FOOL'S EYE VIEW
Socrates Was A Fool!

By James Carlisle
September 2, 2002

On Friday, Nationwide confounded the doom-mongers (yet again) with their latest monthly house price survey. In the month of August, the average price of a home in the UK apparently increased by 2.5% to £110,890, an increase of 22.7% since this time last year.

The annual increase is as astonishing as it is unsustainable and it's no wonder that people are talking about it - particularly young homeowners. From struggling to cobble together a deposit a few years ago, they've developed a little equity in their homes and that provides a warm feeling of wealth. Most homeowners, however, are sensible enough to understand that the short-term movements in the price of their home have little to do with the price of fish.

Bricks and Mortar

We all need somewhere to live, so you can hardly just sell up and spend the dough. So, while people might yak on about property prices a bit too much, it's generally less of the 'I'm so rich now I can buy a flash new motor' and more a case of 'thank heavens I don't have to live with that kind of mortgage'. For people getting on to the housing ladder now, things are less comfortable. They will have to live with that kind of mortgage, but then it should cost them less than they'd otherwise have to pay in rent. If prices take a tumble in the short-term, then it might be hard to move (but if you want to move within a few years you shouldn't be buying in the first place), but so long as they can keep paying the mortgage, people have an innate faith that, eventually, property will come good as an investment.

This long-term faith in bricks and mortar is built on very solid foundations. House prices are linked to the ability of people to pay to live in them and people's ability to pay is linked to their earnings. It just isn't possible for people's wages to fall, over the long-term, relative to the value of the pound. Who would end up generating the pounds to pay all the interest? The Government, via taxation, relies on profits and wages for its income. The banks, meanwhile, can only pay interest to their depositors because of their borrowers' ability to service their debts, which in turn depends on earnings.

Control freaks

So people seem prepared to ignore the short-term fluctuations of the property market and sit back comfortable in the knowledge that things will come right eventually. Unfortunately, people seem to find it very hard to extend this 'hands off' approach to their stock market investments. Part of the problem is that shares, and share-based investment funds, are so easy to buy and sell, so the temptation is there to dip in and out of the market, and/or different shares and sectors, depending on where you think they might be 'headed'.

The biggest problem, though, is that there's just so much data around. With property, we just have to live with Nationwide and Halifax (plus a few others) producing some pretty arbitrary numbers once a month. With shares, there are prices given second by second throughout the day and any amount of other data to digest. Human beings have developed a major shortcoming when it comes to data, in that we seem to have some desperate need to find an explanation for it. This control freak approach might have helped us to find ever more elaborate ways of catching mammoths, it might have helped us to fly to the moon and to decode the human genome, but it unfortunately leaves us with a desperate urge to find order in anything and everything, even where none exists.

The Foolish Socrates

According to my bluffer's guide to philosophy, the Oracle of Delphi once determined that the Greek philosopher, Socrates, was the wisest person in the world. On hearing this, Socrates apparently set off on a rigorous process of self-examination to discover what special knowledge he possessed. In the end, he determined that he had no special knowledge or understanding, but that the Oracle was nevertheless correct. He was, indeed, the wisest person in the world because he alone understood the limitations on man's knowledge and understanding. In other words, Socrates' special knowledge and understanding was to recognise that he had none.

The secret to understanding the stock market is to take a leaf out of Socrates' book and recognise that neither you, nor anyone else (whatever they might have you believe), is capable of understanding its short-term movements. People seem happy to adopt this approach with property, so why not with shares? The answer is probably that, with property market data more scarce, there's less of an imperative to create order out of it and, with the buying and selling of property more expensive and time-consuming, it's a less tempting prospect than trading shares at the click of a mouse. These are, however, simply matters of degree.

Instead, your focus should be firmly fixed on the long term. As with property, the basis for the long-term performance of shares is built on firm logic. Share prices are linked to the capacity of companies to generate profits. Companies' profits, in turn, are linked to people's ability to pay for their products and people's ability to pay for their products is linked to how much they're earning.

Companies are the engine of the economy, while cash is merely a device of that economy - a token. Ultimately, the value of the token is irretrievably dependent on the success of the economy. Taking things to extremes, where would the pound be if every company in the country went bust? Probably in the same place as all those 100 million Deutschemark notes from the 1930s - in a bonfire (or, occasionally, in a flea market).

There is an investment specifically designed for people who are Foolish enough to recognise that they have no special knowledge or understanding of where the stock market, or the different bits of it, are headed at any point in time. It's called an index tracker and it works by representing a cross-section of the entire stock market. By investing slowly and steadily into an index tracker over the long term, you'll come out smiling whichever individual shares and sectors do well and irrespective of when they do it. That's how Socrates would have invested - if he could have given three figs about money of course.

More: The Fool's Index Tracker Centre