Chapter 1 concluded with a graph of the S&P 1500 Index covering the eleven-year bull market. Figure 16.1 is that same graph but extended through September 10, 2021, to now include the 2009 and 2020 bull markets. From the low, March 9, 2009, through September 2, 2021, the index gained 765.42%, meaning $1.00 would have grown to $8.65. In the early stages, $1.00 would have doubled to $2.00. Then the $2.00 would have doubled again to $4.00. Then the $4.00 would have doubled again, plus a little extra. The annualized return was 18.9% over that twelve-year and five-month period.

The ascent is so steep, it makes many of the setbacks and dips along the way appear minor. On the left side, the two European debt crises in 2010 and 2011 don't look as scary as they felt at the time. The sideways volatility of 2015 and early 2016 now appears to be a simple pause. Even the volatility event of late 2018 appears to be just an unpleasant interruption. Based on this figure, it looks like it should have been obvious and easy to invest $1.00 in early March 2009 and turn it into $8.65 in twelve years and five months. It was, as the expression goes, there for the taking. Easy money, but many investors missed it.

In earlier chapters we looked at specific situations that kept some investors out of the market. Some thought inflation was coming back and that interest rates would increase. Some thought unemployment was not dropping fast enough. Some thought stocks were expensive based on a P/E ratio. Some were disappointed with the imperfect nature of the economy, never quite kicking into robust expansion mode. Those were all situational, but what if a primary reason many investors missed the bull market is just due to the quirky way humans reason and evaluate things?

Perceived Uncertainty

In 2003, I did a presentation for financial advisors with Lincoln Investment Planning and their investors. Lincoln called it their South Jersey office, which housed a very good group of advisors. The presentation was making a bullish case for stocks, a correct position as the stock market moved higher the next four years. The audience, however, was worried about the war in Iraq and the questions from investors conveyed that they were uncomfortable with the uncertainty surrounding the war. Then a lady raised her hand and stood up and—scolded is too strong of a word—told the audience a thing or two. “I was a little girl when Pearl Harbor was attacked. That was uncertainty. This is nothing.” Nobody could disagree with her. That was the greatest audience participation I have ever seen.

There is always uncertainty. We live in a random world with random news. People act like there is uncertainty today but there wasn't uncertainty a decade ago or two decades ago. Sure there was. There was uncertainty in the 1990s, 1980s, 1970s, 1960s, and so on. There was always uncertainty but perhaps some investors thought it was unique to 2009 through 2021.

Gains versus Losses

Psychologists gave us a theory that the pain of losing one dollar is greater than the joy of making a dollar. They tried testing this by using volunteer paid college students, but the results were never convincing because the games they played appeared fabricated. Then they turned to the professional golf tour loaded with a lot of statistics and data. They found that professional golfers were more likely to make a par putt (to avoid bogey) than a birdie putt from similar distances. They reasoned that the bad feelings of getting a bogey and losing a shot to par and the field of players was greater than the perceived good feelings of getting a birdie and gaining a stroke on par. They took this as support for the theory of feelings regarding gains and losses.

Applying that logic to investors and the bull markets, maybe some missed the bull market because they reasoned the benefit of making a dollar wasn't worth the risk of the greater pain of losing a dollar. Where they might have gone wrong was in assigning odds to the two events. Not recognizing that we were in two bull markets, they might have thought the odds of gaining or losing a dollar were equal at 50/50. If instead, they could have looked into the future and envisioned Figure 16.1, they would have realized the odds of losing a dollar were much lower than 50/50. In Chapter 1, it was shown that going back to 1926, the S&P 500 Index produces positive returns 74% of the years. It is fine to be human and feel that the pain of losing is greater than the joy of gaining; investors just need to get the odds of those two outcomes correct.

Type 1, Type 2

The side of Table 16.1 shows that an investor can either buy or not buy a stock or mutual fund. Along the top, that asset can either go up or go down in value. In the upper left, if an investor bought it and it went up, the decision was correct. In the lower right, if the investor did not buy it and it went down, that decision was correct. To borrow from statisticians, there are two types of errors: type 1 and type 2. The lower left box shows the type 1 error because the investor did not buy the asset and it went up in value. A lost opportunity. The upper right shows the type 2 error because the investor bought the asset and it went down in value. Lost money. Which error is worse? You would think it is obvious that losing money is worse than missing an opportunity, but sometimes investor behavior appears differently.

In the late 1990s, with many baby boomers in their forties, investors clearly behaved as though they could not stand missing an opportunity. Neighbors and coworkers were bragging about doubling their money on some dot.com tech stock. Investors wanted to participate and keep up. Also recall from Chapter 1, it was a time of high investor confidence as measured by Barron’s Confidence Index. So, determined to not make a type 1 error and miss an opportunity, they ultimately ended up making the type 2 error and losing money when the tech bubble burst.

Fast-forward to the 2009 and 2020 bull markets and it is completely opposite. Baby boomers were in or approaching their sixties, and with Barron's Confidence Index very low, investors clearly behaved as though the type 2 error, or losing money, was the worse error and must be avoided. As a result, determined not to make the type 2 error, they made the type 1 error and missed a great opportunity. We propose that if an investor is overly determined to not make one type of error, they will ultimately make the other.

Here is a tangible example of being overly focused on avoiding one type of error but committing the other type. I was raised in northeast Ohio, moved to Colorado in 1979, and brought my beginner-level skiing ability with me. In Colorado, I progressed to where I could handle the intermediate slopes (never did like the darn moguls). I went skiing one day. I skied aggressively all morning, had fun, and didn't fall once. At noon I went back to the car to get my new Canon single lens reflex camera. In a backpack, I took it to the top of the mountain to take some photos. After taking some pictures, I put the camera in the backpack and started to ski down the slopes. Unlike in the morning when I skied aggressively to have fun, my primary objective was to avoid falling and damaging the camera. I fell five times. Investors who invested to make money did a lot better in the two bull markets than investors who invested to not lose money.

Half Empty–Partly Cloudy

We can all see the impressive market gains in Figure 16.1. Living through it, we all saw the same news events and economic data, but we didn't all interpret events and situations the same way. There is a group that sees the glass as half empty and the day as partly cloudy. They earned lower returns than investors who see the glass as half full and the day as partly sunny. The half-empty people, you know who they are, but you can't tell them that they view the glass as half empty. They think they see the world just right. They thought inflation was coming back and interest rates would increase. They thought the low interest rates were phony and fabricated. They thought unemployment wasn't dropping fast enough and that the consumer would quit spending. They analyzed and analyzed and just came to conclusions that bothered them. And the market just kept moving higher. We have concluded, those who can, do. Those who can't, analyze.

When Will It End?

Similar to bull markets and rallies, peaks and the subsequent bear markets don't issue invitations either. They are just as disguised. Here are the behaviors and conditions often seen at market peaks, although all of them don't appear at every peak. The news will be good and expected to get even better. Investor sentiment will be very bullish. In our valuation system, the leading stocks will be overpriced and the underpriced stocks will not be moving or participating in the final advance. We might guess that the promoters of alternatives and volatility reduction products over the last twelve years will turn about and promote all long and even levered long products. The Fed might be tightening and taking the Federal Funds rate above the inflation rate. Investors, however, will be focused on earnings and the healthy economy and will ignore the Fed. Finally, the big clue will be when your “glass is half empty, the day is partly cloudy” friend throws in the towel and gets more equity exposure.