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“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.“ – Benjamin Graham
From a young age, children learn that two plus two equals four. If someone suggests to a six-year-old that two plus two is anything other than four, the child will scoff. In general, people have an intuitive understanding of basic arithmetic. Probability, however, is different. If you flip two coins, what is the probability that both will come up heads? Many instinctively know the correct answer: 1/4 that both coins will come up heads. Yet it is surprisingly easy to convince many people that the probability is 1 in 3, arguing that there are three possible outcomes: two heads, two tails, and one of each. In other words, humans possess an intuitive grasp of addition but far less for probabilities. 1
A slightly more complicated example would be adding 2 + 2 + 2 + 2. Although the addition problem is more difficult, most people quickly see the answer is eight. Again, little deliberate thought is required as intuition provides a solid grasp of quantities. To make the probability example more complex, imagine flipping four coins; what is the probability that three land heads and the fourth one lands tails? In general, only those with a background in mathematics immediately know the answer. Without training, we lack the intuitive understanding of probability. As it turns out, the probability of getting this result is 1 in 4.
One reason investing is difficult is that it requires understanding probability. Because we lack an innate intuition for probability, many investors’ mistakes stem from relying on mental shortcuts. These shortcuts work reasonably well in many areas of life, but in others – like investing – they often fail. After years of relentlessly higher stock prices, investors assign little probability to an adverse outcome. Legendary investor Howard Marks recently noted that “When you buy the S&P 500 at 23x P/E (multiple of price relative to profit earnings), your ten-year annualized (investment) return has always fallen between +2% and -2%, IN EVERY CASE, EVERY CASE.” Today, the stock market trades at a price-to-earnings multiple of 25. When today’s rate of inflation is considered, Howard Marks’ range of nominal returns becomes negative in “real” terms. Therefore, according to Howard Marks, the probability that the S&P 500 will deliver outsized annualized returns over the next decade is low.
Individual retail investors appear to assign a higher probability to strong future stock market returns than Howard Marks does. According to Reuters, retail inflows into U.S. equity markets in 2025 reached record levels, driven by individual investors’ enthusiasm for ETFs (exchange-traded funds), thematic stocks (particularly the technology sector, including artificial intelligence), and “buy-the-dip” behavior amid volatility from tariffs and lower interest-rate expectations. Data from Vanda Research show that retail investors poured a net $270 billion into U.S. stocks and ETFs in the first half of 2025 alone, the highest on record and surpassing the 2021 meme-stock craze. Today, the mental shortcut ‘buy the dip’ often substitutes for assigning probabilities or engaging in deeper analysis.
Milton Friedman cited Irving Fisher (1867-1947) as the greatest American economist. Yet in October 1929, just days before the Wall Street Crash, Fisher famously declared that stock prices had reached “what looks like a permanently high plateau,” implying that the bull market in stocks during the 1920s was fundamentally sound. He believed that improvements in productivity, technology, and corporate profits justified valuations much higher than in the past. Fisher, a Yale University economics professor, invested aggressively in stocks and ultimately lost his entire fortune in the crash. He justified his speculation arguing that “The indiscriminate prejudice against all speculation, which is so often met with, is beside the point; for, were there no speculators, the same risks would have to be borne by those less fitted to bear them.” In other words, Fisher believed he provided a public service by bearing the risk of a professional speculator rather than the public who “enters the market in a purely gambling spirit,” resulting in “evil consequences for the non-participating public.” Fisher stressed a clear distinction between gambling and speculation. Gamblers “seek and make risks which it is not necessary to assume,” whereas speculators “merely volunteer to assume those risks of business which must inevitably fall somewhere.” 2
Post-crash, Fisher wrote about the dangers of overconfidence in forecasting, the amplifying effects of leverage on market swings, the importance of diversification to mitigate significant losses, and how psychological factors and panic can cause collapses even when fundamentals are sound. He emphasized that market prediction differs from economic analysis and highlighted the difficulty of timing turns amid irrational behavior. “The evils of speculation are particularly acute when, as generally happens with the investing public, the forecasts are not made independently.” If each speculator made up his mind independently, Fisher concluded, the errors of some would be offset by others. But the mistakes of the common herd are usually in the same direction. “Like sheep, they all follow a single leader.”
Passive investing is an approach in which forecasts are not made independently. Popularized by John Bogle, the founder of Vanguard, passive investing has grown massively due to its cost-effectiveness and strong historical performance results. Passive strategies rely on index funds and ETFs that automatically buy stocks in proportion to their weight in a benchmark index, such as the S&P 500. Inflows into passive funds force managers to buy more of the same large, popular stocks (e.g., the “Magnificent Seven” technology giants), pushing their prices higher regardless of individual company fundamentals.
