What if everyone bought the same hot stock?

Conventional wisdom suggests that the stock market is the destination of choice when it comes to laying the groundwork for future financial security and building personal wealth.

Since the rise of the 401(k) in the early 1980s, tens of millions of people have officially become stock market investors. Critics of the status quo worry that public awareness about the risks associated with stock investing needs to be improved.

Generally, I agree.

As such, I have been writing about some of the risks related to stock market investing that I feel people should know more about.

A few of the topics I have covered so far are,

In this post, I focus on two issues that serve as underpinnings for the often futile pursuit of so-called “hot” stocks or other over-hyped trends in investing.

These are the “fallacy of composition” and the “bandwagon effect.”

Fallacy of Composition

Fallacy of composition refers to circumstances in which something that is true for a “part” may not necessarily be true for the “whole.”

For example, if one person stands up at a baseball game, he or she can get a better view. But, if everyone stands up, no one gets a better view.

Similarly, if only a few people bet on a particular horse at the racetrack, they can win big. But, if everyone bets on the same horse, the payoff will be small.

The same logic can be applied to investing.

A share of stock is essentially a claim on a company’s current or future earnings. If a company has a finite amount of earnings, its current stock price may represent a very good value for a certain population of investors.

But, if everyone were to buy the same stock, the fortunes could change.

First, the stampede of new demand would likely drive up the share price.

Sounds like good news, right?

Then again, maybe not…

  • New investors buying the higher priced shares end up paying more for the same proportional share of the company’s overall earnings.
  • If the company’s stock was formerly priced at $50 and paid a dividend of $3.00 per share, the yield would have been a respectable 6%.
  • However, if demand drives the price of the stock to $100 and the dividend per share remains the same $3.00, the yield now becomes only 3%.
  • New investors pay twice the original share price to get half as much yield in return.
  • New investors also bear the risk that the stock price may fall due to the perception that shares have become overvalued.

The point is, what may have begun as a good deal for some, can end up becoming not nearly as good a deal after everyone (or a sizeable population) gets involved.

The Bandwagon Effect

The bandwagon effect refers to incidences where demand for a stock, commodity, or other investment is driven by social pressures such as, “everyone else is buying it.”

In such cases, people are moved to act because they feel societal pressure and/or the fear that if they do not act, they will miss out on an opportunity.

When combined, fallacy of composition and the bandwagon effect can serve to drive prices of stocks or other investments to remarkably high and unsustainable levels.

In general, the later a person arrives to the party, the more he will have to risk, the less he will stand to gain, and the greater the likelihood he will lose.

Mother knew best

It turns out, your Mom knew a little something about the about fallacy of composition and the bandwagon effect when she told you,

“Just because everyone else is doing something doesn’t mean that you should do it too.”

Sage advice for both life and for investing…

The next time you see the masses chasing the latest hot stock or other investment trend, exercise caution.

Just because everyone else appears to be getting involved, doesn’t necessarily mean it’s the right thing to do.

Click here to learn the MOST important secret to retirement success.

So what do you think?

  • Have you ever seen a situation where what was good for a few was not necessarily good the whole?
  • Do you believe the bandwagon effect has had an impact on current U.S. stock prices?
  • Do you think stocks today are properly valued or out of line?
  • Can the fallacy of composition be applied to participation in the market as a whole?

Should you be worried about a stock market bubble?

The future well being of citizens today depends more on the stock market than ever before in history. This is largely due to a shift in the 1980s away from traditional “defined benefit” retirement pension plans in favor of individual “deferred savings” plans like the 401(k).

This shift – unintended if you’ve never heard the story – opened the door for tens of millions of people to become stock investors.

Individuals now rely on stocks for the promise of future prosperity and as a means of assuring financial security in their senior years.

Coinciding with the shift toward stock investing has been a demographic shift in our country.

  • Roughly 8,000 to 10,000 Baby Boomers reach retirement age every day.
  • By 2030, one in every five Americans will be over the age of 65.
  • This change represents an increase over the current senior population of 66%.

The original purpose of the stock market was to serve as a mechanism for businesses raise capital through the exchange of “shares” of ownership in a company.

Whether the market will be suited to serve in its new role of funding consumable income for a large segment of the future population remains to seen.

One factor impacting this question is the recurrence of stock market bubbles.

What is a stock market bubble?

Stock market bubbles occur as a result of cultural, political, and economic trends. They represent a flight from reality that is neither rational nor easily predictable.

A key question when thinking about stock market bubbles is, do stocks at any given time reflect a reasonable representation of their underlying values?

In essence, are stocks worth the prices for which they are trading?

The most fundamental expression of the value of stocks is the “P/E” or price earnings ratio.

  • This ratio is simply the price of stock divided by the stock’s earnings.
  • If a stock sells for $50 per share and has earnings of $5 per share, its P/E “ratio” is, 10.
  • $50 share price / $5 earnings = P/E of 10.

