The Market Can Stay Irrationally Longer Than You Can Stay Solvent

It was John Keynes, the influential British economist, who once said 'the market can stay irrational longer than you can stay solvent', and it's an observation that is equally true in the present day. So what does this phrase actually mean?

Well in stock market terms it basically refers to the fact that the markets are not always rational and therefore there are times when the market undervalues companies and overvalues companies. It is for this reason that you are sometimes able to pick up bargains on the stock market and sell short companies that are clearly overvalued. You will often find that in bear markets nearly all companies will see falls in their share prices, even top quality profit-enhancing companies which creates good opportunities to pick up some bargains.

However what John Keynes was saying was that these irrational markets, which do not accurately reflect the true values of companies, can stay irrational for long periods of time. Whilst value will usually win out eventually, in the shorter term they could fall even further in a bear market and vice versa in a bull market.

Therefore if you are looking for short-term profits by finding undervalued companies to invest in in a bear market, or overvalued shorting candidates in a bull market, you may well lose money if the markets stay irrational in the foreseeable future.

In this day and age when there are lots of short-term methods of trading such as spread-betting and options trading this idea that the markets can stay irrational longer than you can stay solvent is as true now as it's ever been, particularly if you are trading on margin. Therefore if you are a short-term trader looking for contrarian trades in bullish or bearish markets, you have to take steps to protect your capital. This means using tight stop losses and either taking your profits while they are there or letting your winning trades run.

If you are an investor this isn't so much an issue. However you should still invest wisely. In this current climate there are a lot of bargains out there but it's important that you take a long-term view of the markets and only invest in quality companies that ideally pay dividends and are well placed to grow their profits in the coming years. You don't need to throw your money into the markets either. A better approach is to drip-feed your money into these quality companies when the opportunity presents itself.

The point is though that the market can indeed stay irrational longer than you can stay solvent and you should always bear this in mind when investing in shares, and certainly if you are trading on a short-term basis using leverage.

By James Woolley