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If you read my message concerning the market bubble / bear market myth, you
already know HOW (in my opinion) the market has been going up and will
continue to do so. The baby boomer effect on the economy is creating
enormous amounts of real money that is flowing into the market. In
explaining the myth of irrational exuberance, I want to point out a few
important reasons WHY investors are choosing stocks over other investments,
and holding them during corrections.
The primary reason can be explained using another basic concept of
economics- opportunity cost. In terms of investing, the opportunity cost of
any investment decision is what you could have earned had you invested in
something else. Even though I would agree that most stock buyers have never
even heard of the term opportunity cost, more and more of them are catching
on to the effect this principle has on their investment returns. That is,
they are accepting the fact that more people have LOST money by being OUT of
the stock market than by being IN it.
If you had your money in a bank CD last year because you thought the
stock market was overvalued, you didn't earn 3%, you actually lost 27%
because you could have earned 30% in the stock market. I obviously realize
you can take the opportunity cost argument to extremes. Somebody could say
most stock investors lost 70% last year because they had their money in the
market as a whole and not in DELL exclusively (I'm using ballpark figures
here).
However, if you just look at the generally accepted benchmarks of investing-
the S&P 500, Treasury Bonds, cash and CD's, precious metals, etc., I
honestly
believe that the average investor is catching on to the fact that being out
of the stock market and in other investments is, over the long run, costing
them money.
Bears love to talk about the market crash of '87, but just how bad was it
really? Investors who bought stocks on Jan 1, 1997 and didn't panic and
sell, actually FINISHED UP for the year! Even the poor souls who invested
every penny they had the day before the crash got all their money back
within a couple of years, and within about four years they were well ahead
of their cash and bondholder counterparts. Was investing all their money
in the stock market the day before the crash and leaving it there really
that bad of a decision?
What the 1987 crash showed investors was that trying to time the market for
most of them is a recipe for disaster. Everyone on this list knows timing
the market can be profitable, but that simply doesn't ring true for the
average investor. Once again, they know from personal experience that
they've lost more money by being out of the market than by being in it.
Magnifying this reason to "buy and hold" are the tax implications of
selling. We all know these implications, but there's one important point to
them that is easily overlooked. The more the market goes up, the harder the
"penalty" for selling becomes to recuperate.
For example, take an investor who bought shares of Dell just a year and a
half ago at $20 per share. Suppose Dell's stock price collapses from its
current price of 107 down to 80. Because of this, the investor contemplates
selling his position, because he thinks he will get the chance to buy it
back at an even lower price. Although the drop in stock price has been
huge, this investor is still looking at a capital gain of $60 per share.
Let's just use an even number for his capital gains tax rate and assume it's
20%. This means on his $60 per-share gain, he's going to have to pay $12
per share in taxes.
If you think about it then, this means Dell would have to drop from $80 to
$68 in price before this investor could buy back his Dell position AND JUST
BREAK EVEN! It's similar to options analysis. If you buy an option with an
$80 strike price for $5, and the stock goes from 80 to 81, are you in the
black? Of course not, that stock has to go to at least 85 before you're out
of the red. When this investor knows that the long term track record is up,
does it makes sense for him to give up 20% of his profits in an attempt to
catch the bottom?
I obviously understand anything taxed on a percentage basis is all relative,
but the important thing to remember is that with every passing year that the
market goes up, a smaller and smaller percentage of investors have any stock
LOSSES to offset the gains, which therefore magnifies their importance. I
also realize a lot of stock is held in tax-free retirement funds, which
definitely offsets this effect somewhat. But I think the fact that money in
401Ks and IRAs can't be used until retirement also gives people a strong
incentive to leave it alone and to leave it fully invested with a long term
outlook. That outlook tells them stocks are the place to be.
People aren't buying and holding stocks because it's "fashionable," they're
buying and holding them because it's the rational, intelligent decision when
the long term track record of the stock market is looked at by itself, when
compared to other investments, and when the tax consequences of selling are
considered.
Bruce
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