A Realization That Will Improve Your Trading Results

A Realization That Will Improve Your Trading Results

This is a Guest Post By Brian Hunt CEO of InvestorPlace.


It won’t sell any books… and it’s an idea that won’t make the front page of the Wall Street Journal

…but I often tell folks if they’d only realize people are crazy, they’ll see a big improvement in their investment performance.

In fact, one of my top guidelines for investing – and life – is that “people are crazy and life is absurd.”

Knowing this can give you a great new perspective on life. It can reduce stress. It can make you more understanding and forgiving. It can also help you become much better at navigating the financial markets.

Here’s why…

When you realize people are crazy, you learn not to be surprised by market events that seem crazy or unusual to most people.

“Crazy” market events – when stocks stage giant, seemingly-out-of-nowhere moves – happen far more often than you might think.

They happen far more often than finance professors tell you they can.

When you approach the market with this in mind, you don’t expect the market to behave rationally… which gives you a huge advantage over others.

You learn to prepare for what seem like crazy financial events, rather than get blindsided by them. You profit from these events, rather than get bankrupted by them. Realizing people are crazy can be a transformational experience for people.

Believe it or not, this flies in the face of mainstream financial beliefs…

That’s because in the 1960s, prestigious universities began promoting an idea called the “efficient market hypothesis.”

The efficient market hypothesis proposes that the stock market is made up of rational people who make rational decisions. What follows this belief is all those rational people making all those rational decisions always lead to rational stock market prices.

It sounds clean and orderly. And for years, this was academic gospel. Anyone who said otherwise was attacked by an army of professors spouting lots of convincing statistics. These academics declared that market prices always reflect everything known about stocks and bonds. So, trying to “beat” the market was futile.

However, this popular theory is a load of manure. The academics missed a key aspect of human nature: Even rational people do crazy stuff from time to time. It’s just human nature.

Because I know this, I stay prepared for all kinds of market outcomes. I’m not surprised by market moves that catch other people off guard. If something crazy happens in the market, I just think, “Well, no wonder that happened. People go crazy from time to time.

Want proof that people are crazy?

I could write 100 pages about it… but let’s talk about World War I.

Back in 1914, you had the countries of Europe filled with people who generally just wanted to enjoy life and mind their own business. And then, a small conflict erupted into a huge war that killed more than 15 million people.

There were guys fighting in that war who had no idea what they were fighting for… or who they were fighting against. They were just there because some king or bureaucrat told them it was what they should be doing. It was totally insane.

Another reason I can say human nature has a “crazy” streak is our tendency to self-destruct. It’s not rational.

Destroying your life with drugs, or alcohol, or gambling isn’t rational. Punching a wall and breaking your hand isn’t rational. Staying with a spouse that beats you isn’t rational.

Yet, humans do those things thing all the time. It’s part of who we are. So, don’t be surprised when you see people doing crazy things. Take note, protect your family, and don’t be surprised.

If you have a sense of humor and a safe place to stand, you might even learn to get a laugh out of it. Laugh at the absurdity of life.

This realization is so important to your finances because many people invest huge sums of money guided by the idea that markets are rational. That leads to huge mistakes.

Markets are rational, most of the time. Stocks and bonds usually trade for approximately rational prices. But often, the people who make up the markets go berserk. At times, they’ll buy assets for absurdly high prices. At times, they’ll sell assets for absurdly low prices.

Markets can stay in these absurd, irrational states for a long time. There’s a quote from the great investor, Jim Rogers, that captures this idea. He said, “Markets often rise higher than you think is possible, and fall lower than you can possibly imagine.”

If your investment approach is based on the belief people always make rational decisions, or that irrationally-priced markets are sure to quickly return to rational pricing, you’re bound to suffer terrible losses. When you know that people tend to go crazy – and stay crazy for a while – you can keep your capital safe.

On the other hand, knowing that people go crazy from time to time will help you take advantage of great opportunities. It will help you stay patient and buy assets only at bargain prices. You’ll realize you don’t always have to be doing something. You can be patient and wait to buy during periods of irrationally low prices. They will eventually come around.

How about some real-life examples of these ideas at work?

A good recent example is the tech stock craze of 1998 – 2000.

From early 1996 to early 1999, the Nasdaq tech stock index climbed from 1,000 to 2,500. That’s an increase of 150%. It’s an extraordinary move for just three years.

