Trade wars, inflation and interest rates, Jay Powell’s outlook on the economy, Facebook, and Amazon – all are elements that over the last few weeks have sparked the market to a level of volatility that has even some of the most experienced and successful investors in the world shaking their heads. From Tuesday’s open to Wednesday’s close, for example, the Dow Jones Industrial Average moved more than 1,000 points between extreme high and extreme low as China threatened tit-for-tat tariff retaliation. Fears about a trade war got stoked yet again last night as President Trump upped the ante in the (so for) rhetorical war of words, saying that he was considering adding $100 billion more to the list against China. And with the Dow dropping again today by more than 500 points to start retesting the broad market’s long-term trend support, the hand-wringing seems destined to continue through the weekend.
Jack Bogle is one of the most experienced, knowledgeable, and arguably successful investors in the world. Despite being twenty years removed from his retirement from Vanguard, the largest mutual fund company in the world that he founded more than four decades ago, Bogle has never been shy when it comes to sharing his views on the market. He might be 88 years old, but he remains engaged with current events and is as sharp today as he has ever been.
In a recent interview on CNBC, Bogle was asked about the increase in market volatility that has marked the year so far and what it meant for the average investor. Bogle’s answer was to cite Shakespeare, saying that “it is a tale told by an idiot, full of sound and fury, signifying nothing.”
What does he mean? Perhaps contrary to your first thought, the “idiot” he’s referring to isn’t the guy in the White House with the bad toupee; he’s actually taking aim at speculators. What is a speculator? The first things most people with a little bit of investing experience and knowledge think about when they associate the stock market with speculation are very aggressive trading strategies that tend to have high levels of risk associated with them. Swing and momentum traders, for example use information and tools that help them make educated guesses about whether a market should reverse its current direction or follow it. They then make trades that usually last a very short period of time – in some cases as little as a few hours but most often not more than a few weeks. These are strategies that tend to work best when the market has enough volatility to produce significant swings between and high and low points over short periods of time.
One of the most remarkable things about 2017 was the extreme lack of volatility; over the course of the entire year, the stock market managed to avoid any kind of sustained drop of more than 2.5%. Passive money managers – the method of investing Mr. Bogle pioneered with his low-cost index mutual funds – beat active investors handily, and a lot of folks seemed to start buying into the idea that making money in the stock market was easy and low-risk. A lot of aggressive investors started putting more and more of their money into heavily bullish positions, assuming that the ride wouldn’t ever end.
The thing that people seem to have forgotten is that the market is cyclical, swinging not only from extreme high to the low, but also from periods of low price volatility to high volatility and back again. What that does to aggressive investors, more often than not, is to catch them sitting on the razor’s edge of the market at the worst possible time, with too much of their money positioned in exactly the opposite direction of the change. When volatility returned to the market this year and drove the broad indices more than 10% off of their all-time highs, a lot of those people were caught by surprise and so they ended up absorbing big losses in a short period of time with no idea about how to deal with it or put it into any kind of constructive context.
Mr. Bogle continued by saying that high volatility is a concern for speculators, but not for long-term investors, and technically that is true; if you look at market performance over long-term periods of time, you’ll find that taking a consistent, disciplined, and long-term view of your investments generally translates to the best possible returns. The reason I think Mr. Bogle decided to quote Macbeth in describing the current market, however is to point out that when volatility increases in the market, a lot of people – mostly the speculators – spend a lot of time wringing their hands, wailing at the sky, and talking about everything that is going wrong. And since news media is all about grabbing our attention for the next five seconds, those are the talking heads that more often than not end up getting the most air time. That creates more fear and anxiety that even a lot of long-term investors have a hard time dealing with.
The Idiot’s fatal flaw: Emotion
In every one of Shakespeare’s plays, the story’s protagonist displays some kind of fatal flaw that ultimately leads to his or her demise. Those flaws, no matter whether you’re seeing them in Hamlet’s desire for revenge, Othello’s jealousy, or Macbeth’s ambition, boil down to an inability to deal with emotion. The truth is that investing in the stock market, no matter how objective, rational and disciplined you try to be, is always an emotional thing. Anytime you put your hard-earned, and carefully saved capital into an investment, there is emotion involved. That emotion complicates your ability to think rationally about market conditions at any point, and can really compromise the effectiveness of even a conservative investing approach.
