When financial markets reach historical highs, it is human to think twice before investing, or even considering selling everything to take a profit. Our poorly wired brain persuades us that it will not go higher and that a drop is more than likely. Our intuitions are, however, misleading.
Our brain does not always comprehend statistics very well. Imagine you are playing heads or tails. You start by doing 10 tails in a row. Such a series is so rare that you would be tempted to bet on heads for the next flip. Yet, for your 11th toss, there is still only a 50% chance of falling on heads; statistically previous results do not affect the probabilities of the next toss.
Financial markets respond to the same statistical principle. Although counter-intuitive, the fact that prices have climbed over a prolonged period does not in any way prevent them to continue climbing. From an empirical point of view, the historical performance of the world's oldest index, the Dow Jones Industrial, seems to confirm the theory. Here is what we observe.
We tend to consider reaching a historically high level as a rare event, which materializes only once every decade. Yet, over the past 117 years, the Dow Jones index closed at its highest level every 7 months, 15% of the time. Historical tops are thus relatively frequent financial events.
In 68% of the cases, after reaching historic levels, the Dow Jones continued to climb to a higher level a year later. The investor daring to invest at each historical level would have yielded an average return of 7.5% per year. In a way, a top constitutes a market opportunity for the investor who manages to control his emotions and cognitive bias.
A top is defined as the highest part of a set. This notion applied to financial markets therefore presupposes the existence of a glass ceiling that could not be broken. Yet this perception, close to the notion of a mountain chain, is erroneous. Driven by population growth, inflation and increased productivity, financial markets, unlike trees, are meant to go up to heaven over the long term.
Note: This article was written when Easyvest was authorized and regulated by the FSMA as an agent in banking and investment services.