It is early April, and the Australian stock market is about 14% higher than recent lows experienced less than two weeks ago. In my first address, I discussed the importance of holding cash reserves, maintaining your investment time horizon, and investing for a range of outcomes. Below I expand on this last point.
There is a concept in psychology called cognitive dissonance, it is the idea that we feel very uncomfortable holding two opposing beliefs, much like George Orwell’s idea of ‘doublethink’ espoused in his dystopian novel, 1984.
Avoiding cognitive dissonance may be one reason why investors change their views regularly, especially when uncertain. It is very difficult to maintain two different views at once, so we change all the time. Wishing to sell one day, perhaps due to a scary headline, or to buy into the market the next day because the market is rising on some positive news, and then repeat.
We are simply wired to think in a binary fashion, we experience night or day, fight or flight, I love my in-laws, I less than love my in-laws (just kidding of course). Our state of mind fluctuates within hours, days or weeks. Thinking in such a binary fashion may work for day traders, buying and selling out of their positions each day and it worked for us in a dangerous world of the past, where we are either feeling safe or feeling in danger, feeling hungry or satiated. Investing however requires something that does not come naturally, we need to entertain almost two different outcomes at the same time, thus an exercise in ‘doublethink’!
Investors who see themselves as business owners, long term holders of assets, looking to keep taxes and transaction fees low, simply cannot chop and change all the time without harming their portfolio. The great investors think in grey, they remind themselves each day that the future is unknown, so position themselves for a range of outcomes.
The S&P 500 is currently trading at around 18.8 times trailing earnings of 133, or around 2500 points. Earnings may fall by half over the next year or two (a very low estimate), let’s say from 133 to 70, but will the market “see-through” the trough and apply a high multiple of say 40 to these earnings (40 x 70) = 2800 and therefore rise through the crisis?
Perhaps the multiple of earnings will contract to 15 times 70, meaning the S&P reaches 1050 points for a brief period, therefore it crashes from here. What if earnings recover quickly, does the market direction over next year even matter if you think long term?
Ultimately, if you believe in 10 years the market will earn 40% more than last years’ 133, and we assume the market trades on a PE multiple of 20 times (20 x 186 earnings), the US market could be at over 3700 points in a decade, resulting in a 5% return per annum, versus around 1% on cash! This is not a prediction, but one of the outcomes we could entertain simultaneously with other possible outcomes, some better some much worse.
Which outlook yields the least regret? If I am 100% in cash, interest rates fall toward zero, and markets eventually boom, how will I feel with a negative return after inflation? Will I meet my investment goals? Likewise, if I am 100% in shares and the market falls another 40% from current levels, how will I feel if I have no additional funds to invest? Clearly the answer is to invest somewhere in between these two extremes.
A trusted financial adviser can assist you in finding the right balance so that you can entertain the idea of a market crash and market boom at the same time. Yes, it’s a form of ‘doublethink’, however, we do practice it all the time. Don’t believe me? “Well-mannered people are not liars, and they are certainly never rude.”
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