Hey, it looks like the market is starting to bounce ba...nope, it's down again. Whenever your entire portfolio gets subjected to a brutal bear market take down, like the one we've witnessed in the past couple of weeks, it sometimes helps to look to the bright side.
Often that can be hard to find, especially when all you're seeing is red. Something Rady Asset Management CEO Harry Rady said in an interview with Breakout struck a chord with me. Rady, in comparing the recent market tumble with the plunge during the financial crisis, said,
In 2008 and 2009 I believe we lost a whole generation of investors, and those that we didn't lose, just got slaughtered again. So I think it's going to be tough sledding ahead.
One of the most basic principles in psychology is the concept of positive punishment. What the principle essentially states is that when an action is met with an unpleasant consequence, we become conditioned against that action in the future. In investing, this principle takes effect when investors lose huge sums of capital in the stock market during a market crash. Many such investors may swear off investing for good and take their money out of the market permanently.
Think about the investor who was long in big banks like U.S. Bancorp (NYSE:USB) and Wells Fargo (NYSE:WFC) during the financial crisis. He sees his capital get wiped out by more than half, decides eventually that enough is enough, pulls his remaining funds out, only to watch the market come roaring back in 2009. Would you blame him for cursing whoever first came up with the idea of a public offering and abandoning the market forever?
How does this benefit you, the investor who decides to stay in the game? Well, stocks obey the economic law of supply and demand just like anything else. If there are a fixed number of companies that are publicly traded, which are divided into a fixed number of shares of ownership, then the less investors there are bidding for those shares, the lower the prices. When we compare today's market valuations with stock prices in the days of Benjamin Graham, it becomes evident how much more expensive stocks are in modern times. This is in large part because the pool of investors in the market is so much bigger today than it was then.
When the number of investors in the market grows larger, it becomes proportionally harder to outperform. Even legendary investor Warren Buffett said that it's much harder for him to buy undervalued, quality companies today than it used to be, because there are so many more investors competing for the same stocks and they're all so much better educated. However, the flip side is also true: the less investors there are in the market, the easier it is to make money.
When one investor loses the stomach to stay in the market, it benefits all of his brethren who remain behind. Note that I'm not talking about bears and short sellers - those guys are sometimes the smartest people in the room. I'm talking about investors who write off the market permanently. The worse the market crash, the more the investor population is trimmed away, which has the macro effect of driving down stock prices for those that remain invested and increasing their potential returns. If you want to look for the silver lining in every market crash, there it is.
Dividend investors tend to benefit from this phenomenon a lot more than growth investors. When you buy a stock like Sirius XM (NASDAQ:SIRI), Netflix (NASDAQ:NFLX), or SodaStream (NASDAQ:SODA), you're not looking for the company to return profits to you, you're hoping to sell it to the next guy at a higher price. When there are less investors in the market buying and selling, it means you can bag the stock at a relative discount, but it also means it's more difficult to pass it off at a premium.
Dividend investors, on the other hand, can afford to be more cavalier when the market value of their portfolio drops, as long as the quarterly income they receive from it remains untouched. When you own a dividend champion like Altria (NYSE:MO), Annaly Capital Management (NYSE:NLY), or Kraft Foods (KFT), a reduction in market value always carries at least one benefit for you: driving up your yield. As such, dividend investors almost always benefit from a downsizing in the overall investor population. One may be the loneliest number, but dividend investors would have it no other way.