The probability of ruin of unhedged stock market investments is always greater than zero. This implies that in a sufficiently long interval of time, any unhedged investment in the stock market will be ruined. Therefore, unhedged investments in stocks are motivated by greed and wishful thinking as investors hope that that will sell for profit before the uncle point. Recent history proves this is not the case.
I will start with a very brief introduction of what stock markets are supposed to be and what they actually are.
I college you learn that the stock market is where companies raise cheap capital in exchange for ownership in the company. However, there are several other ways this can be done, including private agreements, debt financing, etc. A stock market is not required for the financing of companies, especially when interest rates are low or close to zero.
In reality, the stock market is a betting game designed to benefit intermediaries at the expense of retail participants. Although it is true that companies can find cheap financing in stock markets, this is an excuse for setting up this betting game in which brokers make risk-free commissions while every transaction starts always with a loss equal to commission charged.
More importantly, stock market investing can turn into a negative-sum game when there is high turnover. In negative-sum games, a loss is guaranteed over sufficient time since there is a constant outflow of capital due to various costs, such as commissions, taxes, operational cost, broker charges, adviser fees, etc.
If the above are true, why do people invest in the stock market? This is an issue of mass psychology and how it is modulated by the mass media. The media works closely with the betting game operators because this is where advertising revenue comes from. It is to the best interest of the media to convince its audience that investing in the stock market is a profitable endeavor. Usually, when the sell side wants to get out, the media creates hype about investing in the stock market and when the sell side wants to go in, the media turns to gloom and doom to scare people out. The sell side are the big investment banks that manage portfolios for very wealthy but also extremely greedy clients. The sell side needs people to sell and offer liquidity when markets are about to rise and people to buy when markets are about to plunge. In this way their rich and greedy customers make more and they make fortunes in fees. How else could they pay millions in bonuses? These monies have to come out of someone’s pocket. It is always the pocket of the retail market participant. Add all the bonuses and salaries investment bankers have made in the last 45 years during flat or falling markets and you will get a ballpark figure of how much money retail has lost.
Unhedged retail portfolios will be ruined but even if one succeeds to explain why, the retail investor will continue buying stocks because of cognitive biases at work. The media succeeds in persuading the public that if they do not invest in the stock market they are missing big because of moves in stocks of corporations such as Amazon, Microsoft, Apple and Tesla, to name a few. Apparently, the media always remembers the stocks that did well and rarely those that did not. Recently, the media has also convinced the public that central banks will always provide a hedge, in the form of a put option and they will never lose any money. This was done because memories of the last two bear stock markets with declines of close to 50% are still fresh in the minds of retail investors. In other words, the betting game is carefully played to suck in the largest number of retail participants so that profits of operators are maximized.
Why ruin of an investment in the stock market is inevitable
As Nassim Taleb beautifully explained in a recent interview in Bloomberg TV, the probability of the market expectation is not the same as the probability of a retail investor expectation. Over the longer-term, the market appears to go up, as the chart of the S&P 500 below shows:
Since 1974, the annualized return from investing in large capitalization US stocks has been about 6.6% after adjusted for inflation using the CPI (Consumer Price Index.) In reality it is lower because the S&P 500 index involves rebalancing. But this is the story what the media and academic publications sell to the public. However, ruin of individual investors can occur at any time because at some point they feel they can no longer recover or must reduce position. This has occurred three times since 1974, as shown in the table below:
|Year||Loss from a 60 month high||1-year max loss||2-year max loss|
The 2-year max loss is especially problematic for retail investors. Losses greater than 30% are difficult to handle for people above a certain age, usually 50 to 60. Reducing position due to fear equates to uncle point and ruin and money lost will never be recovered. This is what the media and the operators of the stock market betting game will never discuss. Instead, they are offering hopes of everlasting intervention by the central bank to support the market. But what can go wrong?
What could cause stock market investment ruin?
Any random and unexpected event that impacts investor psychology and confidence in the future state of the economy can cause ruin; for example, an unexpected geopolitical conflict or a financial crisis, such as the one that occurred in 2008. These events cannot be predicted and although their probability is small, it is still finite. If the probability of ruin is finite, ruin will occur at some point. Hedging is necessary but very expensive. Hedging is a form of insurance and a premium must be paid, usually on a quarterly basis. If the cost of insurance is added, stock market gains become less attractive that those from investing in treasury bonds.
The stock market is a betting game similar to a casino. The probability of the expectation of the casino operator is known and it is close to one but the probability of the expectation of any one individual investor is not known. Risk is inevitable if an investor stays invested for a sufficiently long interval of time. Therefore, investing in the market is a gamble motivated by greed and wishful thinking.
In the last 46 years there have been already three periods with losses in the stock market above those that usually retail investors can withstand without getting out or reducing exposure, what is effectively considered ruin.
Hedging risk is expansive and reduces returns significantly. It is also something that cannot be done effectively by retail investors but requires paying additional fee to a professional adviser.
Disclaimer: The article reflects the opinions of the author and all information in it is general and impersonal and does not constitute investment advice.