MarketWatch is one of the most widely read and influential sources of financial information in the world. Indeed, I consult the MarketWatch website several times per day because of the excellent news and commentary regularly provided.
It is precisely because I consider MarketWatch to be such a reputable provider of financial information that I was shocked when, on Friday afternoon, I saw the following headline as the lead story on the front page:
I believe that this may be the single most deceptive and dangerous financial headline I have ever seen published by such an influential provider of financial information.
This MarketWatch headline feeds into the anxiety that is being felt by many people that have not participated in the (mostly paper) gains generated by the most recent stock market rally. This anxiety has two interrelated sources. The first source of anxiety is simple greed. People become frustrated and jealous when they feel that they are "missing out" on stock market gains being achieved by others. The second origin of this anxiety is intellectual. The conventional wisdom - assiduously promoted by the investment industry - is that investors should be fully invested in stocks at all times. Investors that have deviated from this dogma are prone to feel insecure and even guilty.
Investment industry propaganda has successfully inculcated into the investment culture of the US the idea that every moment that a person does not own stocks (every single stock in existence, in fact), is a potential opportunity to enrich themselves that they are squandering.
Lottery promoters promote the exact same idea: Every lottery ticket that is not purchased (for every lottery in existence), represents an opportunity to win a lottery that is lost.
As the MarketWatch caption says, "those on the sidelines, as with the lottery, stand no chance."
It is important to understand what is wrong with this argument.
Seduced By The Lottery
It is, of course, trivially true that if you do not play the lottery, you cannot win the lottery.
But the question that intelligent people should be asking is not whether it is possible to win the lottery by playing the lottery, but whether it makes economic sense to play the lottery at all.
Whether or not you should "play" the lottery or the stock market is not a function of whether it is "possible" to win. Of course, it is possible to win. "Possibility" is not the issue; probability is.
From a strictly economic point of view the decision about whether or not you should play the lottery is a function of the expected return. Expected return is calculated by weighing the probabilities of gains and losses. If the value of the expected gain scenarios (multiplied their probabilities) exceeds the value of the expected loss scenarios, (multiplied by their probabilities) then playing the lottery makes economic sense.
As it turns out, playing the lottery is the textbook example of an activity that has a negative rate of expected return. People that play the lottery, on aggregate, will lose. This is guaranteed. Furthermore, in a true lottery, the probabilities of gains versus losses are perfectly distributed in an even and random fashion. There is no way for a person to "play" the lottery in such a way as to make the expected returns of buying a lottery tickets positive. The expected return of purchasing lottery tickets is always negative, no matter how many tickets are purchased, when where or why.
Therefore, from a strictly economic point of view, playing the lottery is utterly irrational.
Thus, economically speaking, contrary to what the MarketWatch headline implies, not playing the lottery is, in fact, the only way to "win."
Seduced By The Stock Market
A fundamental difference between the lottery and the stock market is that the expected return of playing the lottery is always negative whereas the expected return of investing in the stock market can be positive.
However, the expected returns of investing in the stock market - particularly relative to the expected returns from investments in bonds or cash instruments -- is not always positive, by any means.
For example, indices and index ETFs such as SPY, DIA and QQQ will have negative expected returns over given time-frames if valuations are extremely high and/or projected earnings growth rates are very low or negative. At those particular times in which expected returns are negative, buying stocks is no less economically irrational than purchasing lottery tickets, from an economic point of view.
That does not mean that money cannot be made in the stock market when expected returns are negative. Individuals can and do profit from investing in stocks even if the expected returns over a given timeframe are negative. The same is true of playing the lottery or playing slot machines. These latter two activities always have negative expected returns. Yet people can and do win money during given time frames playing the lottery and playing slot machines.
In fact, one of the main reasons that people play slot machines and play the lottery is that they graphically witness people collecting jackpots. People that witness this feel that by not playing, they are "missing out." Under these circumstances, people are emotionally very susceptible to the message: "If you don't play, you can't win." Spurred on by the greed impulse and the aforementioned flawed logical argument, people are lured into committing economically irrational acts - i.e. playing games of chance that have negative expected returns.
The exact same set of emotions and flawed arguments drive people to invest in stocks even when expected returns are negative. That is how investment bubbles are formed. In a bubble, people are not properly calibrating the probability of gains against the probability of losses. In a bubble, people are simply focused on one side of the equation (potential gains) and the fact that, "if you don't play, you can't win."
Stock market investing is economically irrational - in the same sense that playing the lottery is irrational - when the expected returns from investing are inferior to the returns offered by safer investments such as cash and bonds.
Indeed, I happen to believe that right now is one of those times when the expected returns on stocks are negative relative to the expected returns on cash instruments. I therefore believe that it is not presently wise to be heavily invested in stocks. This is an issue that I have addressed elsewhere, and I will not elaborate on it here because it is not the focus of this article.
My concern in this article is to refute the dangerous and irresponsible claims that people should invest in the stock market because "if you don't play, you can't win" and that "those on the sidelines, as in the lottery, stand no chance."
Propaganda that encourages people to always be invested in stocks is irresponsible.
Intelligent and mature individuals need to deprogram in their minds the "cult of equity" dogmas promoted by the investment industry and become keenly aware of the fact that there are times when, in order to achieve their investment goals, people need to refrain from investing in stocks.
Contrary to what the MarketWatch headline suggested, in order to win, investors need to learn when and how not to play in the stock market.
Specifically, during times when expected returns are low or negative compared to relatively safer investments such as cash and bonds, investors need to learn to attain the serenity that allows them to depart from the herd and contentedly leave fleeting stock market gains on the table.