Stocks and Flannel Jammies

My wife has a great Christmas tradition. Every year she makes pajamas for our kids, the only present they open on Christmas Eve. She has done this for years and the fact that the kids are much older now (three are young adults living on their own) has not dampened her enthusiasm. Yesterday we were running errands and she said, "By the way, we have to go to the fabric store--flannel is 40 percent off and I have to buy it before the sale ends." I thought her statement was very interesting in light of a conversation I had with a gentleman the day before.

The gentleman asked my opinion about the market. He was particularly interested in whether or not he should sell some of his stocks since the market has been so bad this year. As most of my clients would expect, I had to check the vigor of my response. "Absolutely not!" I said. "This is a buying opportunity!"

The contrast between these two situations raises an interesting question: Why is it that we think a 40 percent drop in the price of flannel (or any other consumer good) is a good thing and a 15 percent drop in the price of stocks is a bad thing? The answer lies in the nature of the products. Consumer goods, by definition, are meant for consumption. We expect their value to go away as use them. But most people view assets like stocks as a store of value. We invest money in stocks with the expectation that our investment will grow. When it doesn't, we may become offended in our expectations causing us to lose confidence in the worth of the asset. As our confidence fades, our urge to sell the asset builds and we feel the urge to bail out, often at the exact worst time.

If we are going to be good investors, we need to remember the underlying premise of investing, i.e., that the economy rewards prudent risk-taking over time. Experience shows that economic activity ebbs and flows and the rewards to investors come in spurts. We need to discipline ourselves to take advantage of these ebbs and flows. Of course, we want to be discriminating buyers--not everything that falls in price is a bargain. By controlling our emotions, we allow ourselves to see the way things really are. And when we do, we begin to see the 15 percent fall in stock prices with the same eye to value that my wife had when she saw the 40 percent fall in the price of flannel.