As Irving Fisher observed, the mistakes of the common herd are usually in the same direction. Passive outflows, yet to be meaningfully felt at any level, could trigger mass selling. With passive investment vehicles holding over 50% of U.S. equity assets, estimates suggest the share is far higher when sovereign wealth funds are included, leaving fewer active investors focused on company fundamentals and valuations. Stocks rise or fall based on collective inflows and outflows rather than unique insights, fostering momentum-driven herding. In top-heavy indexes, passive capital concentrates in a handful of stocks, inflating valuations and increasing market fragility. Investors indirectly follow the crowd by delegating to indexes, assuming “everyone else is doing it” via the market’s aggregate wisdom.
A market crisis is the penalty for a prior, widespread forecast error. Such a general error may result from the coincidence of many independent mistakes by individuals, but it is more often the result of a lack of independence. “A sudden rush of all the passengers on a ferryboat to one side will produce a ‘list’ in the boat’s position, and sometimes cause it to capsize, though the independent movement of the individual passengers will seldom or never produce disaster,” wrote Fisher. He wanted to highlight the dangers of crowd psychology and over-optimism by describing how overconfidence charms investors into overinvestment during booms. The massive shift to indexes creates a “herd” blindly piling into rising markets, echoing the 1920s euphoria Fisher so famously underestimated. When sentiment reverses, for whatever improbable reason (e.g., interest rate hikes, recession fears, armed conflict), synchronized passive outflows could worsen market drops and amplify volatility far beyond what fundamentals warrant.
Much of the current market exuberance is driven by record profits. Corporate profits are at record highs because the U.S. government and households are running a massive net deficit. The government spends a considerable amount on national defense and to support American families. Subsequently, the government runs a deficit, meaning its spending exceeds its tax revenue. It issues debt (bond certificates) to finance that deficit. Sometimes the Federal Reserve, the country’s central bank, buys the bonds. When the Federal Reserve buys government bonds, it creates new money. That money can take the form of Federal Reserve notes, which we know as paper cash (dollar bills), or bank reserves, a digital book entry that banks hold at the Federal Reserve (not physical paper, but still money). When people casually say, “the Fed prints money,” they refer to this process of creating new dollars. To the U.S. government, these are “IOUs.” On the other side of the ledger, they are “Treasury bonds” or “cash” to the holders. The deficit is financed by issuing a combination of new government debt and new Federal Reserve liabilities to pay for government expenditures.
Final Monthly Treasury Statement, Receipts and Outlays of the United States Government, For Fiscal Year 2025 Through September 30, 2025, and Other Periods
In a well-functioning market economy, accounting shows that if households and the government together consume more than their income, other sectors must produce more than they consume, thereby accumulating financial claims rather than goods and services. This excess production is effectively purchased on behalf of households that receive government transfers such as Social Security, income support, and public health benefits. In recent years, roughly two-thirds of the U.S. federal budget has been spent on retirement, supplemental income, and health care benefits for American families. In return, producers receive new liabilities (debt or cash) issued by the government to finance its expenditures. Ultimately, the deficit of one sector becomes a surplus of another, and the liabilities issued by one sector become the assets of the other. The “surplus” of corporations is otherwise known as corporate “free cash flow.” In aggregate, the government and households run a deficit, which is the mirror image of the corporate surplus. Perhaps at some point, the market will no longer allow the U.S. government to run such large annual deficits. Until that time, corporate profits will continue to benefit.
According to Bloomberg, Wall Street expects S&P 500 earnings per share to grow by a strong 13% in 2026. Decades of government deficit spending and overconsumption have sustained profits and inflated U.S. economic output. The COVID-19 pandemic prompted a massive government policy response that further supported corporate profits through record deficit spending. The government’s stimulus checks and transfer payments expanded household and business balance sheets, prompting yet another quick rebound in consumption. Taken together, deficit spending and overconsumption help account for the exceptional growth in U.S. earnings. Admittedly, these profit drivers justify today’s lofty market valuations, making U.S. stock market performance the envy of the world since the 2008 financial crisis. Over this period, the S&P 500 outpaced the global stock market index by 10.6% annually.
While U.S. stocks appear unstoppable, market participants should not be complacent. Unlike market bottoms, which tend to be dramatic, if not violent, market tops unfold over a more extended period. A rational investor today should assign a higher probability to a market cycle top forming than to a new bull market beginning. Perhaps, out of prudence and a desire to preserve capital, market participants would be better served by becoming a little more fearful and less greedy. Valuations never dictate when the stock market will drop, but they can provide insight into assigning a probability to how far it will eventually fall. A blended average of several valuation metrics for the US stock market is at a record high, based on data going back over 100 years. The stock market could drop meaningfully, as it has historically when valuations reach such levels. Like Irving Fisher in 1929, every investor today must assign their own probability to such outcomes.
The price-to-sales (P/S) ratio is one valuation metric currently at an extreme. It is calculated by dividing the S&P 500 Index’s market capitalization by the total sales of all its component companies over the past 12 months. This ratio is effective because sales are less subject to accounting adjustments or management manipulation than earnings, making it a more reliable indicator of how a company’s fundamentals compare to its stock price. While bullish investors argue that earnings justify today’s rising stock prices, the price-to-sales ratio does not. In fact, this indicator sits at its highest level on record – more than double the historical average and well above the levels seen throughout the technology bubble in the late 1990s.
