A few weeks back, I referenced Robert Shiller’s book Narrative Economics. The idea is that stories—to a surprising degree—often drive markets. The investment world is also driven by a good number of sayings and aphorisms. Many of these are entertaining, and some are even useful. But they can also be tricky. Any time advice is delivered in a pithy phrase, it seems to carry extra credibility—as if it were a truth handed down from above. That, of course, isn’t always the case. But it can be difficult to tell fact from fable. Below are some of the most common investment sayings.
Never try to catch a falling knife. Whenever a stock drops, two camps usually emerge: The first argues that the stock is now a bargain and thus more attractive to buy. The other camp argues that a stock that’s fallen probably has further to fall, so it should be avoided. While this “falling knife” expression is usually invoked by stock-pickers, it also applies to the overall market. In an environment like this, in fact, those in the falling knife camp are able to make plausible arguments to back up their cautious view. The list of economic woes, including inflation, is well known.
Does that mean you should stand clear of the stock market? Or do stocks now represent an attractive bargain? What’s the right move? I have often referred to the stock market as a Rorschach test. The market is always tricky because it depends on your perspective. But in this case, I think you can sidestep the question entirely. The market very well might have further to fall. But here’s the way I’d look at it: Suppose you’re trying to drive from New York to California. Along the way, you’ll inevitably run into obstacles, traffic jams and other setbacks. But that wouldn’t stop you. You’d simply keep heading west, focusing on your ultimate goal.
I suggest stock market investors look at it the same way. If your timeframe is five or ten years or more, I think you can have a good amount of confidence that the market will be higher then than it is today. And what if your timeframe is shorter? The way to avoid worry is to avoid investing those dollars in the market at all.
Trees don’t grow to the sky. This is another saying often invoked by stock-pickers to convey caution. The idea is that everything has a limit. Intuitively, this makes sense. None of the original stocks in the Dow Jones Industrial Average, for example, is still included in the index. Some are out of business, while others, like General Electric, are shadows of their former selves and have greatly disappointed investors. That history seems to support this aphorism.
But on the other hand, many companies have grown far beyond what anyone would have ever thought possible. In recent years, many technology companies attained valuations north of $1 trillion. Even after declining 23% this year, Apple is still worth more than $2 trillion. And that skyscraping value is arguably well deserved. Apple’s revenue last year exceeded $365 billion, and its profit was nearly $100 billion—both unthinkable numbers. Will Apple be even bigger and more valuable in the future? As history has shown, anything is possible.
You may notice, though, that I’m using Apple as the only example here. That’s for a reason: because it may be the exception rather than the rule. That, in fact, is another investment pothole to beware of. There will always be exceptions. And those exceptions will, by definition, be the ones that come to mind most readily, because they’re so notable. But don’t let them distract you from the big picture. According to work by Hendrik Bessembinder, the vast majority of stocks, on average, haven’t done any better than humble Treasury bills. Apple has been great, but it really is the exception. Most trees don’t grow to the sky.
The wisdom of crowds. When I was in school, a finance professor conducted a powerful demonstration. He sat each of us down at a computer in a simulated trading environment. Soon after trading started, something remarkable happened: The prices of the fictitious investments each converged with their fair value. The professor had successfully demonstrated the wisdom of crowds. The message: Any one individual might be right or wrong in his estimate of an investment’s value. But in aggregate, investors do tend to arrive at the right answer.
That was what we saw in the controlled environment of the computer lab. But what about in the real world? As we all know, collective self-delusion often takes over during bull markets. In that way, crowds can actually go farther off track than any one individual might. This dynamic may be even more of a hazard today than in the past. That’s because ideas can spread much more quickly online, especially on social media, where there is little fact-checking and where echo chambers often develop.
What’s the answer? My view is that markets are generally efficient. They often lead to rational price levels. But prices can, and often do, become detached from reality. Fortunately, there’s a solution: To protect yourself, I’d rely on traditional valuation metrics. Something as simple as a price/earnings (P/E) ratio would have told you that pandemic darlings like Peloton, Shopify and Zoom were absurdly overpriced. To be sure, no metric is perfect. But they can help you identify extremes. A stock trading at a 20 P/E may or may not be overpriced. But if it’s trading at a 400 P/E—as each of those stocks was—it’s much easier to guess what’s going to happen next. At times like that, it’s best to rely on facts and data rather than popular opinion, no matter how great a company might seem or how popular it might be.
Fortune favors the bold. This is an ancient Latin proverb. In TV commercials for crypto.com, Matt Damon has employed a variation: “Fortune favors the brave,” he says. The message: Be contrarian. Be adventurous. That’s where the profits lie.
Investor Peter Thiel has taken this a step further. At a cryptocurrency conference earlier this year, Thiel took aim at Warren Buffett for his opposition to bitcoin. Among other things, Buffett has called cryptocurrencies “rat poison.” Thiel’s view: Buffett is old fashioned and just doesn’t get it. At the crypto conference, Thiel reportedly dismissed Buffett as “a sociopathic grandpa from Omaha.”
Since Thiel made that statement in the spring, bitcoin is down 55%. That would seem to validate Buffett’s opposition. But we shouldn’t be too quick to dismiss Thiel. As you may know, he was the first investor in the company formerly known as Facebook. He took a chance on Mark Zuckerberg when he was just a 19-year-old college student—and after at least one established venture capitalist passed on the opportunity. Thiel made a fortune with that bold bet.
How, then, should investors think about this? Is being bold a virtue or not? This is a little bit of a trick question. When Thiel bought his stake in Facebook, it cost him just $500,000—a sum he could easily afford after having co-founded PayPal. So it was a bold move but not terribly risky. And I assume Thiel can easily afford whatever risk he has taken with cryptocurrency. But billionaires are in a different category. What works for them may not make sense for the general public.
There’s another, more important lesson here: A few weeks back, I talked about investment analyst Elaine Garzarelli and hedge fund manager John Paulson. Each is famous for making a notable investment prediction. But each later stumbled. And those are just two examples. There’s no denying their success, or that of Peter Thiel. But as individual investors, we still need to take their advice with a grain of salt. Indeed, if there’s one investment saying that you can truly take to the bank, it’s this one: Past performance does not guarantee future results.