Why Investing Makes Smart People Feel Stupid

Consider interest rates: From 1953 until 1981, a casual observer would assume rates would continue rising indefinitely, while from 1983 until the present, the same observer might project that interest rates would eventually fall to zero. Interest rates factor into the valuation of both housing prices and the stock market, so a good chunk of the appreciation of both investments over the last 20 years is attributable to falling rates.

10-Year Treasury Note Yield 1953-2000

Source: Federal Reserve

In fact, it is increasingly unlikely that the yield on the 10-year Treasury will again touch the low of 3.55% set in the first week of October. I'm not too worried about the stock market falling in the background of modestly rising interest rates (it's about 32% undervalued at current rates, according to calculations from First Call). However, I've shifted my clients' fixed-income investments to the short-term (least interest rate sensitive) part of the Treasury market, and I'm very leery about real estate right now, which, given 80% financing, is an investment highly leveraged to interest rates.

In planning your investment strategy, consider under what scenarios a long-term trend might change direction and whether a change in direction would benefit or harm your investments. Consider also that a solid long-term trend may have short sharp countertrends. I often use the example of the tide coming in -- successive waves may have no apparent pattern, but at the end of the afternoon the ocean is at the top of the beach. The S&P 500 exhibits a long-term growth rate of 8%-10%, but as we've seen over the past 10 years, there can be considerable deviation, positive and negative, from that trend.

S-Curves

I wrote an entire column on the S-Curve concept some years ago. In brief, a trend that looks like a hockey stick (flat to rising sharply) may often be the midpoint of a trend that is ultimately S-shaped (flat to rising sharply, but then flattening out again). Adoption of new technology (like DVD players, for example) often shows an S-curve growth pattern. Investors often assume that the hockey stick part of the curve will continue to eternity, and jump on a trend just as it starts to peter out. Remember when investors were hot for Y2K stocks in the mid-'90s? I always asked, "What happens to these companies on Y2K+1?"

Running With the Herd

It's easy to buy what everyone else is buying, and it's very uncomfortable to be selling what everyone else wants. One of the most succinct statements of contrarian investing I have ever read was contained in the Berkshire Hathaway 2000 Annual Report: "I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement." Can you imagine bragging at a cocktail party in 1999 about your Old Economy stocks? Warren Buffett can, and that's why he's a billionaire.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. Edwards was a contributor to Harry Domash's Fire Your Stock Analyst: Analyzing Stocks On Your Own available at Amazon. At the time of publication, his firm held no positions in any companies named in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.