As investors we make our decisions about the future based on past events. We look at the past and try to predict what will happen in the future. Everyone does this, but with varying degrees of success. Some simple minded people like to look at a past trend and extrapolate it linearly, other simple people think every phenomena in the markets is mean reverting. These are oversimplified examples, but they show the biases investors have when they decide how to allocate capital in the markets.
As you already know biases are very not good, especially in investing. I like to read investing forums and subreddits (individual communities on Reddit) to get a feel for the conventional wisdom around investing and events in financial markets. This is a great way to crowd source information from people that think they are far smarter than they actually are. Specifically for subreddits I am talking about places like r/investing and r/stocks, Reddit has a built in feature where the responses to posts are voted on, and therefore the top ones are the most popular opinion. A great place for discovering the conventional wisdom of the day.
There are three extremely common ideas I see shared in 2019. These are all treated as gospel, and continuously parroted back whenever any beginners ask for advice.
- Dollar Cost Average (DCA) into low cost index funds
- Time in the market beats timing the markets
- Either invest 100% in stocks or have a 60/40 stock bond portfolio
Basically, set up an investment account that automatically deposits money from your paycheck and invests in a S&P 500 index (and possibly a bond etf as well). The idea is that the stock market over time will increase and therefore there is no reason to do anything other than invest in U.S. stocks or bonds. Unfortunately this advice is peddled by the big financial media companies, financial advisers, investing books, and the crowd on forums. The most persuasive reason to use this investment strategy is the historic return profile, the S&P 500 and treasury bills/bonds have had incredible returns in the past.
This would be a great strategy to blindly copy if the future was always like the past. Unfortunately these ideas all reek of “rear-view mirror investing”, the same bias people had when they made recklessly leveraged investments in U.S. real estate from 2004-2008. We know how that ended.
This conventional wisdom is only revisited after a market crash.
The Greatest Bias
The biggest bias I see in investing is people investing in their home market without even a second thought. No bias is as pervasive and risky as home country bias, just ask Argentine investors.
This is the chart of the Argentine Merval, the important stock index of the Buenos Aires Stock Exchange (Argentine equivalent of the S&P 500). This 48% stock market crash in U.S. dollar terms was the second largest of any single day drop of any major stock index since 1950 as per Bloomberg Data. The crash was caused by a wider than expected defeat of Argentine President Mauricio Macri (a conservative, free market president) in primary election to the center-left Alberto Fernandez.
2020 U.S. Presidential Election
In September 2019 the stock market is mispricing a lot of risks. One of the greatest risk is the election of a “socialist” candidate. Bernie Sanders, not surprisingly only has a 9% chance of winning the Democratic presidential nomination. Elizabeth Warren has a massive lead over Joe Biden, and she is the massive favorite to win the nomination.
This is from Predictit, a website that shows the market odds for political events. Elizabeth Warren has a huge lead among Democrat candidates, although she is behind Trump in the odds to become the next president, as of September 28, 2019.
Donald Trump is at 41%, and Elizabeth Warren is at 32% even though she has not even secured the democratic nomination. What do you think the odds will be if she wins the nomination? Probably significantly higher than 32%, and probably higher than Donald Trump. That being said Donald Trump is a wildcard candidate, and he was significantly behind in the polls before he won the presidency in 2016. There is still a huge risk to the markets from a Warren presidency.
Wall Street knows this, as an article from CNBC says, Wall Street Democratic donors warn the party: We’ll sit out, or back Trump, if you nominate Elizabeth Warren. One of the reasons she is such as threat to the markets is her plan for a wealth tax in which there will be a 2% annual tax on households with a net worth ranging from $50 million and $1 billion, and a 3% annual tax on households with a net worth exceeding $1 billion. This is Kryptonite for the wealthy, and Kyptonite for the financial markets. Elizabeth Warren knows one thing – it’s good politics in a country with such a high level of income inequality.
I'm Elizabeth Warren and I approve this message. https://t.co/2Ewkbm0ZwA
— Elizabeth Warren (@ewarren) September 10, 2019
I don’t know who will be nominated by the Democrats.
I don’t know if Elizabeth Warren would beat Donald Trump in an election.
I don’t know how much markets would drop if Elizabeth Warren gets elected.
What I do know is the markets are underestimating the risk of an Elizabeth Warren presidency. If Elizabeth Warren gets the Democratic nomination AND the economic data starts to deteriorate, the markets will start to price this risk in. If that happens I recommend you look at investing in international markets, and in safe havens. You should be making a list of investments now so you are prepared and able to move quickly if this development happens.
Don’t make the same mistake many Argentine investors made