Usually the earnings used to calculate P/E are based on what a company actually earned in the prior year. P/E ratios are also commonly calculated for collections of stocks as represented by indexes such as the Dow Jones Industrial Index.

Historically, the Dow has had an average P/E of about 15.

When former Federal Reserve Board Chairman Alan Greenspan made his famous remark about “irrational exuberance,” it was early in December of 1996. At the time, the Dow was trading around 6,700 with an average P/E of 25. However, it wasn’t until five or so years later in 2000/2002, that the bubble finally burst.

There have been at least five major bubbles in the last 116 years: 1901, 1929, 1966, 2000/2002, 2008/2009. Some point out that the time span between recent crashes has decreased.

Below is a chart from Nobel Prize winning economist Robert Shiller that shows real or “inflation corrected” prices versus earnings for U.S. Stocks from 1870 through modern times.

(For advanced students, see Dr. Shiller’s P/E chart reflecting “real” ten year trailing earnings.)

Robert Shiller S&P 500 S&P Composite Stock Price Chart

You can see from the chart above that bubbles generally occur in relationship to the spread between the prices of stocks and their earnings.

When the next bubble will occur is anyone’s guess.

The older people become, the less time they have to recover from the negative effects of market turbulence like bubbles. To protect themselves, individuals should become more aware of the risks associated with stock investing, seek help from a qualified advisor, and plan accordingly.

Click to learn how to create reliable income for your retirement regardless of whether the market goes up or down. 

What are your thoughts?

  • Does it surprise you to learn that the senior population is increasing by such a large extent?
  • Have you ever thought about or looked at P/E ratios before?
  • Do you think the stock market will be able to provide a reliable means of income security for our growing senior population?
  • Have you ever wondered how you will derive income from your nest egg to pay bills when you retire?

The Risk of Sequence of Returns

For years we have heard it repeated over and over from the financial sector – and their willing allies in academia and the media – that investing in stocks will provide us the best possible returns over time.

In a recent post, I pointed out that one of the problems with this conventional wisdom is how one defines “over time.” Depending on when you invest, how long you stay invested, and the time frame in which you need your money back, can have a dramatic impact on your actual results.

But the difficulties don’t end there…

The risk of Sequence of Returns

This problem relates to the “sequence” or the order in which a person receives his or her investment returns while withdrawing funds from a portfolio during retirement.

It is an enormous concern, though few people have any idea it exists.

It is both uncontrollable and unpredictable, and, depending on how it plays out, it can lead to a the early depletion of person’s retirement fund.

Here’s how it works.

Consider the following three numbers:

-13, 7, 27

Add them up and you get 21.

Divide 21 by 3 and you get an average of 7.

This is called an “arithmetic average.” Similarly, the oft quoted “7% inflation adjusted rate of return including dividends on stocks over time” is an arithmetic average.

You can add the three numbers above in any “sequence” you like and you’ll still get a total of 21 and an average of 7.

-13 + 27 + 7 = 21. (21 divided by 3 = 7)
7 + -13 + 27 = 21. (21 divided by 3 = 7)
27 + 7 + -13 = 21. (21 divided by 3 = 7)

But, here’s the rub…

The order in which those numbers appear as “returns” in a person’s portfolio can have a major impact on how long his or her portfolio lasts during retirement.

Let’s take the same three numbers: -13%, 7%, 27%, and apply them in different orders as rates of return on a portfolio that is funding systematic withdrawals – just as would be the case for someone funding his or her retirement.

  • We’ll start with a $100 nest-egg and take $10 out of the portfolio each year to pay bills.
  • We’ll run two sequences, both with 7% average returns
  • The only difference between the two scenarios is the sequence or the order in which the returns are achieved.

In Sequence One, the order of returns will be: -13% in year one, 7% in year two, and 27% in year three. The returns will continuously repeat for a running average return of 7%.

In Sequence Two, the order of returns will be: 27% in year one, 7% in year two, and -13% in year three. The returns will continuously repeat for a running average return of 7%.

Let’s see what happens…

Sequence #1

Sequence Number 2

Sequence Two ends up yielding 44% more income than Sequence One (i.e. $168.37 versus $116.81) and lasts five years longer.

This happens with exactly the same $100 nest egg, exactly the same rate of withdrawal, and exactly the same long-term average rate of return.

The only difference is the unpredictable and uncontrollable sequence of returns.

These examples show that a difference in the order of returns – notably, more negatives in the early years just before or just after retirement begins – can have a dramatic impact on how long a person’s retirement money will ultimately last.

Click to learn more about how to overcome the risk of sequence of returns and guarantee you never run out of income in the future – regardless of how long you live or what the markets do.

So, what do you think?

  • Have you ever heard of the risk of “sequence of returns” before?
  • With tens of millions of people in 401(k) type plans that may be affected by this concern, why don’t we hear more people talking about it?
  • Does the example above illustrate the concept clearly enough?
  • What other issues does becoming aware of this risk bring to mind? (I’ll tell you one – women are the most at risk because they live substantially longer than men…)

Email me your thoughts or comment below.