Genuine ignorance is . . . profitable because it is likely to be accompanied by humility, curiosity and open-mindedness; whereas the ability to repeat catch-phrases, cant terms, familiar propositions, gives the conceit of learning and coats the mind with varnish waterproof to new ideas.

~ John Dewey

Update: This article was included in the Carnival of Financial Planning #145 posted at The Skilled Investor. Thanks!

Today’s Friday Food for Thought is a little different from past editions. Most of the articles I’ve highlighted so far have been those that I’ve found inspiring or otherwise agreed with. Today I’m writing about an article where I found myself completely disagreeing with almost every line.

I chose to highlight this article, not to criticize the author or those who would agree with him, but just to show that there’s another side to every opinion. Just because something is written in a fairly mainstream medium and expressed in an authoritative manner replete with “familiar propositions”, that doesn’t mean we should accept it as fact.

I also chose this article because these same arguments are trotted out by the ostrich crowd every time the market takes a dip. I just wanted to point out some of the questionable logic in these clichéd contentions, which you will probably recognize from things your advisor has said to you, from investment industry publications, and from many other forms of media.

The article in question was entitled Emotion Isn’t Something to Fear, But to Exploit. It was published on May 22, 2010 on the Globe Advisor website. At the time, the markets were already a few weeks into what has become a pretty volatile correction. The gist of the article was that downdrafts in the market are no time to panic. Rather, we should use the emotional reactions of other investors as a buying opportunity.

Let me just say that I kind of agree with the general idea that buying low and selling high is a good strategy. But anyone who has ever tried to do it knows that it’s a lot harder than the author would have us believe. My disagreement with this article lies mostly in the rationale presented to support the argument. Let’s take it one point at a time:

Ignorance Is Profitable? Really?

The article begins, as many of this type do, by brushing aside some of the major factors that may have lead to the stock market slide, stating that many of them “make no sense, are half-baked guesses, or are (at best) incomplete.” The factors in question included worries about the spread of the European debt crisis, violence in Thailand, fears about financial regulation, and Germany’s sudden ban on naked short-selling.

I had a hard time finding any of those ideas either irrelevant or half-baked. Unlike the author, and (according to him), most individual investors, I do care about Portugal’s debt to GDP ratio, I do have a clue about what a credit default swap is, and I am distinctly not under the impression that ‘”naked” is something you get with your spouse, not with your portfolio’. This is the same kind of patronizing and dismissive commentary we heard daily as the subprime mortgage meltdown began. Here’s a taste courtesy of a recent article at Credit Writedowns:

“. . . market reactions are widely out of proportion to the real problems. . . recent events are a disturbing comment on the power of fear. . . brave people will make a fortune buying in these days, and then we’ll all wonder what the scare was about.”

The  commentary above, written by a well-known expert, appeared in the Sunday New York Times on August 12, 2007. The S&P 500 had closed out that week at 1453. Indeed, it rose to 1576 in October of 2007, but then began its steep decline to 666 in March of 2009. The massive bounce off of that low reached about 1220 this April before heading downward again. Apparently, ignorance isn’t always bliss.

Emotional Investing vs. Ostrich Investing: Which Is Worse?

The author of the Globe Advisor article goes on to posit that when investors sell into a market like this, they are selling “for one reason: because stocks are going down. It’s emotion that’s driving them, not reason.” I would argue that there’s another reason investors might sell: They don’t want to lose money. That seems pretty reasonable to me. Is it more reasonable to take some money off the table when you see trouble coming, or to sit it out and lose more money?

Investors who trim positions when stocks have run a long way and real economic problems are at the doorstep have money to invest when the storm passes. Those who pretend there is no storm may be unprepared for it and more than a little disappointed with the results. Stocks can and do fall for long periods of time. That hasn’t been the case in North America for quite some time, but is that a reason to assume it won’t happen? If anything, the law of mean reversion argues the opposite.

Why These Tactics Work

These “don’t let emotions drive your investing” pep talks are delivered by advisors everywhere everyday, and more so when markets decline. We are told that every market decline is the result of some over-emotional, cowardly cabal that is spooked at the slightest sign of trouble. Are you going to be one of those girlie investors? I think not. This is the type of market machismo that can lead to serious capital losses. The killer is, these arguments work. We listen. Why?

• We Don’t Want to Look Stupid: Many of us perceive others to have greater knowledge than we do, and we accept what they have to say at face value. Worse, we buy into the intimidation tactics that hint that we are being over-emotional or just plain stupid for wanting to preserve our own capital. Remember: Your advisor will be paid whether your portfolio gains 40% or loses 40%. A better strategy might be to trust but verify.
• You Don’t Need to Worry: This is one of the messages inherent in the ostrich approach. It’s something we like to hear, so we tend to go along with it.
• You Don’t Need to Do Anything: You mean I can just leave my money where it is and the market will take care of everything for me? Great! Where do I sign up? How many advisors or financial writers would be willing to guarantee your capital for you under these assumptions?

Every Dip Is a Buy and Down Markets are Irrational

These types of advisor-friendly articles can usually be counted on to back up some of their claims with quotes from market sages like Ben Graham and Warren Buffet. Our author doesn’t disappoint: ‘”The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.”‘ That’s from Ben Graham, so it must be true, right?

What about the fact that markets sometimes make molehills out of mountains, downplaying major threats to your money? I’m thinking about Nasdaq in 2000, subprime in 2007 and CDS and sovereign debt in 2010. What about the idea that markets can become very irrational on the upside as well?

The author goes on to submit that Graham’s message is that the “best way to make money in the stock market over the long run is to (mostly) ignore the stock market” but admits that Graham “didn’t quite put it [in] those words.” Next comes the obligatory swipe at technical analysis. And apparently, the toxic mass of credit default swaps (which does in fact have the potential to sink the global economy) are no concern of ours.

Rather, says the author, we need to focus on buying good businesses at compelling valuations. That’s one argument I can buy. But again, the route he takes to get there is somewhat spurious. “If Johnson & Johnson . . . were a private company, would it be worth $15 billion less than it was a month ago? Clearly not. But as a public company, it has shed about that much in market capitalization as Europe’s crisis gained steam.”

OK. I agree that J&J is a great company that you might want to buy on a pullback. But I don’t think it’s irrational for the market to lop off a chunk of market cap under the current conditions. What if the market is simply pricing in the real risk to corporate earnings that the sovereign debt crisis and a potential blow-up in the credit default swap market represent? That seems pretty rational.

If you do choose to buy, where will you buy? If it’s down 10% right now as a result of those wimpy sellers, maybe today is the right time. But what if it falls another 10%? Buy more, you say. What if it falls another 10%? Inconceivable. So was the S&P 500 at 666. What if it’s not inconceivable?

My point is simply that you need an allocation strategy and a sell discipline that limits your risk. Although I don’t agree with the current Keynesian approach to the economic crisis, two quotes from John Meynard Keynes seem appropriate here:

1. “Markets can remain irrational longer than you can remain solvent.”
2. “The long run is a misleading guide to current affairs. In the long run we’re all dead.”

The problems in the financial system are real. Pretending they don’t exist is a great way to lose money. What’s your opinion?