After this big move, many tech stocks traded for very expensive prices. So, some smart traders bet against stock prices rising. They put on trades that would profit if stocks fell, but would lose if stocks rose.

Part of their thinking was sound. Back then, stocks were trading for 50, 100, even 300 times earnings. Those are absurdly expensive valuations. It was only reasonable to expect those expensive stocks would decline and trade back down to rational prices.

But a lot of those bets turned out to be losers because the market kept going up and up and up. From early 1999 to late 1999, the Nasdaq gained another 40%. Stocks that were trading for crazy prices started trading for crazier prices. Traders bet even more on a market fall. Then, from late 1999 to early 2000, the Nasdaq gained another 42%. It was truly insane.

Eventually, stocks crashed, but they rose for a long time before rationality sank in. The people who stuck with bets on prices becoming “rational” got killed.

The realization that “people are crazy” also helps investors stay patient and wait for bargains.

One of the biggest things investors struggle with is the impulse to “do something.” It’s a natural tendency to want “action.” Both amateurs and professionals struggle with this.

This tendency is dangerous because it leads folks to buy assets just to feel like they are doing something.

When you buy assets just to fill a psychological need – instead of an actual good reason – it leads to poor outcomes. It’s like marrying the wrong person just because you’re in a hurry to get married.

What you want to do is stay patient, knowing the market will eventually offer up bargains, and only buy when great bargains appear.

The great investor, Ben Graham, encouraged folks to think of participating in the stock market as if you were a partner in a business. Your hypothetical partner is a crazy guy Graham called “Mr. Market.”

Mr. Market goes through big mood swings.

Each day, he offers to buy your share of the business or sell you his share of the business at a given price. The decision to buy or sell is up to you. You can sell your share of the business to Mr. Market, buy Mr. Market’s share, or just do nothing.

Some days, Mr. Market is on an even keel. He offers to buy or sell at a reasonable price. Some days, Mr. Market is in a wildly optimistic mood. He offers to buy your share at a price much higher than the real worth of the business. Some days, Mr. Market is in a terrible mood. On those days, he offers to sell you his share for a very low price.

I think Graham nailed it with this stock market analogy. He knew people tend to go crazy from time to time. And he knew it presented opportunities to make incredible investments.

Mr. Market’s crazy behavior turns up in both individual stocks and broad market sectors. If you can stay patient and wait for Mr. Market to offer shares at very low prices, you can snap up great bargains.

For example, after the 2008/2009 credit crisis, some of the world’s greatest businesses were available for bargain prices.

The blue-chip industrial giant, 3M, traded for a P/E of around 8 and offered a 4.9% dividend yield. 3M is one of the world’s safest companies. It has raised its dividend for more than 50 consecutive years.

Altria, the dominant company behind Marlboro cigarettes, got so cheap that it offered investors a near-9% dividend yield. Disney, the premier entertainment company, sold for a P/E of less than 10, which is extremely cheap for an elite business.

Elite businesses often trade for at least 15 times earnings. But during the market panic, you could buy many great businesses for less than 10 times earnings. It was an amazing bargain to buy the likes of Disney and 3M for less than 10 times earnings. Since they were very high quality businesses and investors could have picked them up for bargain prices, a further decline in share prices – if things got crazier – could have been waited out.

Nobody can tell you exactly when the next crisis will strike a given market, but you can bank on it eventually happening. After all, people tend to go crazy from time to time. Mr. Market will sell assets to you for pennies on the dollar.

If you know this, it will help you stay patient and wait for the next fire sale.

I’ll sum up by saying I believe most people are generally good. People are mostly rational. But we’re all human. It’s in our nature to do crazy stuff from time to time… especially when it comes to money and investments.

If you operate under the assumption that people are crazy and life is absurd, you’re able to imagine almost any type of market environment. And you’ll be a better investor because of it.

You’ll never stubbornly stick to a losing position with the belief that it has to go your way because your way is the “rational” one. If a stock can trade for the crazy price of 100 times earnings, it can trade for a crazier price of 200 times earnings. A market with 50 years of regular pricing tendencies can go completely nuts in 50 seconds.

Because you know anything can happen, you stay cautious toward the market.

You’re also able to stay patient because you know somewhere, in some asset class, people will go nuts. That’s just what they do from time to time. And you can be there to buy bargains from crazy Mr. Market.

In my next essay I’ll discuss where to find the stocks that bring 100-fold return.



You can see more work by Brian at InvestorPlace.com.