Investing rules to follow when markets don't make sense

It can be really hard lately to see how many of the traditional rules of investing—or rational thinking—apply.

Tesla stock has risen fourfold this year, making it worth more than Volkswagen and Toyota combined—even Elon Musk has said it is overvalued. The cryptocurrency ether has gained more than 150% in 2020, rising 75% over the past two weeks alone. Investors poured money into Hertz even after it declared bankruptcy, driving shares up almost 900%.

The Standard & Poor's 500 stock index is higher than it was at the beginning of 2020, even as nearly 5 million people in the U.S. have now been infected by the coronavirus, the economy continues to struggle, and President Trump has declined to say that he'll accept the outcome of the November elections.

The strong performance of the biggest technology companies—which account for over 20% of the value of the S&P 500—is one literal explanation for what is going on. Another is that extremely low interest rates make equities—and cryptocurrencies, I suppose—more attractive to investors looking for any kind of return. And a third reason is that the U.S. government has shown a willingness to write humongous checks and intervene in markets when trouble arises, reducing the seeming riskiness of risky bets. The simplest explanation for the rise in shares in gravely troubled companies like Hertz is that people who would otherwise have been betting on sports started betting on free stock-trading apps like Robinhood when the virus left them homebound and forced pro sports to pause.

In such an environment, the existential macro risks—of a deep, extended recession because of the pandemic or a U.S. constitutional crisis—fade into the background. When stocks, cryptocurrencies, and junk debt are the only way to make any significant short-term returns, it becomes easier —and necessary?—to put aside anxieties about the logic underpinning their gains. The overriding anxiety is a fear of missing out on a further surge in markets.

As Justin Lahart pointed out recently in The Wall Street Journal, it usually takes stocks several years to recover from a deep drop. Given the somber outlook for business performance, the accelerated bounceback we've experienced already could be all we're going to see for awhile. And there's a risk that investors will even have to give back those gains if economic or political shocks spook people enough to take money out of the market.

The traditional rules of investing would tell you that the current outlook is generally pretty crummy and it's hard to justify a lot of the runup in markets based on business fundamentals. I assume that this is right—and that investors' current bullishness ultimately reflects their increased willingness to accept risk, whether that's acknowledged or not.

Another way to think about it is what Matt Phillips highlighted in his New York Times article headlined "Repeat After Me: The Markets Are Not the Economy":

Economists who have studied the performance of stock markets over time say there’s relatively little evidence that economic growth matters to the outcome of the market at all.

Matt suggests that our current experience "could snap any illusions that the logic of the market is derived, in any consistent way, from real-world events."

After their surge, Hertz shares did fall again. And I assume that ether and Tesla will drop as well at some point. The S&P 500 presumably isn't immune to another decline either.

But, like Matt, I've given up expecting markets to be as rational as I'd like them to be. And that leads me back to two other rules of investing:

  1. Know how much risk you can tolerate. Some investments—in bankrupt companies, and most cryptocurrencies—are essentially gambling. Good for you if you get lucky. Also, if you'll need the money you're thinking of investing soon, it's not a good idea to put it in assets that could drop significantly, including the S&P 500. If you can wait awhile to access your money, the stock market should eventually recover from any drop and deliver gains to reward the risk you took.

  2. Individual investors rarely succeed in timing the market. Research shows that they miss out on the opportunities for gains when they bail when the market is falling, or keep cash on the sidelines waiting for buying opportunities. It's generally better to stay invested, and add to your investments regularly.

As hard as it can be emotionally to do so, following these rules makes it a lot easier to successfully navigate the moments when markets really don't make sense.

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