Why Should We Worry About Stock Bubbles?
By David Henderson
A number of commenters on my proposed bet with Bob Murphy seem to have missed the point. Rather than respond to each of them in comments that I know few people will read, I’m responding here.
Various people have argued that my proposed bet isn’t much of a bet because a 10% fall in the S&P 500 over 5 years is not exactly stellar performance. True, it’s not.
But that gets us to why we should worry about stock bubbles. When I read Bob’s original post, I thought that I would worry if the S&P 500 were to be much more than 10% lower 5 years from now. Why? Because, as I mentioned in my previous post, a substantial part of my wife’s and my net worth is in stocks. If I thought that stock prices would be, say, 25% lower 5 years from now, which is about the time I would need to start drawing on them for retirement income, that would be a big worry. If stock prices were, say, 9% lower 5 years from now, that would not be a big concern. This is not just a dry theoretical issue to me: I’m betting a substantial portion of my retirement income on the stock market.
Note also, by the way, that if the S&P 500 were 9% lower 5 years from now, I would probably have a higher real value in my stocks than I have now, even without putting any new money in. The reason: with the mutual funds that I own, the dividends are re-invested in the stocks. With dividends of only 2% per year, I would probably come out ahead.
A number of other commenters, both here and on Facebook, pointed out that the S&P 500 could easily fall by more than 10% sometime between now and 2020 and then recover. They argued that, therefore, I was proposing a “one-sided” bet. They missed the point also. Sure, the S&P 500 could fall by more than 10% between now and 2020. But that gets us back to why we–or at least I–care. I care because I’m a buy-and-hold person, investing for the long run. I don’t care much what happens in between as long as it’s close in 2020. If you’re a long-term investor, you shouldn’t either. Such a fall before 2020 would matter only to people who want to use the funds before 2020 or to people who try to be “market timers.” I NEVER try to be a market timer.
Here’s what can go wrong if you time really badly:
For instance, if an investor stayed fully invested in the S&P 500 from 1993 to 2013, they [sic] would’ve had a 9.2% annualized return.
However, if trading resulted in them missing just the ten best days during that same period, then those annualized returns would collapse to 5.4%.
Missing these days do so much damage because those missed gains aren’t able to compound during the rest of the investment holding period.
When these issues come up in my class in our 5-minute discussions, I summarize this point by saying, “I’m too dumb to be a market timer. And so, probably, are you. But I’m smart because I know I’m dumb.”
Other commenters wrote as if they think that whenever prices fall, they will automatically bounce back. That certainly didn’t happen after the 1929 crash. Sure, the Dow-Jones Index got back to its 1929 peak–in 1954.
I remember my mentor and editor at Fortune magazine, the late Dan Seligman, dealing with this issue after the DJI fell by 22.6% on black Monday, October 19, 1987. A huge percent of his 401(k) was in stocks. When I called him in the next few days to discuss one of my book reviews for him, he told me that he was retiring at the end of the month. I was surprised. He seemed to love his job and his “Keeping Up” column was one of the most popular parts of the magazine. He was only 63.
He explained why he was retiring. Under Time Inc.’s 401(k) plan, when you retired, you could cash out at the value of your portfolio at the end of the preceding month. Retiring at the end of October would, he calculated, save him from a loss of a few hundred thousand dollars. And remember that this was in 1987 dollars. He managed to negotiate to keep his column for a while, but he was not a full-time employee any more and lost a good bit of his power in the organization. I think he missed it. Of course, as we know now, stock prices recovered relatively quickly. Had he known that, he would not have retired at such an early age. But you can’t know that stocks will bounce back. If you could, you would not worry about “bubbles.”
One final point. One commenter used language that I often see used to describe a fall in stock prices. He called it a “correction.” The language is misleading. It implies that prices were above their value based on fundamentals and so the drop takes the price to its correct value. But we don’t know the correct value. Moreover, if falls in price that take stocks to their “correct” level are a “correction,” then we should also say that increases in prices of “undervalued” stocks are a “correction” also.