I had an entirely different column in mind for today. But the events of last week were so peculiar, and so revealing of another classic investor foible, that I shifted gears.
This will be one of the few Apprenticed Investor columns written in response to current events. I'm doing so because I feel it's necessary to address last week's topsy-turvy market action. More specifically, the investor reaction to it.
A brief background: In my day job, I advise institutional investors on the state of the markets. When risk, according to my metrics, has risen unacceptably relative to reward, I become cautious. When the reverse happens, I get more aggressive. This has been my style for some time, and it works for me. Once I explain the process, I'll lay out the mistakes the public makes in reaction to these market calls.
'Are You a Bull or a Bear?'
I've heard this question countless times the past few weeks. And I find it a stunning rejection of Darwinian logic that proponents of such blather have managed to evade extinction. Investors simply never get asked a more distracting and pointless question. Effective investors find their style, then read the market and adapt accordingly.
Of course, in discussions about Wall Street, the bull and bear are mesmerizing. How often do we hear a newscaster somberly intoning: "The bears got gored by the bulls on Wall Street today..." The very next day, we hear the same talking head reverse course: "On Wall Street, the bears came out of their caves to chase the bulls, as the Dow dropped..."
The markets we saw last Wednesday and Thursday are textbook examples of why the colorful imagery of the bulls and bears is magnetically attractive to copywriters and repellent to good investing.
Why is this such a problem? Because of the "folly of forecasting": Once people commit to a position, there is an unfortunate tendency to root for that perspective. Even worse, people stick with their forecast, regardless of what is actually happening in the market. We addressed this in the very first Apprenticed Investor,
Expect to be Wrong. But instead of preparing, people dig their heels in and cost themselves money by being more concerned with trying to be right rather than making money.
Surely, there are cheaper places to look for validation than the stock market.
Bull and Bear, a Matched Pair
In a firm I worked at during the bubble years, many of the brokers had bulls on their desks, but no bears. I used to take away their bulls, and refuse to return them unless they promised to display the bear also. I did this to prove a point: There are two sides to every market.
If you ever meet a money manager/broker/financial adviser who only has bulls displayed, run -- don't walk -- to the nearest exit. Why? Because it reveals a fundamental lack of market understanding: Markets go up and down; the bull and the bear each have their day.
And that's why the bull or bear question is inane. Stockholders should be watching market signals, economic issues and corporate earnings, with an eye toward adjusting their risk profile and investing outlook. Why? Because just like markets, risk goes up and down also. But once an investor commits to the bull/bear question, it leads to the unfortunate tendency to cheerlead for their last call rather than focusing on protecting capital. This very quickly can become an expensive hobby.
Red or Green: A Case Study
Here's a hypothetical example: Let's say you have a few errands to run that will require your driving a car. Before you turn the key, decide the following: Are you a "red" or a "green?"
You have to be something, so pick one before you leave the garage.
Now, apply that choice at every signal you hit on your errand. If you're a red, come to a dead stop at every signal. If you are a green, just drive through the next red light. When the cop asks why, just tell him it's because you are a "green." (Good luck in court).
Clearly, this is absurd. Rational people observe the color of the light, and step on the brake or accelerator as appropriate. Yet when it comes to the markets, many otherwise rational people do just this. They have predetermined their intentions and invested their dollars -- regardless of the many signals the broader market gives. One need look no further than recent history to see that ignoring market signals is a recipe for disaster.
Let's say you are a bull, and the
is tightening, corporate earnings are sputtering, the yield curve is inverting. Do you drive straight through the red light, going aggressively long the
? Or do you notice the signal?
Now imagine you're a bear and sentiment is at an extreme negative, year-over-year
earnings have gone from bad to so-so, and the Fed is cutting rates. Do you stop at the light, shorting the
, even though it's bright green?
Savvy investors get long or short (or move to cash), as conditions dictate. When all the signals line up in the market's favor (regardless of style (valuations, sentiment, monetary policy, etc.), the smart investor gets long. When the indicators line up the opposite way, that investor gets defensive.
The terms bull and bear are anathemas to me. You can be long or short or mostly cash at various times -- sometimes all at the same time. So why commit to dogma? The market does not require you to declare your party affiliation or sign up for a religion. "Are you now, or have you ever been, a bear?" is not a question on a new account form. If there's a perceived advantage to being bearish, you should get bearish and vice versa.
Now, on to the public's reaction to bearish or bullish calls: One of the typical emails I get, particularly after making a bearish argument is: "In the long run, doesn't the market tend to go up? Isn't that reason enough for a bullish bias?"
It depends. If you bought stocks in 1966 when the
first hit 1000, well, the long run hardly bailed you out. The Dow didn't get over 1000 until 1982. How'd you like to spend 16 years and end up with a precisely 0% annual return? And that's before factoring in inflation.
The problem with the so-called long run is that it overlooks the here and now. "This long run is a misleading guide to current affairs," wrote John Maynard Keynes in his seminal 1923 work,
A Tract on Monetary Reform
. "In the long run," Keynes noted, "we are all dead."
It has also been an excuse for some terrible advice. Example: "Buy and Hold" works well during some periods (1982-2000) and poorly during others (1966-1982; 2000-2005). If you noticed a pattern here, you are already ahead of the herd.
Adaptability is the key to surviving these longer-term cycles of boom and bust. It is important to have a degree of sensitivity to changing market and economic conditions. Once you recognize a transition is taking place, or hear someone who does, you must be flexible in your response. It's a lot like Darwinian evolution: Adaptability remains the key to survival. This is just as true for investors as it is for iguanas.
Ignore the market's reality in favor of the long-term view, and you'll die with your conviction intact -- but likely little else.
Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to