Resist Fear and Greed By Investing for All Seasons

— -- The current bull market has persisted for about six years now. This is a tale of two types of investors and their behavior in this kind of market.

One is limited by fear and the other is at risk from greed – the two nemeses of successful investing. Both types of investors make mistakes that severely limit their wealth accumulation by limiting their compounded returns.

During bull stock markets, it’s not unusual for some clients to tell me they’re afraid of investing more money in the stock market at prices that they believe are at an all-time high. Those who had this concern two years ago have since watched the market post many subsequent all-time highs.

Then there are the investors who have the opposite problem. During the bull market, they chase returns by putting everything they have into pricey stocks without regard to risk, acting as though the market will never decline. Surprised when bull markets turn bearish, they overreact by selling at low prices.

The folly of both groups lies in their denial of the reality that eventually, everything will go down. That’s right: All types of investments will eventually decline significantly in value — and eventually rise again. History shows that this has always happened, and it will continue to happen with the same certainty that the swallows will return to San Juan Capistrano.

Hyman Minsky, an economist and professor at Washington University, did research that shed light on economic factors indicating why. In his 1976 paper titled “A Theory of Systemic Fragility,” Minsky demonstrated how a stable economy always leads to optimism, to the point where people take more risks, which leads to instability because “success breeds a disregard for the possibility of failure.” He showed how “the absence of serious financial difficulties over a substantial period” results in a “euphoric economy” — where risk-taking gets out of hand.

Caught up in this optimism, banks lend to borrowers who aren’t likely to repay the loans. This and other factors transform a healthy economy into a debt-ridden one, resulting in over-leveraged investment markets that eventually seek equilibrium, bringing on the bear. Thus, Minsky showed the world that in the American economy, health invariably sows the seeds of sickness that is often accompanied by the decline of investment markets. This is in our nature because ours is a culture of excess and consequent austerity, of boom followed by bust.

Minsky’s use of the word “euphoric” preceded economist Robert Shiller’s use of a similar phrase for the title of his book about the 1990s bull market. The title, “Irrational Exuberance,” refers to the wildly inflated values of dot-com stocks in the tech bubble of that market. Irrationally exuberant investors took a big hit when this bubble burst in 2000. The irrationally exuberant have something in common with those who let fear of an inevitable decline prevent them from taking advantage of a bull market: They mistakenly believe that they need to be doing different things with their portfolios when the market is up or down.