Emotion is the reason aggressive strategies, like momentum and swing trading are so hard for most people to make money with. These are strategies that operate with a low probability of success in any given trade; under even the most favorable circumstances, the most successful and profitable traders admit they only actually make money on 25 to 30% of the trades they make. That reality works directly counter to our natural, competitive desire to win.
The only way to make money in the long-term when you’re working with such a large majority of losing trades is be very disciplined in your trade execution, which means being able to cut your losses quickly when you have them, and conservative about money management. Conservative money management means keep the sizes of each trade small relative to the total capital you have to invest. The problem is that our emotions make it harder to keep those rules in mind in the midst of a string of losses; in fact, experience shows that most traders in these circumstances will increase their size and frequency of their trades because they become more and desperate to get the money they lost back as quickly as possible.
Emotion plays its role with long-term investors when the market is volatile, too, because the noise that comes from the aggressive, short-term traders – the ones Mr. Bogle calls speculators – creates a sense of worry, anxiety and even panic that forces a lot of inexperienced long-term investors to overreact. So when things are looking so confused, and future seems so uncertain and fraught with danger, what can you do to keep the kind of balanced, long-term view in mind that has helped investors like Mr. Bogle and Warren Buffett find such great success? The answer lies in understanding the difference between speculation and investing.
Benjamin Graham, the man many credit as being the “father of value investing,” and who taught Warren Buffett the investing principles and methods that Mr. Buffett still uses today, defined investment versus speculation in his book, Security Analysis, a book that despite having been written almost 85 years ago has never gone out of print:
“An investment operation is one in which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Any kind of investment that offers a reasonable rate of return for the capital required, along with safety of principal, according to this definition, qualifies as an investment. Mr. Graham wasn’t actually saying, however, that to be a wise investment, it has to be free of speculation; in fact he recognized that any investment in the stock includes some speculative element, because “investors have been willing to pay so much for so-called quality, and future prospects…that they have themselves introduced serious speculative elements into common stock valuations.” The question is whether or not a speculation is “intelligent”:
“Intelligent speculation presupposes at least that the mathematical possibilities are not against the speculation, basing the measurement of these odds on experience and the careful weighing of facts.”
An intelligent speculation is one that balances risk against probability of success. There are many profitable momentum and swing traders, who have managed to be successful specifically because they’ve been able to figure out how to balance the reality of a low winning probability with the ability to cut losses short quickly, maximize gains when they have them, and to utilize careful position sizing principles throughout. These are aggressive investors that can’t be called speculators, or Mr. Bogle’s Idiots, because they understand how to balance market volatility against their method. They know how to stay the course even when market conditions change drastically. Because that is a very difficult, time-consuming and expensive process for most people, these investors are the exception rather than the norm.
Long-term investors also become speculators when they surrender their ability to balance their emotions to the whims, fancy, and desperation of today’s market. If you’re investing and calling yourself a long-term investor because “that’s what my mutual fund guy told me I should do,” for example, there’s a good chance that you’re going to fail, because the market is going to test your resolve and work to cloud your judgement. The only way to survive that test is to understand not only what you’re investing in, but also why. If the reason you’re making an investment is no longer valid, it’s time to get out and move on to something else. That’s true no matter whether you’re investing for the short or long-term, whether your investment is based on a bet that market is going to rally off of support or because you believed a company’s fundamental business is worth more than today’s stock price shows.
Another mistake speculators – Mr. Bogle’s Idiots – make is to assume that a profitable result is the only real barometer of whether an investment was wise. To cite Mr Graham, I’ll refer to a series of lectures he presented called Current Problems in Security Analysis over the course of several months from 1946 to 1947:
“It is a great mistake to believe that a speculation has been unwise if you lose money at it. That sounds like an obvious conclusion, but actually it is not true at all. A speculation is unwise only if it is made on insufficient study and by poor judgment…in some cases the thing will work out badly. But that is simply part of the game. If it was bound to work out rightly, it wouldn’t be a speculation at all, and there wouldn’t be the opportunities of profit that inhere in sound speculation.”