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An expensive place to find out who you are

"If you don't know who you are, the stock market is an expensive place to find out."

These words, spoken in 1723 by Adam Smith, philosopher and economist, are a timely reminder that asset prices can fall much faster than they can rise. Apart from March 2020, many investment advisors have not experienced a severe bear market (prices falling sharply and remaining low for a period of time).

I am old enough to have lived through and participated in several bull and bear markets, including 'Black Wednesday' in 1992. Bull markets (continually rising prices) lead to bear markets which lead to bull markets. This cycle of market behaviour is as constant as the relentless ocean tide. Bull markets do not die of old age with a whimper; they die of euphoria and go out with a bang!

A successful investor understands that the first challenge to navigate these extremes is to 'know thyself'. Without knowledge we won't have understanding, and without understanding we won't be able to control our emotions and think rationally at times of severe movement in prices.

If you had a choice, which would you prefer: a) prices rise by quite a lot and remain high for several years, or b) prices fall and remain low for several years? If you chose high, you would join 90% of investors, both private and professional. However, this is the wrong way to optimise returns; unless you are a seller, you would have chosen against your interests.

When you buy a common stock, what you buy is the right to receive the dividends paid on a share of stock. We buy dairy cows for their milk and hens for their egg production. If running a dairy, we would want to pay low prices for cows in order to obtain more milk per dollar. For every $1 we invest in a stock, we receive more dollars in future dividends as a percentage of our investment.

Counter-intuitively, long-term investors should wish share prices to stay low so they can accumulate more shares at low prices and thus receive more future dividends. In the 72 years between 1927 and 1999, for example, a $1 investment grew to over $106, and by reinvesting dividends, the total return was $2,592. Reinvestment of future dividends is important because it helps to smooth out the peaks and troughs of market prices.

If you are caught up in the excitement of rapidly rising prices, as is the case today in some crypto, equity and commodity markets, or sharply falling prices, as in the US Treasury bond market, go for a long walk and calm down. Impulse is the enemy of the successful investor; benign neglect is a friend. When prices are rising, we need to guard against attempting to win big, committing too much to a single investment, or borrowing unnecessarily and overextending responsibilities and commitments.

Successful investors avoid speculation, understanding that it produces a poor risk-adjusted reward. At the same time, they are careful not to succumb to fear. Knowing who they are, they invest within their sphere of competency.

The author - jb@ehh.gi - is a member of the Society of Trustees and Estate Practitioners and an investment counsellor. The comments and observations by the author are a reflection of his opinion and do not constitute an offer to buy and hold securities, nor does he receive any remuneration of any kind from names referred to.