"I can calculate the motion of heavenly bodies, but not the madness of people."
-Newton
Isaac Newton is famously attributed to that quote after he lost a fortune investing in the South Sea Bubble in 1720. He was a genius of the highest order, but not even he could predict the stock market. There are many similarities between the stock market and the evolution of our understanding of physics.
There is a widely held belief in finance called The Efficient-Market Hypothesis (EMH). It was conjured up over 50 years ago by a graduate student who was looking for a formula that beat the stock market. The problem was that he couldn't find one and over the long-term it always reverted back to the market average. Other professors picked up on this and it spread like wildfire through academia. There are now 1,000s of papers and studies written on the subject and many people believe it to be true.
EMH basically says that markets are perfectly efficient. In consequence of this, one cannot consistently achieve returns in excess of average market returns when they hold the same risk factor, given the information available at the time the investment is made.
This whole scenario reminds me a lot of Newton's 3 laws of motion. Newton is said to be responsible for bringing order to the heavens, but there are areas where the 3 laws break down and can't explain certain movements. This I believe to be true for the stock market as well.
Then enters Einstein! Einstein's theory of relativity helps to fill in more of the gaps that Newton's theories couldn't handle. Predicting the movement of the moon, that's easy. Predicting the movement of light around a supermassive black hole. Well that's a little trickier. Actually a lot harder!
The same holds true for the stock market. Warren Buffett has said repeatedly that the key to getting rich is, "To be fearful when others are greedy and greedy when others are fearful." What does this mean? Touching on what I posted yesterday, it means that EMH falls apart when people become irrational. The entire world of financial and economic academia revolves around people being rational. The light moving around a super massive black star is like us being irrational. This is also where the opportunity for you to get rich comes into play.
The problem with fear is it's hard to quantify, actually it's impossible to quantify and therefore test, yet we know it when we feel it. Fear is kind of like catching the early flight home from San Diego and a couple of nude people jump out of your bathroom blindfolded like a goddamn magic show ready to double team your girlfriend...that's fear! The ability to hardness that fear and not let it control you is the key.
George Soros, arguable the greatest stock market speculator who ever lived, says that he use to get actual physical ailments when the market became fearful. He knew that change in the market was coming because his lower back would start to hurt. People thought he was crazy, but his record speaks for itself and it's perfectly logical because his brain was signaling that something was askew with his surroundings. That brain signal would then give him a physical indicator. Much like when I got off at the wrong train stop in Barcelona to find myself in the middle of a turf war that I had no business being involved in. I sensed fear, I responded by getting by white ass back on the train. A similar thing happened in Harlem, but that's a different story...
I know for a fact that this happens, because it has happened to me twice so far. I screwed up the first time, but not the second! The first time was in the spring of 2003. I was in grad school and was overwhelmed with school and not able to give as much attention to investing as I would have liked. Sensing the fear in the market, I assumed the worst was coming so I panicked. I developed a pain in my abdomen that was a physical signal of the stress. Not recognizing what was happening, I sold and it cost me almost a 100% return over the next 4 years. The second incidence was in the spring of 2009. The market was falling irrationally given the circumstances and I developed the same pain in my abdomen. Recognizing the physical symptom, I bought heavily instead of sold, and reaped a huge reward. That's the fear side...
What about the greed side? That's so much more difficult to gauge because greed generally builds slowly, not quickly like fear. The good news is that there are more reliable quantitative indicators that can be used to see greed coming. My 2 favorite are Schiller's PE ratio and TMC/GDP. Both have proven to be the most reliable at determining when the market is overvalued. Be careful because they are signaling that right now.
So in short, what can you take away from this too long of a post? Here it is: the stock market acts rationally a lot of the time meaning you can't do better than the average. However, there are moments when you need to buy when everybody else is selling and selling when everybody else is buying. You have to listen to your body when this happens because there are few reliable financial indicators to tell you when this happens. If all of this sounds way too complicated or not fun at all. Then just keep putting a fixed amount of money each week, month, or year into a low cost index fund. You'll do just fine over the next 30 years.
