Whoa! What’s All That Turmoil in China Doing to My Investments?

Wayne,

One of my friends noticed that the recent stock market turmoil in China had apparently caused her retirement investments to decline in value, and she wondered what she ought to do to protect her assets. Here’s my answer to her.

In capitalism, the value of assets (or anything else for that matter) is a psychological property. It exists in people’s minds and is not intrinsic to the assets themselves. You and your Dad noted the recent turmoil in Chinese stock markets that appeared to be influencing US, European, and Japanese markets and were concerned about the effects of this on your investments.

There are what are known as “fundamentals” of a stock or other asset, which are properties of the asset that most people agree have something important to do with the price at which most people would be willing to buy or sell that asset. As even these fundamentals only have significance in so far as people think that they do, they are also psychological properties. These are matters such as a history of growth or profits for a firm, and location, location, location for real estate.

As you know, psychological states are subject to many influences, rational and irrational, some of which may vary rapidly. Those people who engage in rapid trading in stocks to earn their money are trying to understand and anticipate not just changes in the fundamental properties of some stock or asset, but they are trying to anticipate changes in the psychological states of other investors.

That of course is notoriously difficult. John Maynard Keynes famously compared this type of investing to a beauty contest in which the judges didn’t have to choose which contestant was the most beautiful, but which contestant the other judges would think is the most beautiful.

Furthermore, a lot of the chatter that we see on TV at the gym, on Cramer’s show, for example, comes from investors who are trying to influence the psychological states of other investors. Someone buys gold or gold futures. That person now wants the price of gold to go up, and he doesn’t care if it goes up for good reasons or bad. If he can persuade enough investors that buying gold is a good idea, then the price will rise, and he can sell his gold for a profit. And the same goes for so-called short sellers, who profit if prices fall. Those guys, try to talk the price of an asset down, by criticizing the company, in the hope of inducing people to sell their shares. (A short seller sells shares at today’s price. But he doesn’t have to deliver those shares to the buyer for a couple of days. If the price of the shares falls the short seller buys the shares he has to deliver at the lower price in a couple of days, and keeps the difference between what he sold his borrowed shares for and what he paid to buy the shares he delivers. Or he may do this with futures, involving longer lead times.) A big time short seller wants to be invited on Bloomberg or Cramer or Faux Business to discuss the many flaws he sees in the firm whose shares he has just sold.

In the long run, however, all this buying and selling based upon fluctuating psychology tends to average out and prices of assets reflect the fundamentals and changes one way or another in those fundamentals. History shows that investing in a broad range of assets, stocks, real estate, and so on, is like investing in the fundamentals of the entire US economy. This is the reason why it makes sense to pay attention to economic turmoil in China and to the European nations’ incompetent economic management, in so far as this has to do with the long terms behavior of the fundamentals of the US economy. Paul Krugman’s op-ed column today about the Chinese stock market fluctuations and long term changes in the Chinese economy is an example of proper long term thinking. Here’s another assessment of the state and future of the Chinese economy. This is why many investment advisers and economists encourage people not to check the value of their investments every day, or even every week, or month. Every quarter or even every year is more like it.

Bernard

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