behavioral economics

Simply Effective: Avoiding Stampedes

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“Avoiding stampedes” may be the simplest and most straightforward of our three fundamental principles of investing. Let’s talk about what it means.

In our view, a stampede in the markets has two features: large volumes of money changing hands, and irrational pricing. Information, evidence and indications about money flows are readily available. The assessment of pricing is necessarily more subjective.

At the time, many believe that prices make sense—or they would not be where they are. Technology and internet stocks in early 2000, homes in 2007, and commodities in 2011 all fit that pattern. At the peak, some true believers thought there was significant room for further increases. Only with the benefit of hindsight is it obvious that things were out of whack.

These examples are all about stampedes into a sector. Money also stampedes out of things at times, as we know. Stocks during the last financial crisis and high yield energy bonds near the bottom in oil prices in early 2016 are prime examples.

You may recognize a pattern. The habit of avoiding stampedes is a contrarian approach to investing—going against the crowd. If everybody else is doing it, we probably don’t want to.

In fact, if everybody else is doing one thing, we may seek to do the opposite.
Behavioral economics lends support to our practice, in our opinion. Much work in that field purports to show that most people do the wrong thing at the wrong time, thereby hurting their returns. Doing better than average would seem to require doing the opposite of what most people do.

(Of course, no method or system or theory is guaranteed to work, or even to perform the same in the future as it has in the past. And putting a theory into practice may be difficult to do.)

In practice, being a contrarian can be lonely. The crowd at the diner is unlikely to endorse doing what nobody else seems to be doing. We don’t care—we are striving to make investment returns, not please the crowd.

Clients, if you would like to talk about this or anything else, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Every Share Sold is Bought

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We talk a lot about cycles, but there’s one truth to them that we could come right out and say more often: there are no ups without downs, no downs without ups. Night and day. Yin and yang. Buy and sell.

People sometimes lose sight of this reality, especially when talking about the waves of selling that engulf the markets from time to time, cratering prices. They might say, “Long term investing is all well and good, until the financial crisis comes and wipes out half your account—that happened to me.”

In the last crisis (2007–2009), the markets recovered and went on to post gains for many years. When I inquire whether their accounts have bounced back since then, some reply, “Of course not! Everybody had to sell out to save what was left!”

Life is too short for most arguments, isn’t it? We move on to other topics. But the fact remains: even on the worst days in the depths of the crisis, when the market was suffering large percentage losses, we believe every share sold was also bought. There are two sides to every transaction, a buyer and a seller. Not everybody “had” to sell out.

In the fall before the market bottom in March 2009, noted investor Warren Buffett wrote in The New York Times that the economy was likely to be larger—and company profits higher—ten and twenty years in the future.1 Therefore, he was buying.

We felt the same way.

But it may feel as if everybody is selling. In the crisis, one of you told us it was no longer possible to talk about the economy or markets at coffee in the mornings, because every single person there called you a fool for staying in or told you all your money would be lost. Another said the same thing about the Friday night dinner crowd—you felt lonely. But you persisted.

It is popular lore among financial advisors to presume that people are really not capable of investing effectively, pointing to behavioral economic studies. You know we have worked hard to find you, the exceptions: people who either have the native good sense to invest effectively or who can learn how to do it.

We believe that every share sold is also bought. We have a choice, which side of those transactions to be on. Clients, if you would like to talk about this or anything else, please email us or call.

Notes and References

1. Warren Buffett “Buy American,” The New York Times: https://www.nytimes.com/2008/10/17/opinion/17buffett.html. Accessed: September 24, 2018.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing, including stocks, involves risk including loss of principal. No strategy assures success or protects against loss.

 

World’s Biggest Roller Coaster?

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The biggest roller coaster in the world is Kingda Ka, at Six Flags Great Adventure in New Jersey. Sometimes investing provides a similar experience.

We have written before about the lovely decade of the 1990s, when the major stock market averages more than tripled. When you get up close and really look at what happened, however, it looks a whole lot different. We examined the data for the S&P 500 Stock Index.

During that decade, there were 1,171 trading days when the S&P went down. The total points “lost” on those days adds up to 5,228. Put that in perspective: the decade started at just 353 points! The down days “lost” more than fourteen times the beginning value1.

Who would knowingly stick around if, on the first day of the decade, we knew that 5,228 points would be “lost” on the down days?

There is a reason we put the word “lost” in quotation marks. It might be more appropriate to speak of temporary declines rather than losses. We say this, because of what happened on the other 1,356 trading days in the decade.

On those up days, the market went up a total of 6,344 points—or more than 17 times the beginning value1. If we knew only that piece of the future at the outset, money might have flooded in.

The bottom line is, here is how we got a triple in the market: it went up 17 times its original value, and down 14 times its original value, in totally unpredictable bits and pieces of rallies and corrections. Patient people prospered.

It is hard to argue with a triple. That is a fine result. This is why we talk incessantly about the long term, long time horizons, keeping the faith, following fundamental principles, and not panicking at low points.

During the decade, how many times did 10% corrections have to be endured? 20% bear markets? Were there any 30% or 40% losses? WHO CARES? It didn’t matter to long term investors.

Clients, if you would like to talk about this—or anything else—please write or call.