Surveying today’s market landscape, one cannot argue that there is an edge to investing in artificial intelligence (AI) stocks. To consistently outperform, the investor needs to understand what the market has already priced into a stock. When Nvidia, the world’s largest AI-related stock, trades at 23x sales (not earnings but sales), there is a level of confidence already priced in that will be almost impossible to meet, let alone surpass. However, it is not just the leading technology stocks that are currently trading expensively; the median price-to-sales ratio across all S&P 500 companies suggests that markets are broadly overvalued. As to the extent of the overvaluation, the institutional investment firm GMO noted that more than 30% of U.S. market capitalization now trades at more than 10x sales, a level eerily reminiscent of the technology bubble. History suggests such extremes do not continue indefinitely, and a prudent investor would be wise to assign a suitable probability to such an outcome.
As enthusiasm for artificial intelligence lifts overall stock market indices, many investors appear to be abandoning fundamental analysis, paying any price to own the most popular stocks. When expectations are set too high, even great companies can disappoint. Today’s market reflects more than optimism; it reflects risk. History suggests such extremes rarely persist without painful corrections. Valuations are becoming expensive in a very real sense: based on average earnings, the number of hours a worker must labor to buy one unit of the S&P 500 index has jumped to more than 200. The average wage earner needed only 140 hours before the COVID-19 pandemic and not much more than 100 hours at the market peak of the technology bubble in 2000, which preceded a fall of more than 50% over the next two years.
One of the most interesting aspects of bubbles is their regularity, not in timing but in the progression they follow, according to Howard Marks of Oaktree Capital Management. “Something new and seemingly revolutionary appears and worms its way into people’s minds.” This invention captures the market’s imagination, and the excitement of owning a piece of it is overwhelming. Early participants enjoy enormous gains, while those on the sidelines feel intense envy and regret. Motivated by the fear of missing out, they rush in to share the excitement. They do so without knowing what the future will bring or considering whether the price they are paying can be expected to produce a reasonable return at a tolerable level of risk. By contrast, as Howard Marks notes, the value investor studies companies and assesses their intrinsic value and outlook. Decisions are based on price relative to value.
The most dramatic change the investor faces in the short term concerns the price of an asset relative to its underlying value. Driven by human psychology, stock prices are far more volatile than company earnings. Greed drives market participants to chase rising stock prices, while fear overwhelms rational behavior when stocks fall sharply. Market bubbles are not caused directly by technological or financial developments. Instead, they result from applying excessive optimism to those developments. Because there is no historical precedent to restrain the imagination, the future can appear limitless for the new and exciting. A future perceived as limitless can justify valuations that go well beyond past norms, causing stock prices to race far ahead of what is justified by reasonable earnings power.
Every bubble tends to replace analysis with imagination. Unfortunately, today’s extreme overvaluations suggest the upside potential for the broad market is limited, while downside risk is potentially significant. Stocks can remain expensive for extended periods, often longer than seems possible. While necessary for determining market risk, valuations are not a reliable timing tool. They are, however, essential for risk management by assigning probabilities to avoid the most overpriced market segments, a critical component in protecting one’s portfolio. Current stock market valuations are so stretched that even if the major indexes climb to new highs, the upside remains muted. Fortunately, some opportunities are still attractive – particularly in more value-oriented investments of the energy sector and defensive sectors with pockets of value in consumer staples.
Benjamin Graham, often regarded as the father of value investing, emphasized rational, disciplined approaches to investing in the stock market. Investing is not a zero-sum competition, like gambling, where success means outsmarting or outperforming everyone else. Too many people approach the market this way: chasing popular stocks, trying to time market highs and lows, or following the herd. Graham saw this as “speculation” rather than true investing. Trying to predict the behavior of others is risky because market sentiment and short-term price fluctuations are factors outside of one’s control. To do so is to play their game, which is often driven by hype, fear, greed, or irrational exuberance.
True investing is an individual pursuit. One defines their own goals, risk tolerance, and strategy, then sticks to them with discipline. It means avoiding impulsive decisions driven by fear (selling during crashes) or greed (buying overvalued assets). The investor strives to buy undervalued stocks with strong fundamentals to buffer against mistakes or downturns. With a long-term perspective, the value investor focuses on what a business is truly worth rather than reacting to short-term price swings. Compounding wealth steadily over time, not quick wins, is how St. James prefers to play the game. “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game,” captures the essence of Graham’s philosophy. St. James has developed its own “game” based on research and patience. At times, this mindset turns investing into a solitary, introspective activity in which success comes from consistency and from avoiding the impairment of investment capital, not from external validation or comparisons.
With kind regards,
St. James Investment Company
1 Terry Odean, What I Know About How You Invest, Legg Mason Investment Conference, 2003.
2 Irving Fisher. The Nature of Capital and Income, London, Macmillan Company, 1906, pages 295-300.
We founded the St. James Investment Company in 1999, managing wealth from our family and friends in the hamlet of St. James. We are privileged that our neighbors and friends have trusted us to invest alongside our capital for twenty years.
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