[Originally published on 8/8/2014]
The following chart was posted:
The chart was followed with commentary:
Retail investors have completely mistimed the market, yet again. According to the recent AAII Asset Allocation Survey by retail investors, cash levels in July dropped to the lowest level since 1999 at only 15.8%. Just as this was happening, European markets like DAX 30 have started a free fall of 10% in only a few weeks, while S&P 500 is also experiencing the strongest sell off in months. It seems to be that the same old theme of buying very high and later down the track, most likely panic selling into an upcoming low, will once again be occurring.
The blogger Tiho is correct, the data shows that retail investors held more cash when stocks were at their lowest point in the cycle. But I think some context needs to be added here. First, the idea that investors were wrong suffers from “hindsight bias.” We now know what the lowest point was in the market cycle, investors in the middle of crisis did not. In fact, for the first time since the Great Depression, ordinary people wondered if the United States was about to enter into a depression (some would argue we did) and that in a depression, cash is king.
Cash is king because of the flexibility it would allow the individual if the economy continued to fall and, more importantly, if the market continued to fall. If investors viewed holding stocks as an asymmetric risk, meaning the cost of missing out on a large gain didn’t hurt as much as losing an additional 50 – 80% of their assets, then they made a rational decision. Hindsight bias disturbs not only what could have happened, but how people should react to their potential future possibilities.
The following is a chart of the market environment between 1920 – 1940 and includes the crash of 1929 and the entire Great Depression:
Stocks fell 48% from their high in 1929. People who bought at that low were rewarded with a 48% gain fairly quickly when the market bounced back (though they needed a 108% gain to break-even). This is similar to what happened (though not as quickly) in 2009, but these investors didn’t actually turn out to be as lucky as our “totally wrong” 2009 investors, as the market then plunged over the next several years by 86%. People lucky enough to buy at that low were rewarded with a 94% increase (this truly was a good time to buy if you were a long term investor!). But that huge increase was met with another dramatic drop in 1933 of 37%. Investors were once again rewarded for buying at this point and holding on, experiencing an increase of nearly 300% – clearly anyone who had held cash was “totally wrong.” Actually, 1937 turned out to be the peak and prices proceeded to fall into the next year, costing investors 49%. By the end of 1939, stocks were still half what they were at the height of 1929 and 20% below the level at which stocks had fallen right after the first part of the 1929 crash (all of these numbers exclude inflation/deflation and the effect of dividends).
It was a wild ride and those retail investors in 1929 who held cash at the same point that retail investors held cash in 2009 didn’t turn out to be “totally wrong.” Those investors preserved cash and held on during a tough time in American history. Some retail investors in 2009 realized that the possibility existed that the tough times of the Great Depression may in fact reoccur and they weren’t willing to risk what could have been significant downside (as well as extreme volatility) with what money they had left. Perhaps the George Santayana quote stuck in their mind “those who cannot remember the past are doomed to repeat it.”
Maybe retail investors aren’t idiots and maybe they aren’t “totally wrong,” perhaps they had good reason to raise cash. We now know how history has turned out (at least so far), but it wasn’t so clear in the depths of 2008 and 2009.
This is not to say that retail investors (or any investor for that matter) should bail out of falling stock markets. It simply means that they should have a plan and know their tolerance for risk. Markets sometimes are great givers, but they can also be great takers and those who have now appeared to be “correct” for buying or sticking it out would have looked like fools during the Depression.
Bottom line – many investors have clearly made mistakes and having such low levels of cash right now is likely one of them, but we should be cognizant that the future holds many paths and just because some chose the path that turned out to be correct, it doesn’t mean it was obvious at the time or that the slightest change in the economic system wouldn’t have made that path “totally wrong.”