Dr. Shiller explains in his book Irrational Exuberance that it is completely rational for inexperienced public investors to behave in the stock market like tulip bulb or postal reply coupon investors. He explains that such people are attracted into a rising stock market or single stock if they have heard of windfall profits of inexperienced family, friends, acquaintances or even media ac- counts of the sort. The inexperienced public investor rationalizes that if another inexperienced public investor has made money in a specific stock, if they buy the stock at today’s prices, it will probably be worth more tomorrow.
Beware of Tops and Bottoms
Shiller explains that this is very rational in the middle of an extended bull move in a single stock, but is very dangerous at the top when insiders have sold out and no smart money is left to support the market. When the bull market collapses like a house of cards, the public sells in panic and dramatic stock price crashes occur — the 1929 to 1933 and 2000 to 2003 crashes are two examples.
The Wall Street hype machine works hard to pull inexperienced investors out of the public into the market as the stock market comes to a boil and insiders bail out, leaving the public holding the bag. Maggie Mahar, a Yale English professor and first-rate financial journalist, describes what happens to the trustingly unwary at the top of a bull market in her book Bull!:
While [corporate executive] insiders bailed out, most small investors did not sell. They did what they were told [by Wall Street], “buy and hold,” doubling their bets all the way up. The higher the most aggressive growth [mutual] funds rose, the greater their allure. In 1999 [inexperienced] investors wagered twice as much on these funds as they had in 1996 and 1997 put together. Even after the NASDAQ began its long slide, investors continued to chase the last best thing — at the end of 2000 [inexperienced] individuals were investing in aggressive growth funds at more that twice the rate as they had in 1999.
Those With the Least Lose the Most
As always, when a bull market ends, those who could afford it least lost the most. In Massachusetts, Sharon Cassidy, a divorced college professor who had single-handedly put her four children through college, began to step up saving for her own retirement in 1990. By then she was 52, and earning roughly $42,000 a year. Listening to the financial advisors who visited her college, she stashed most of her money in broad-based equity funds, and, by the end of 1998, she had managed to accumulate over $350,000. At that point, she felt she was in sight of her goal: retirement in four years, at age 62, with $500,000.
When the market skidded, she held on. “I felt I had no other choice,” said Cassidy. Then the bear showed his claws. By the end of 2001, at age 63, she was forced to rethink her life plan. “If I work until I’m 70, I can retire with $400,000” she said. I’m lucky – I like my work, and $400,000 is a lot more than most people have. But I’m angry, angry at myself and angry at the people who advised me.”
My advice to you is not to let yourself be misled by Wall Street. Learn to buy when inexperienced public investors like professor Cassidy are discouraged, and you won’t have to suffer through what she has. Learn to sell when people like professor Cassidy are counting their eggs before they hatch!
– Doc Brown
BIO: Doc Brown is a national expert on the stock market. His courses “How to Make a Million Dollar Portfolio from Scratch” at the Oxford Club is a national bestseller. Dr. Brown’s research appears in some of the most prestigious academic journals in the field of finance. See Journal of Financial Research and Financial Management. Scott is an associate professor of finance in the Graduate School of Business at the University of Puerto Rico.
TIP: One of the great advantages of Exchange Traded Funds (ETFs) is that you can buy ETF put stock options to hedge against any un- expected general breaks in the stock market that might cause a loss in your stock portfolio.
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