Why the Stock Market Confuses You (and you don't make money)

You likely have three ideas that are not correct which cause you to lose money in the market.

The stock market and economy should move hand-in-hand

If the economy is doing well why isn't the stock market doing well?

The fact that you expect the economy and the stock market to move together is something you made up.

In fact, the stock market typically leads the economy by 6 to 9 months. So if you see the stock market going down right now, you can expect the economy to turn down in 6 to 9 months. The stock market has always been a collection of expectations. The stock market reflects the aggregate expectation of investors for the future. Therefore, in the short run there is no correlation between the economy and the stock market.

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I am sure you have heard of the the Conference Board Leading Economic Indicators. You may be surprised to know that the S&P 500 Stock Index is one of those 10 indicators. So it is common economic knowledge that the performance of the S&P 500 is a very important predictor, combined with the other indicators, in forecasting the economy. The market and the economy do not go hand-in-hand.

Take a guess at the best-performing year in the stock market in the last century. The Dow Jones industrial average (DJIA) rose 81% in year which started off with 8.5% unemployment and World War I already raging in Europe (1915). The next best year was 1933, smack in the middle of the Great Depression. The stock market rose 67% that year while the unemployment rate was just under 25% and previously middle-class families were standing in soup kitchen lines. The GDP was half the level of four years prior.

Remember these facts next time you get confused about why the economy is good but the stock market is bad or vice versa.

You can however expect that the stock market and the economy correlate in the long run. As the US economy has grown over time, the stock market has risen over time.

Reversion to the mean--your best tool for investing

You have probably seen those ads in the newspaper by mutual fund companies touting how well one or more of their funds have done in the last one to three years. As you might guess, potential investors see those ads and salivate at earning such returns and pour money into those funds. Guess what happens next. Those funds begin to decline and all those new investors who bought at the top now have losses combined with tears. This phenomenon is called reversion to the mean.

While reversion to the mean may be a fancy looking mathematical formula:

you are well familiar with it. Have you ever said,"what goes up must come down." That's reversion to the mean.

This idea by the way was not discovered by an investor. It was actually uncovered by a geneticist in 1886 who noted that taller-than-average parents typically had a shorter than average child and vice versa. The idea applies to most any random event as it is common sense that the further observation from the average the more likely the next observation is closer to average.

A number of years ago, I recall reading a research article by Morningstar. It was not a public article so I can't reference it for you online. It was part of their paid subscriptions. The research article studied the future performance of the best-performing mutual funds and the worst performing mutual funds. The conclusion was that the worst performing funds where the best performers over the following three years. And as you probably have already guessed, the best-performing funds were the worst performers over the following three years.

If you invest in biotechnology companies because they have been hot, know that at some point they will become cold and underperform. This is the sole element which makes the stock market a difficult place for most investors, the market requires that one’s timing be correct. Unfortunately, most investors timing is backwards. They purchase after an asset has gone up and sell after an asset has gone down.

Why do you behave in this backward fashion? Because you have allowed your emotions to dictate your investment decisions. When everybody feels good and the news is good and the market has gone up, that's when you invest. In fact, that's when the smart money sells - they were just waiting for you to put your money in. When the market has been beaten up and has declined and everybody is nervous and all the news is sour, people cash in their chips. In fact, it's the time when you should be investing. But don't feel bad. It turns out that the CEOs of the largest companies in America do the same thing.

You may have noticed the news headlines of heavy common stock buybacks as the market approached its height. In fact, the CEOs were squandering the company's cash by using it to buy the company shares at the highest prices. The time to do buybacks is after the shares decline 30% and they can be purchased on the cheap. So you're in good company with all those MBAs and people who sit on boards of directors.

Therefore, if you want to lose money, chase what is hot; If you want to make money, do the opposite. And this leads us to our third problem with investing.

You Invest from fear

I don't think that anybody will ever quote me but when it comes to investing my advice is to, "save your emotions for your family and friends, use your head when it comes to money." That’s easier said than done because you don’t control your emotions, they control you. And for that reason, I am a proponent of using automated systems for investing as that is the only way you will ever free yourself from the prison of investing emotionally. In the next post, I'll explain in detail how to use investing systems to know what to buy and when to buy and what to sell and when to sell.