Money Turns Us Into Idiots

Telling results from a Powerball frenzy... The world of behavioral finance... Money turns us into idiots... Overcoming loss aversion... A simple test for deciding whether to hold or sell your stocks... A dismal forecast for stock returns... The urgent 'wake-up' call you can't afford to miss...

Editor's note: Last Wednesday, we mentioned a must-see event happening this week...

In short, our colleague Dr. David "Doc" Eifrig will host a retirement "wake-up call" this Wednesday, June 23, at 10 a.m. Eastern time. The event is designed to help anyone in... close to... or simply dreaming of retirement – which is mostly everyone, we hope.

You see, the next big crash could wipe out everything you've spent a lifetime building. But you don't need to be a victim... Doc wants to help as many folks as possible protect – and hopefully, keep growing – their nest eggs no matter what happens moving forward.

So again, we invite you to join us this Wednesday... It won't cost you a penny to hear what Doc has to say. We only ask that you save your spot ahead of time right here. (And as soon as you do, Doc will send you a free signup bonus to help you get ready for the big event.)

And with the wake-up call in mind, we're turning the Digest over to Doc and his team...

Today, you'll hear from analyst Jeff Havenstein about the world of behavioral finance – and what you can do to overcome certain common investing traps. And then, in tomorrow's Digest, Doc himself will join us to talk about "doublespeak" from CEOs of public companies, what they're saying today, and why you should make sure your portfolio is ready right now.

We'll begin with Jeff's thoughts...

Back in 2017, the Powerball jackpot climbed to $700 million – and a frenzy ensued...

With the lure of a life-changing sum of money, millions of people rushed out to buy tickets.

It was madness... The lottery dominated the news cycle, and it became the main topic of conversation around company water coolers across the country.

At the time, it was the second-largest lottery jackpot in U.S. history. And amid all the hysteria, financial website Business Insider ran an experiment...

A reporter stood at a lottery stand in New York City and offered to buy just-purchased tickets from people for up to double their face value. No strings attached.

Think about that for a second. The choice should've been simple... Heck yes, I'll take that deal.

Everyone who Business Insider approached knew the tickets would likely be worthless after the drawing (or at least not worth the grand prize). After all, the chances of winning the $700 million grand prize were more than one in 292 million.

If nothing else, those folks could've taken the money and bought twice as many lottery tickets, increasing their odds of winning.

But that's not what happened at all... Most folks decided not to take the offer.

Even though it was statistically a long shot to hit the jackpot, they held on to their tickets as if they had the winning numbers. Those folks didn't want to give up the chance – as infinitesimal as it was – of striking it rich.

If that sounds like irrational behavior, that's because it is... Something in our animal brains creates an attachment to the ticket. Once it's ours, we value it more.

The point is this... People make weird decisions when it comes to emotions and money.

It's not just the case with lottery tickets. The same is true of people holding stocks they should be selling, too... We get emotionally invested, and we don't always do the right thing.

This idea is less important now when the market is soaring and almost everything is up, up, up. But as I (Jeff Havenstein) will help you see in today's Digest, getting out of duds at the right time will become particularly critical over the next decade... when we're likely to see underwhelming returns in the stock market.

If you're older than 50, you can't afford 10 years of negative returns. And frankly, no one reading this essay wants to waste that much time when they're saving for retirement.

So I want to help you see how to avoid being an irrational investor and how to get out before your stocks fall. To do that, we must first dive into the world of behavioral finance...

I still remember one of the first things Doc did when I first joined his team at Stansberry Research...

He plopped a 706-page book – Behavioural Investing by James Montier – down on my desk.

"Better get started reading now," Doc said.

I'm so glad he did... The book explores the biases we face in our investing decisions. And more important, it details how to adopt an empirical-based approach instead.

To really understand why investors do the things they do, you need to understand behavioral finance. It helps explain why the market has mood swings – going from a state of panic one day to a state of euphoria the next.

I'll give you an example of why some investors act irrationally. And again, this behavior is a big reason why many investors find themselves in over their heads with losses...

Years ago, researchers at the London-based investment firm DrKW conducted an experiment...

In the study, DrKW asked 300 fund managers this question...

You are offered the following bet. On the toss of a fair coin, if you lose you must pay £100, what is the minimum amount that you need to win in order to make this bet attractive to you?

In a perfectly rational world, just £101 would make for a good bet (if you could make it repeatedly). This would give you an edge and a profit. And as a fund manager, that's all you can really ask for.

But the fund managers in the study wanted almost double that – an average of £190. They weren't willing to risk a loss unless the money was far in their favor.

As it turns out, people dislike losses about two times more than they enjoy gains.

This is known as "loss aversion." It's the idea that losses have a larger psychological impact than gains of the same size.

