Being a stock market investor is hard.
Every single day, a myriad of factors influences the ebb and flow of prices on the screen.
There’s unemployment data, inflation, GDP growth, trade imbalances, FX rates, yield curves, household debt levels – the list goes on ad infinitum.
And yes, that’s before we even get to the bigger macro variables like election outcomes, wars, and pandemics, all of which can annihilate market sentiment in a heartbeat.
It’s a real-time informational catastrophe. No surprise investors are confused, exasperated, and heading for the exits!
But the really fascinating bit about the stock market is that over the long run, none of the factors above matter.
That’s right. It all becomes a wash – because there are just three things that explain the vast majority (85%+) of stock market returns over extended time periods.
#1. Long-term economic growth
#2. The allocation of that growth to public market investors
#3. Risk aversion
We’ve covered #1 and #3 on this blog in the past but it’s worth doing a quick recap.
#1 is pretty easy. Economic growth is good.
It allows businesses to grow their earnings and increase the dividends they pay to investors.
There isn’t anything you can do about it other than trying to be a productive member of society and contributing to that economic growth.
#2 is also straightforward – and outside of your control.
As a public market investor, you only get to participate in the profits of publicly listed companies.
There are some hugely successful private companies out there but they are owned by financial sponsors or private individuals – so in the words of immortal Seinfeld:
C’est la vie.
Now, #3 is where things get interesting.
Risk aversion is basically an academic-sounding term for how investors feel about the market prospects at any given point in time.
One way to measure it is to look at valuation multiples, which I’ve also covered off in detail here.
The bottom line is that investors feel good, they pay more per dollar of expected future earnings.
When they don’t, they pay less – and you see that in the chart above, where the ratio declined from about 21x just a few months ago to about 17.6x today.
Now, there are two reasons risk aversion is fascinating.
The first reason is that based on the study I referenced above this factor determines a whopping 75%+ of ALL stock market fluctuations over time.
That’s right. When it comes to the stock market, short-term emotions are MUCH more important than long-term economic fundamentals.
(As an aside – it makes perfect sense. Long-term economic growth is relatively stable and would never drive the stock market volatility we are constantly experiencing).
The second reason risk aversion is fascinating is that it is the ONLY factor we get to control.
Yes, you read that correctly. You – and only you – control 75% of the returns you will ultimately experience over your investing lifetime.
So why the heck are most people just so damn bad at this?
There are multiple, yet related explanations for why investors succumb to herd behavior.
One reason is that humans are social creatures.
From an evolutionary perspective, that’s a blessing. But this aspect of our personality also makes it very hard to avoid doing whatever it is everyone else is doing, even if it’s taking out a second mortgage up to pile in on the next SPAC, GameStop, or the latest sh$tcoin.
Then there’s FOMO. There’s nothing more frustrating than watching people (many of them much dumber than you) getting obscenely rich practically overnight.
Finally, there’s chemistry. Making money gives us a dopamine hit – and we come back for more and more – until the tide turns.
In fact, this last bit may be the biggest obstacle of all. Put simply, if you enjoy making money – you will ABSOLUTELY HATE losing money.
There’s just no way around it. Our brains are designed in such a way that losses loom much larger than gains. Losing $100k in a downturn is always going to feel twice as bad as making $100k in a bull market.
Put another way, if making money makes you giddy, losing money will leave you downright depressed – with all the bad decisions that follow.
And so, the road to becoming a better investor doesn’t start with learning to nurse your losses.
Instead, it starts with emotionally detaching yourself from the gains, even when you are making money hand over fist.
The first step here is reducing the frequency of those net worth updates – and looking past the headline number when you do get around to it.
Running the spreadsheet every other week won’t help you reach FI any earlier. Once a quarter or every six months will do equally well.
When you do run the spreadsheet, don’t get too excited when you see that number ticking up during the next bull run.
Acknowledge your good luck, but also acknowledge that your luck may turn on you the following day. The number in the spreadsheet has nothing to do with your investing skills or your self-worth as an individual.
And then – get on with living your life. Let the stock market do its thing while you do yours.
Be as good as possible at your job. Maximize your compensation.
Try to grow the gap between income and expenses – but not at the expense of enjoying life. Have an investment plan that puts those savings to work.
Look after your health. Spend time with friends and family.
Not only you will come out far ahead of where you had started, but you will also have a much more pleasant journey.
As always, thank you for reading – and happy investing.
About Banker On Fire
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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
Find out more about me and this blog here.
If you are new to investing, here is a good place to start.
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