It’s a strategy that’s worked well for investors from at least as far back as 11 September 2001. And now they seem to have decided that come what may, the stock market only goes one way in the long run – up.
Goldman Sachs, Greece, Portugal, Clegg-mania, the Chinese property bubble – investors don’t care. In fact, the more threats that can be thrown at the market, the better. Because then the bulls can point to the great big ‘wall of worry’ that the market has to scale.
And now, with such a huge rally behind us, combined with poor returns on cash, we’re reaching the point where investors are more scared of being out of the market than they are of being in the market.
The psychology behind this is easy to understand. But it’s also dangerous. Here’s why…
Why investors are racing to get back into the market
With inflation – in the UK at least – rapidly eating up any chance of a decent return on your savings, you might be tempted to pile everything you can into the market.
And there are still some attractive stocks out there. My colleague David Stevenson pointed to one cheap sector yesterday. We’ve also been keen on defensive stocks for a long time, and still are.
• one cheap sector
• Inflation beats expectations – yet again
• What’s a saver to do?
However, investors now seem to be at the stage where any sense of discernment is being abandoned in the race to get into the market. And there are well-trodden psychological reasons for this.
Research from academics such as Daniel Kahneman and Amos Tversky has shown that people fear losing money roughly twice as much as they enjoy winning it. And what this means, paradoxically, is that we’ll take bigger risks to avoid losing money than we will to gain it.
Kahneman and Tversky presented investors with a choice. Either you lose $500, or you flip a coin – heads, you lose $1,000; tails you lose nothing. The majority of people opted for the latter option. This is an oversimplification, but you get the drift (for a very readable primer on behavioural economics, I recommend James Montier’s Little Book of Behavioural Investing).
Inflation is rising
What’s all this got to do with the rising stock market? Well, just look at the latest inflation data. Britain’s consumer price index (CPI) inflation grew at an annual rate of 3.4% in March. Other than a spike up to 3.5% in January, that’s the highest inflation has been since late 2008. And Inflation beats expectations – yet again, all the other inflation measures are similarly high.
There are some pretty specific reasons for the rise. The high oil price; the weak pound; and the change in VAT. And it’s fair to say that each of these could be temporary. There are plenty of logical arguments supporting a potential slide back into disinflation. There’s no fundamental reason for the oil price to keep rising, or even remain at current levels. Sterling’s fortunes are tough to predict at the best of times, and the election makes it nigh on impossible. That VAT rise can probably be discounted.
And with unemployment high and the economy still wobbly, there’s no reason to expect a wage-price spiral to take off. It’s all pretty convincing.
Special FREE report from MoneyWeek magazine: When will house prices bottom out – and how will you know?
- Why UK property prices are going to fall 50%
- When it will be time to get back in and buy up half price property
And yet. When was the last time we had inflation surprising on the downside? The vast majority of ‘shocks’ in the past two years have been on the upside. And despite all the dire threats of deflation heard in 2008 and 2009, CPI inflation never actually went negative. In fact, it didn’t even fall below 1% – that’s the level at which Mervyn King has to write to the Chancellor to explain why prices aren’t rising fast enough.
So it’s no wonder that many savers find it hard to believe that prices will fall in the near future. And that leaves them facing precisely the choice in the above example. Either take a guaranteed loss on your savings account, or risk it on the stock market. Sure you might lose money, but you also have a genuine chance of making a return after inflation.
Stocks are no replacement for a savings account
The psychology is understandable. But it’s also dangerous. We like global defensive blue-chips here at MoneyWeek and we’ve been tipping them since the market bottomed back in March. We think that in a very uncertain time, these stocks will take whatever the economy can throw at them and survive while still paying you a half-decent income.
But we’re not going to pretend to you for a moment that these stocks – or any others – are a substitute for a savings account. Stocks can tank at short notice, regardless of how ‘safe’ they are. So you only invest your long-term savings in them. Don’t go punting next year’s school fees or the deposit for the home of your dreams in the market.
As my colleague Merryn Somerset Webb has pointed out recently (What’s a saver to do? ), it’s not a very satisfying answer, but if you’re talking about money you’ve earmarked for a short-term purpose, then you just have to find the best savings rate you can and hope that inflation does fall back.
How likely is that to happen? Well, we recently got some of the smartest pundits on either side of the inflation / deflation debate into the MoneyWeek office to argue the case for each. You can read the end result in the next issue of MoneyWeek magazine, out on Friday. (If you aren’t already a subscriber to MoneyWeek, subscribe to MoneyWeek magazine.)
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