[dropcap]N[/dropcap]ot even 12 years into this millennium, we have already had several new investing paradigms pop up. These include:
- Year 2000 – Cash flow no longer matters in the new-age economy.
- Year 2001 – Stocks will falter as we’ve never faced terrorists using technology against us.
- Year 2007 – Stocks will continue to surge as real estate could never decline nationally.
- Year 2008 – The financial system is in shambles – prepare for the great depression ahead. Capitalism is dead.
And in these latter months of 2011, many investors are again saying “this time it’s different.” Sovereign nations including the US are deep in debt and continuing to borrow. Indeed, we seem to have yet another new paradigm.
In hindsight, new trends look silly
Looking back with today’s hindsight, the four trends between 2000 – 2008 look downright silly. How could cash flow really not matter? It was patently absurd to value a company in the billions of dollars just because it had a “dot com” in its name. And, of course, real estate values can decline for years. Duh!But the current new paradigm that capitalism will fail because of our debt levels doesn’t seem quite as absurd. Maybe that’s because it has yet to play out so we can’t use hindsight to confidently predict its silliness.
New trends are behavioral based
Traditional economics is based upon the premise that human beings are primarily logical, and draw upon that logic when making decisions to maximize our wealth. Behavioral economics, on the other hand, disputes that premise with the conclusion that human beings are primarily emotional. Emotions make every one of us a loose cannon in our decision making at some point. Behavioral finance raises awareness of the predictably irrational behavior that consistently results in lowering our wealth.
In good times, we need to convince ourselves that it is reasonable to assume that more good times are to come. When we react from fear, we also need to convince ourselves our panic was logical. In reality, we all know that neither good times nor bad last forever.
The media’s role
New paradigms seem to be occurring at a faster level. I suspect that this is because of the increased role of the media. There are more financial and economic news shows now than ever before. Not to mention the instantaneous access we have via the web to follow the stock market and commentary, which does a brilliant job of predicting the past. Finally, social networking allows these new paradigms to spread faster than any virus.
Stick to the old paradigms
Nearly every new paradigm will eventually be proven to be wrong and, in hindsight, embarrassingly silly. And in the light of sanity returning, many investors will even deny they ever believed in them as they feel shame over how much money they lost. Bubbles based on new paradigms are not so easy to spot before they pop. The best warning sign is that anyone questioning the new paradigm is intensely criticized.
There are a few old paradigms that investors periodically pronounce dead-as-a-doornail, that actually persist and seem to work in the long run. Here are three:
- Stocks are risky but, over a long period of time, tend to provide attractive returns as compensation for taking a smart risk.
- Diversification can lower, but not eliminate, risk.
- Picking an asset allocation and sticking to it provides a higher return than following new paradigms.
There will be many new paradigms in your lifetime. So when you get that irresistible urge to follow one of them, let it pass. Consider Personal Capital to manage your finances for free.
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