-Newton
Isaac Newton is famously attributed to that quote after he lost a fortune investing in the South Sea Bubble in 1720. He was a genius of the highest order, but not even he could predict the stock market. There are many similarities between the stock market and the evolution of our understanding of physics.
There is a widely held belief in finance called The Efficient-Market Hypothesis (EMH). It was conjured up over 50 years ago by a graduate student who was looking for a formula that beat the stock market. The problem was that he couldn't find one and over the long-term it always reverted back to the market average. Other professors picked up on this and it spread like wildfire through academia. There are now 1,000s of papers and studies written on the subject and many people believe it to be true.
EMH basically says that markets are perfectly efficient. In consequence of this, one cannot consistently achieve returns in excess of average market returns when they hold the same risk factor, given the information available at the time the investment is made.
This whole scenario reminds me a lot of Newton's 3 laws of motion. Newton is said to be responsible for bringing order to the heavens, but there are areas where the 3 laws break down and can't explain certain movements. This I believe to be true for the stock market as well.
Then enters Einstein! Einstein's theory of relativity helps to fill in more of the gaps that Newton's theories couldn't handle. Predicting the movement of the moon, that's easy. Predicting the movement of light around a supermassive black hole. Well that's a little trickier. Actually a lot harder!
The same holds true for the stock market. Warren Buffett has said repeatedly that the key to getting rich is, "To be fearful when others are greedy and greedy when others are fearful." What does this mean? Touching on what I posted yesterday, it means that EMH falls apart when people become irrational. The entire world of financial and economic academia revolves around people being rational. The light moving around a super massive black star is like us being irrational. This is also where the opportunity for you to get rich comes into play.
The problem with fear is it's hard to quantify, actually it's impossible to quantify and therefore test, yet we know it when we feel it. Fear is kind of like catching the early flight home from San Diego and a couple of nude people jump out of your bathroom blindfolded like a goddamn magic show ready to double team your girlfriend...that's fear! The ability to hardness that fear and not let it control you is the key.
George Soros, arguable the greatest stock market speculator who ever lived, says that he use to get actual physical ailments when the market became fearful. He knew that change in the market was coming because his lower back would start to hurt. People thought he was crazy, but his record speaks for itself and it's perfectly logical because his brain was signaling that something was askew with his surroundings. That brain signal would then give him a physical indicator. Much like when I got off at the wrong train stop in Barcelona to find myself in the middle of a turf war that I had no business being involved in. I sensed fear, I responded by getting by white ass back on the train. A similar thing happened in Harlem, but that's a different story...
I know for a fact that this happens, because it has happened to me twice so far. I screwed up the first time, but not the second! The first time was in the spring of 2003. I was in grad school and was overwhelmed with school and not able to give as much attention to investing as I would have liked. Sensing the fear in the market, I assumed the worst was coming so I panicked. I developed a pain in my abdomen that was a physical signal of the stress. Not recognizing what was happening, I sold and it cost me almost a 100% return over the next 4 years. The second incidence was in the spring of 2009. The market was falling irrationally given the circumstances and I developed the same pain in my abdomen. Recognizing the physical symptom, I bought heavily instead of sold, and reaped a huge reward. That's the fear side...
What about the greed side? That's so much more difficult to gauge because greed generally builds slowly, not quickly like fear. The good news is that there are more reliable quantitative indicators that can be used to see greed coming. My 2 favorite are Schiller's PE ratio and TMC/GDP. Both have proven to be the most reliable at determining when the market is overvalued. Be careful because they are signaling that right now.
So in short, what can you take away from this too long of a post? Here it is: the stock market acts rationally a lot of the time meaning you can't do better than the average. However, there are moments when you need to buy when everybody else is selling and selling when everybody else is buying. You have to listen to your body when this happens because there are few reliable financial indicators to tell you when this happens. If all of this sounds way too complicated or not fun at all. Then just keep putting a fixed amount of money each week, month, or year into a low cost index fund. You'll do just fine over the next 30 years.
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