The majority of classical economic theories are based on the assumption that investors are rational...

And as we learned above, even the professionals who do this for a living can be irrational.

We've written in the Digest about what's been going on with the "meme stocks" recently. AMC Entertainment (AMC) – with $3 billion in losses over the past 12 months – is up almost 350% over the past month. And dying video-game retailer GameStop (GME) went wild again, too.

But there is little doubt that this entire episode will end badly at some point...

New traders, tired of hearing about other people's big gains, will get in on the action. But the music will stop eventually... And shortly after some poor souls buy, many of these stocks will drop by half – or worse. This sort of thing is unavoidable. It happens all the time.

The truth is, though, that money makes most of us act irrationally. Few of the Reddit traders bidding up these stocks actually want to own – or even understand – the underlying business of AMC or GameStop... They're just greedy to make a quick buck.

Money turns many of us into idiots. And it's not just with meme stocks. Consider this...

'If it could just get back to my buy price, I would sell and move on'...

Does that sound familiar?

The whole time you're holding, you've got your money tied up in a stock that the market has dumped. Meanwhile, other stocks are shooting up, and you're missing out.

Believe me... the dollars you could earn by "getting even" are no more valuable than the dollars you would earn by switching to a better stock.

The smart move is to cut your losses and move on. But many investors simply can't do that...

Emotions get the best of us. We dig in and say we're not losing money on this investment... and the loss ultimately gets worse.

A seminal study of 10,000 individual brokerage accounts by Terrance Odean of the University of California, Davis found that investors held losing stocks for a median of 124 days versus 102 days for winning stocks.

So it's not just you... It's everyone.

It's built into our brains. And it's extremely hard to let go.

Fortunately, the solution to overcoming loss aversion is simple...

Use stop losses. They take the emotions out of investing, forcing you to sell losers and move on to the next opportunity even though you may not want to. This easy-to-implement strategy will help you preserve your capital and live to fight another day.

Every investor should always have an exit plan in place when they make an investment. And great investors learn early on that losses are part of the game... No one is perfect.

Now, think back to the Powerball example for just a second...

Why is it that people valued the lottery ticket they just bought so much more than before they bought it? Well, it's because of something called the "endowment effect"...

This phenomenon – also known as "divestiture aversion" – occurs when we place a higher value on something simply because we own it.

Richard Thaler, an economist and behavioral scientist who won a Nobel Prize for his work in this field, loved to show this concept with coffee mugs.

He'd offer to sell folks a generic coffee mug with a university logo on it... The average price people would be willing to pay was $2.50. However, if he gave the mugs to people for free and then tried to buy them back... the mug holders would demand an average of $5.25.

Once it becomes "your" mug, it becomes a lot more valuable to you. We demand unreasonably high prices to sell things we own.

That's another reason why investors have a hard time letting go of stocks they own that are clearly losers. Because they own a particular stock, they feel that it's more valuable to them... despite what the market says.

Here's a simple solution...

Imagine that you could turn all of your stock holdings into cash right now... And then ask yourself if you would use the cash to buy the same stocks or would you buy something else?

If you would buy the same stocks, then it's a stock you want to keep holding. If you would buy another stock, then it's time to sell and move on. Your money is better allocated elsewhere.

It's simple, but people don't usually do it... This mental test will help you in the long run.

The last thing I want to talk about today is something called 'recency bias'...

Recency bias is when people give more importance to recent events compared with what happened further in the past. And if you let this bias infiltrate your decision-making process, you're in for a few rough years in the market...

Stocks have been on fire recently. Over the past six months, the benchmark S&P 500 Index is up 14%.

In fact, in just about any period you look at over the past decade, stocks have done well...

Any investor looking at this chart will think that the good times should keep rolling. After all, stocks have been up for the better part of a decade... why wouldn't that trend continue?

Even after one of the worst economic crashes of all-time last spring because of COVID-19, it only took the market about six months to recoup its losses. Take a look...

Because returns have been so extraordinary lately, our brains will trick us into thinking that these are the type of returns to expect over the next six months, 12 months, two years, even 10 years.

But even if the good times continue in the short to medium term, there's no way the market will continue to return 30% or 40% per year – like it has over the past year – forever.

You have to remember that the market goes in cycles. And of course, part of the cycle is when stocks don't do well.

I don't want to scare anyone, but returns for the next decade likely won't be good...

As you know, stocks are expensive today. On average, they trade for 32 times earnings. Historically, they've traded for about 17 times earnings.

In other words, stocks in general currently cost about double their long-term average.

That information alone is not a reason to sell everything and hoard your cash, of course. As we've seen, stocks can always get even more expensive...

