't try to profit from irrationality per se. Instead, I would find more opportunities to profit in the long run due to my pre-defined buying and selling strategy.
Profiting from irrationality is a losing game
Focusing on irrationality to make money is a grossly overused and misunderstood investing strategy.
Nassim Taleb, author of Antifragile, the Black Swan, and several other books (all of which I recommend) is the most recent prophet in the "profit from irrationality" train.
Taleb structures his hedge fund as fund that normally loses a little money every single day, but when the market takes a huge hit, his fund will grow disproportionately large. He does this through buying and selling options rather than stocks directly.
Because Taleb is certain only of uncertainty, he structures his fund to benefit from downside volatility, and he has made billions of dollars, so it's fair to say his strategy works both in practice and in theory.
The question I have to ask is how long Taleb could have remained solvent had he not benefitted from the terrorist attacks of 9/11/2001? Could he have lasted 5 more years? 10 more years? 30 more years?
Theoretically, he would eventually speaking make a ton of money. Practically speaking, he was just as likely to go insolvent as he was to benefit from the irrationality he spoke of.
A movie called the Big Short recently came out that highlighted a similar strategy that made several (apparently good-looking) men billionaires when they shorted the largest American financial instituitions in the months leading up the mortgage bubble collapsing. They saw the irrationality of subprime lending, and they knew it would eventually lead to a meltdown of epic proportions.
The question I have isn't about whether or not these men correctly identified irrationality. They obviously did. My question is how many others went insolvent trying the same thing?
The markets can stay irrational for much longer than an individual investor can stay solvent. For every Big Short, or Black Swan, there are hundreds or even thousands of others who bet on irrationality working out there way and losing everything.
Even sure bets go awry. Let me give you one such example:
Did you know that I can theoretically beat the lottery? Any time the jackpot exceeds $850M, I could print off all 292 Million combinations of numbers and come out with some profit after taxes. The problem with my strategy isn't that it's theoretically incorrect. The problem is that the coordination required to achieve printing that many tickets makes the practical undertaking of "beating" the lottery a non-sequiter.
In theory, there is no difference between practice and theory. In practice, there is.
Beware of your own attempts to best irrationality
The moral of this is that the markets don't behave in an expected fashion over a period long enough for most investors to attempt to best irrational markets and remain solvent.
If you take on huge leverage in real estate, and suddenly real estate prices drop by 50% and rents drop by 20%, you might be able to cash flow your underwater empire for a while, but make no mistake that your leverage can just as easily sink you. The markets may stick in "over-correct" for much longer than you can continue to feed the beast.
If you purchase options every single day for the next decade, you're much more likely to piss away a reasonable nest egg with options fees than you are to bank roll your yacht.
When you decide to begin investing (which I think you should do as soon as possible), try to go in with the mindset that you're not some hotshot investor with a tip that will allow you to beat the market. You may develop a strategy that allows you to beat the market by a little bit (as an activist board member, Warren Buffett has more than doubled market returns for decades), but if you're attempting to benefit from irrationality, you're much more likely to go broke than you are to make money. Markets can stay irrational longer than you can stay solvent, and there is little you can do about that fact.
I'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life.