The Markets Can Remain Irrational Longer Than You Can Stay Solvent
It basically refers to the fact that in bull markets shares can race ahead of themselves and overvalue certain companies whilst in bear markets shares can fall substantially resulting in certain shares trading far below their realistic fair value. Indeed it is these scenarios that enables investors and traders to pick up bargains and sell short companies that are valued far too highly (in terms of market capitalization/profits or price/earnings ratios, for example).
These markets are said to be irrational because they do not accurately reflect true market valuations but what John Keynes is pointing out is that these irrational markets can stay irrational for a very long time. In other words, in relation to individual shares, just because a stock is massively oversold does not mean it cannot go even lower, and vice versa when the share price is overinflated.
In the long term prices will usually drift towards their true value but shorter term they may remain oversold or overbought for a very long time. Therefore this is worth bearing in mind particularly in the present day when so many people are involved in short-term trading through spread-betting and trading in futures and options where leverage is often used to trade larger positions on margin.
Irrational markets do not necessarily present great trading opportunities. If you're an investor you can drip-feed your money into good quality highly profitable companies in bear markets and not have to worry so much about short-term falls because you have a longer term view and are not trading on margin. However if you are a trader trading on margin you can very easily lose a lot of money, particularly if you are very highly leveraged.
Therefore it's important to protect your capital as much as possible. This means using a tight stop loss and either taking your profits when they are there or letting your winning trades run for as long as possible.
You will often hear this famous quotation about the markets remaining irrational longer than you can stay solvent because it's completely true. You often get irrational markets when there's a strong bull or bear market so it's well worth bearing in mind during this present economic crisis because there are some good quality companies trading at very low prices at the moment, but they could go even lower in the short-term.
Click here for information about useful stock market tools and resources including a review of Marketclub and a full ADVFN review.View all articles by James Woolley
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