If there's one thing you need to know about speculative markets, it's that they can run much higher and last much longer than you can ever imagine. I personally think the next few months of market returns are going to be fantastic.

But that's the short term. Over the long term – the next decade or so – there's going to be a crash. And there will likely be a slow, brutal recovery.

The chart below looks at the cyclically adjusted price-to-earnings ("CAPE") ratio in various years and the return of the market over the following decade.

The CAPE ratio takes the regular price-to-earnings ratio and smooths out earnings. The idea is that earnings are too low when things are bad and too high when things are good. Smoothing out earnings – then comparing them with current prices – gives a more accurate indication of whether stocks are cheap or expensive.

When the CAPE ratio is small, market returns over the following decade tend to be higher... and vice versa.

The CAPE ratio is currently at roughly 35. That's high... And it tells us that the next 10 years of investment returns likely aren't going to be good. Take a look at the historical chart...

This chart should make you nervous. Look at the current CAPE ratio (the dotted line) and picture where the dots would cluster at that level. It wouldn't be up near 10%... or even 5%. Based on history, as you can see in the chart, we should expect low – or even negative – annualized returns over the next decade.

I'm a bull over the short term. But you can see that the potential for high long-term returns in the market doesn't look great.

If you're a younger Digest reader with an investment horizon many decades from now, then this likely won't matter much to you. Just hold on for the ride... You'll recover. Remember, the market is cyclical... It won't stay down forever.

But if you're already retired or getting close to your retirement age, you probably can't afford to see a decade of flat or even negative returns in the stock market.

Should you turn to bonds for safety?

Not so fast...

Yields are incredibly low right now. In fact, bonds have the lowest interest rates they've had in centuries... For example, the 10-year U.S. Treasury only yields about 1.48% right now.

This means they're not going to provide much return for you.

There's also the real possibility of inflation. A bond pays a fixed amount of income, no matter what... So when inflation reduces the value of each dollar you're earning, streams from fixed incomes are worth less.

As a result, bonds' forward returns are as discouraging as stocks'... This isn't a great place for investors to turn to today, either.

In other words, we're at a dangerous crossroads right now.

When you add everything up, it's what Doc is calling a 'Retirement Crisis'...

It's a scary time to be retired or getting close to your retirement... No one wants to outlive their money because of poor investment returns. And no one wants to be forced back to work.

Because of that, Doc is hosting an urgent "wake-up call" this week...

On Wednesday morning, June 23, at 10 a.m. Eastern time, Doc and senior analyst Matt Weinschenk will sit down to discuss what's coming in the markets.

During the event, they'll address all your most pressing concerns about retirement – including what stocks could realistically return after a market crash, whether you should make changes to your 401(k) account, how to protect against inflation, and more.

Most important, Doc and Matt will detail exactly how you can prevent everything you've built from being wiped out. Best of all, this wake-up call is absolutely free to anyone who wants to attend... We only ask that you register in advance. Get started right here.

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In today's mailbag, more feedback on electric vehicles (EVs), stemming from Mike Barrett's Digest last week... and thoughts about our retirement "homework" assignment from last Thursday's Digest. Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"In ten years, all the car companies will be making EV's. There'll be a hundred million of them in America alone. What's going to happen when all these vehicles are hungry for electrical current, but the new sources of that juice are feeble windmills and solar panels?

"Are we setting the stage for one of the biggest eras of human misery since the dust bowl? Please tell me how I'm wrong." – Paid-up subscriber Jerry F.

"It seems to me that self-driving cars and trucks won't solve the problem of traffic congestion. What is needed is computer control of all vehicles to get the maximum use of existing roads and highways. We all see examples of traffic sitting waiting for the light to change from red to green, while nothing is moving through the intersection. Well-done computer control of traffic lights and vehicles could go far towards reducing congestion without making more real estate lost to new roads and highways, and widening existing ones. Just my thoughts for what they're worth." – Paid-up subscriber Bill N.

"I started working after college in 1950. There were many articles saying don't depend on Social Security as it may not be there. Articles were saying try to determine how much annual income you will need at retirement... then try to have a pot of money that generates your needed annual retirement income WITHOUT spending any principal! This way you cannot outlive it!

"My wife never worked as she was a homemaker taking care of our four children. I never made outstanding annual income... but every year we added money to our 'stock investment pot.' I am now 93 and our 40 years of stock investing have been thankfully outstanding. Like Warren Buffett says... trust the U.S. economy...

"We were 'buy & hold' great stocks investors... we went down with every market crash. With this system you leave a lot of principal to your children but you never worry about running out of money in retirement. With the help of Stansberry Research, for the first time I am ready for a market crash if it comes." – Paid-up subscriber Jim M.

Regards,

Jeff Havenstein
Baltimore, Maryland
June 21, 2021