Halloween is around the corner, as evidenced by the annual return of the “Pumpkin Spice Latte” at Starbucks and 5-pound bags of sweet stuff at the grocery store! That’s also a good time to stab through the heart and kill with a silver bullet all those scary senseless finance myths, truisms, and falsehoods. Every time I hear one of the phrases below I suffer a mini heart attack. I hope people would stop saying those.
1: “Cash on the Sidelines”
If there is a lot of cash on the sidelines, the theory goes, it’s money waiting to be deployed into the market, sending stock prices skyward. That’s a common theme you hear from the talking heads on TV. But it’s nonsense. It reveals a fundamental misunderstanding of how financial markets work. For every dollar a buyer deploys into the stock market, a seller has to take money out of the market. And that money will end up, you guessed it, on the sidelines.
The total stock market valuation does not go up because money flows into it (small exception: IPOs). Instead, folks who were previously not invested revise their valuation assumptions upward and now have to entice an existing stock owner to sell. The only way to do that is to offer a higher price. Thus, money previously sitting on the sidelines flowing into the market is not the cause for the market to go up, but a symptom. But it could also be a symptom of a falling market when existing owners ask for lower prices to entice the folks with money on the sidelines to buy.
Amazingly, even in the world of sports, this sideline analogy is somewhat asinine. For every player you bring in from the sideline, one of the current field players has to leave. You can never adjust the quantity of field player, you can only replace one player with another. If a diabolical death sounds too cruel it’s time we at least “sideline” this senseless phrase.
2: “Market Timing”
If index returns are not enough and active management is too costly, what is one to do? Market timing! Simply buy low and sell high. Geez, why didn’t I think of that before? Market timing is easy in hindsight but in real time it’s very hard for professional investors and retail investors alike. If the China devaluation last year had sunk the global economy it would have been very smart had you sold in late August. But that didn’t happen. Everybody who tried to time the market and sold at the bottom regretted that decision.
Timing the stock market is poison for us in the FIRE community. Especially in the accumulation phase, I have greatly benefited from not losing my nerves during the major market drops and rather pumping new money into the stock market while everybody else was selling. I would leave market timing to the experts (who, by the way, also get it wrong about half the time!) and just roll with the punches in the stock market. Read Burton Malkiel’s book (paid link) if you don’t believe me!
3: “You need an Emergency Fund”
Most of us in the FIRE community strive to save 25 years (years!) of expenses or more. That’s 300+ months of expenses, so we don’t believe that there is a need keep 3, 6, or even 8 months in cash/money market at essentially zero interest rate. We don’t want to repeat ourselves and simply refer to our previous posts:
4: “Buy the biggest home you can afford”
These are quite possibly the seven most dangerous words in personal finance. And, of course, the related “I will use my house to retire.” If you had done this around 2003 and were smart enough to sell your house in 2007, good for you. That rule might have worked as planned because the house probably appreciated much faster than the carrying cost of a large house. But that kind of calculation doesn’t normally work. That fancy bathroom or kitchen? It will look only so-so after five years, slightly outdated after 10 years and embarrassingly outdated after 20 years. So, be prepared to apply a 5% depreciation rate to the major components of the structure. And don’t forget to heat, cool and clean the place. It will be hard for the average expected home price appreciation to keep up with that cost.
5: “It’s a bubble”
We had the dot-com bubble in the early 2000s, the housing bubble in 2008/9. Now we have a new real estate bubble, a new equity bubble, a bond bubble, a credit bubble, a private equity bubble, and whatever the bubble of the week might be, according to the talking heads on TV and some bloggers on the web. Every time an asset class becomes more expensive than the historical norm, journalists and analysts are quick to use the B word. The only current bubble I see is the rampant overuse of the word “bubble” itself. True, equities and bonds are expensive but a bubble looks different. What distinguishes a bubble from a simply expensive market is that in the latter there are still potential and possible paths of outcomes that justify today’s valuations, while in the former there aren’t.
The path that justifies today’s valuations? If the central banks across the world return to normalcy along a very, very gradual path without sinking the economy, a continued oil price recovery, business investment bounces back, millennials move out of their parents’ basements and form households, inflation stays calm, etc. In that case, today’s valuations are fine. You may disagree with how likely this scenario may be, but at least there is a scenario with a probability greater than zero. Hence, today we’re likely not in a bubble. Tulips in Holland in the 1600s and pets.com in 2001 were certainly bubbles because there were no fathomable circumstances justifying prevailing valuations and it was just a question of time for the imbalance to collapse. But those occasions are extremely rare.
Honorable mention: “the company missed the earnings estimate”
This was pointed out by Andrew at Par Compounded in the comments section below. Love it. That phrase is totally nonsensical. It’s the other way around: the forecasters got it wrong. As Andrew put it, it’s like saying the weather missed the weather forecast.