In the battle between our emotional self and our rational self, there is no contest: Plunging share prices almost always unleash an all-too-human sense of terror in many clients. That leaves advisors with the unenviable task of trying to calm them and thereby save them from costly self-inflicted investment wounds.
How do you train investors to be less skittish about market declines, and instead see them as an opportunity? The key is to get clients to view stocks as having two prices: the price at which you can currently buy and sell — and the underlying fundamental value.
In his 1949 classic, The Intelligent Investor, Benjamin Graham tells the parable of the manic-depressive Mr. Market. “You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low,” Graham writes. “But the rest of the time, you will be wiser to form your own ideas of the value of your holdings.”
How can you help clients avoid being seduced and bullied by rising and falling share prices — and instead have their own idea of the market’s value? Consider these three strategies:
THINK LIKE A SHOPPER
You might start by encouraging clients to think like department store shoppers, who buy with gusto whenever there’s a sale. Many investors, of course, do just the opposite, rushing to sell when the stock market cuts its prices.
To be sure, the analogy isn’t perfect. When shares tumble, it’s usually because the quality of the “merchandise” has been called into question, perhaps because of political upheaval or slower economic growth. These problems are often temporary and tend to unnerve professional investors, who account for most of the market’s trading volume and whose paycheck depends on their performance in the next 12 months or so.
Your clients, by contrast, probably plan to hold their stocks for at least a decade and often far longer. Today’s worries will be long forgotten by the time they need to sell, and any short-term market decline should be viewed not as a cause for worry, but rather as a chance to buy at cheaper prices.
FOCUS ON YIELD
Behaving like a department store shopper is easier when you have a grip on what stocks are worth. That brings me to the second strategy: Get clients to think about how much in dividends and earnings they can buy with each dollar invested.
The S&P 500’s dividend yield is readily available. Lately, it’s been a tad above 2%. The S&P 500’s earnings yield is less frequently discussed, but it’s easy enough to calculate. Suppose the S&P 500’s price-earnings ratio is 20. To find the earnings yield, you simply divide 100 by 20, which would give you your answer: 5%. That tells you that, for every $100 invested, you buy yourself $5 of annual earnings.
Now, suppose stocks drop 30%, so the market’s P/E falls from 20 to 14. Due to that plunge in prices, every $100 invested buys $7 of earnings, rather than $5. If bond yields rose to 7% from 5%, clients would immediately grasp that bonds are now better value. By talking about the S&P 500’s earnings yield, you can frame the conversation with clients in the same way.
As with the shopping analogy, there is a potential glitch. If the S&P 500 did indeed fall 30%, it’s probably because the economy is slowing sharply, and this would probably depress corporate earnings in the short term. Indeed, that’s currently an issue for the U.S. market. The S&P 500’s trailing 12-month reported earnings peaked in September 2014 at $106 and have been slipping ever since. (This $106 is calculated so it’s comparable to the index value for the S&P 500, which has lately been bouncing between 1,900 and 2,100.) What to do? To sidestep the problem caused by weaker earnings, you could calculate the market’s earnings yield using those peak earnings.
Alternatively, you could figure out the S&P 500’s earnings yield using the Shiller P/E, named after Yale economics professor Robert Shiller. The Shiller P/E is based on average inflation-adjusted earnings for the past 10 years. Due to that averaging, the Shiller P/E is less sensitive to short-term dips in earnings. To find the current Shiller P/E, run an internet search for “Robert Shiller’s home page,” click on the online data tab and open the third link listed, the one with data on U.S. stock markets since 1871.
WALK THE LINE
Not sure your clients are ready for a discussion of earnings yields? Instead, you might ask them to imagine a line rising steadily at 6% a year. That 6% is my best guess for the long-run total return on stocks. I get there by combining the S&P 500’s 2% dividend yield with 4% annual growth in earnings per share. Meanwhile, I suspect inflation will run at around 2% a year.
If the S&P 500’s earnings per share do indeed climb 4% a year, share prices would also climb at 4% — provided the market’s P/E ratio stays the same. But the P/E almost certainly won’t stay the same. Instead, it’ll climb whenever investors grow ebullient and tumble when there’s panic in the air.
Whatever happens, you should encourage clients to focus on that 6%-a-year growth line and tell them to view short-term movements as deviations from that trend.
Just had a gangbuster year for stocks? Share prices will be above the 6%-a-year growth path, and you might caution clients that they are likely to suffer somewhat lower future returns as a consequence. Conversely, when share prices tumble, they’ll fall below the 6%-a-year growth path, and you can explain to clients that it’s reasonable to expect the market to do some catching up.
When will the catching up occur? That, alas, is a question you won’t be able to credibly answer for clients. Still, you will have them engaged in a far more productive conversation. Instead of simply telling clients “don’t panic,” you will have them focused on the market’s fundamental value and viewing plunging share prices as an opportunity, rather than as a ticket to the poorhouse.