What caused the housing boom? Did people really believe that a median home price of over $500,000 in San Diego were realistic? Were people caught up in the dot-com boom really rational?
Economics 2.0, reviews a paper saying that rational people will often buy assets that they themselves believe are overvalued. Why?
Let’s say I believe that most investors think of the market as being overvalued. I also know, however, that most investors have not yet sold out. My conclusion from that is that they expect a price increase, at least for the short term, and are therefore unlikely to sell tomorrow. I will step up and buy.
The same will occur tomorrow, with the effect that my daily predictions for the next day’s average market assessment will not be in line with my long-term forecast of the average market value assessment. This discrepancy grows wider with each day as observant investors have an incentive to “ride the bubble.”
The book also reviews an article by Javier Estrada the thick tails of the stock market returns distribution. This makes effective market timing very difficult:
Someone having invested a fixed daily amount in the Dow since 1900, but having missed the ten most profitable trading days, would have lost 65 percent of all returns. By contrast, someone having managed to avoid the ten worst trading days would have increased his gains by 206 percent. “These magnitudes are enormous, given that ten days account for only 0.03 percent of the days considered,” Estrada writes. Results are similar when viewed in the context of shorter time spans. “A negligibe proportion of days determines an enormous creation or destruction of wealth and, therefore, the odds against successful market timing are simply staggering.”
This is more academic evidence supporting my own buy-and-hold investment philosophy.
- Norbert Häring and Olaf Storebeck (2009). Economics 2.0: What the best minds in economics can teach you about business and life. Palgrave MacMillan, New York, NY.
- Franklin Allen, Stephen Morris and Hyun Song Shin (2006) “Beauty Contests and Iterated Expectations in Asset Markets,” The Review of Financial Studies, Vol. 19, No. 3, pp. 719-752.
- Estrada, Javier (2007) “Black Swans, Market Timing, and the Dow” Working Paper.
Interesting. What gain would a buy-and-hold strategy have produced?
In the Buy-and-hold, you hold securities for the long run and each year rebalance. Thus, in the run up to the boom, you would have earned less money than someone who had all their money invested in stocks or housing. However, during the bust, since you would have rebalanced your gains to safer investments (Treasury bonds), you will lose less money.