Notes & References

1Standard & Poor’s 500 index, S&P Dow Jones Indices: https://us.spindices.com/indices/equity/sp-500. Accessed October 3rd, 2018.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in this material may not develop as predicted.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

 

Four Trends for Fall, 2018

© Can Stock Photo / Elenathewise

The gap between consensus expectations and reality as it unfolds is where we think profit potential lives. This is why we put so much effort into studying trends, and the ramifications for investors.

One year ago, we wrote about four trends. The next energy revolution (solar + batteries), long range prospects for the world’s most populous democracy, the airline industry, and rising interest rates continue to play roles in our thoughts and portfolios.

Other ideas are also in play.

1. Thinking about the next few years, our highest conviction idea is inflation will exceed consensus expectations. Some of the ways we act on this belief may provide some counterweight to other portfolio holdings, since inflation hurts some industries while it helps others.

2. As the economic expansion lengthens toward record territory, the desire to extend our lifespan tends to be insensitive to the business cycle. Biopharmaceutical companies, working on cures for everything from Alzheimers to various forms of cancer, seem attractively priced.

3. The trend toward rising interest rates, noted last year, may have an effect on weaker and more leveraged companies. We are looking to avoid the second-order and third-order effects that higher rates may have on some borrowers.

4. US stocks have become popular relative to international equities, with dramatic outperformance over the past decade. At some point the trend changes, and better value usually wins out.

One of the difficult things about being contrarian–going against the crowd–is that we sometimes look silly. When everybody else is having more success in the short run while we search for bargains, it can be tough. But that is what we do. We’re excited about the continuing evolution of your holdings as the future unfolds.

We can offer no guarantees except that we will continue to put our best effort into the endeavor. Clients, if you have any questions or comments or insights to add, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

 

Is a Drop a Loss?

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We humans use stories about events great and small to help understand the world. One of the common stories about the stock market contributes to a great misunderstanding, however.

A market decline from some higher point in the past is often spoken of as a loss. Yet whenever the market is trading at an all-time high, every past downturn has been fully recovered. One might ask where the loss actually is.

To illustrate, the decade of the 1990’s was a good one for the broad stock market, as measured by the S&P 500 Stock Index. It more than tripled, rising from 353 points to 1,469. Yet of the 2,527 trading days of the decade, 1,171 saw a decline—a drop—in the market index.1

Those down days represent a cumulative 729% in “losses.”1

In a decade when the market tripled, how does it make sense to speak of losses during the interim? Particularly losses equal to many times the beginning level?

The market is volatile. Values fluctuate. It goes up and down. But if you have long term goals, it might pay to focus on long term results, not temporary downturns. If you invest next week’s grocery money in the stock market, then yes, a temporary downturn will result in a loss when you sell out in order to buy food. Otherwise, we would say a drop is not a loss.

Note: one should never invest next week’s grocery money in the stock market.

Our business is striving for long term results for people who share our time horizon and philosophy of investing. We talk about it every way we know how, in many venues, to reinforce effective investing attitudes and to forewarn those who lack them.

Clients, if you would like to talk about this or anything else, please email us or call.

1Standard & Poor’s 500 Index, S&P Dow Jones Indices. Retrieved September 18th, 2018.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

 

Pain Fades Away

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Some pundits calculate the current run-up in the stock market as the longest bull market in history. It seems many have forgotten how tumultuous and uncertain things have felt at times during the rise.

Before the rise began, a punishing drop in the market (and investment account balances) happened, from mid-2007 to spring 2009.

Then, just a couple years into the recovery, we had one of the most turbulent periods ever. In August 2011, after dropping more than 5% the week before, the Dow Jones Average dropped another 5% on Monday, August 8. This 634-point drop was partially offset by a sharp rebound on Tuesday, a 429-point gain. Wednesday reversed again, with a drop of 519 points. Thursday’s gain of 423 points ended a string of daily moves greater than 400 points, down-up-down-up.1

Since the market was much lower then, an equivalent 4% move today would be about 1,000 Dow points! Imagine that four days in a row. We lived through it.

Why did this happen? Developments developed, happenings happened, and pundits spewed punditry. It would spoil our story to detail the details. As it turns out, they don’t matter.

We’ve been asking people whether they remember this episode. Few do. Thus our conclusion: the pain is temporary.

If you do a little math with our story, you’ll note the Dow dropped more than 10% in six days1. This was alarming to those who were paying close attention. Yet from the longer-term perspective, it probably would have been a mistake to sell at any point in there.

After all, this turmoil happened during the longest bull market in history!

The next round of turmoil is always out there. When we counsel patience, it is with the long term—and a knowledge of history—in mind. Clients, if you would like to talk about this or anything else, please email us or call.

Notes & References

1Standard & Poor’s 500 index, S&P Dow Jones Indices: https://us.spindices.com/indices/equity/sp-500. Accessed September 4th, 2018.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Animal Spirits

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More than eighty years ago, economist and thinker John Maynard Keynes wrote that “most, probably, of our decisions to do something positive…can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction…”1

The term animal spirits dates back to the Middle Ages as a way to refer to the vagaries of human activity. Keynes used it to describe concepts such as consumer confidence and the willingness of businesses to invest capital.

In recessions, animal spirits are subdued; during economic expansions, they are said to be stirring. The idea of animal spirits helps explain the booms and busts of the markets and economy.

As contrarians, we seek to discern when the dominant trend has gone too far, either from excess optimism or an overabundance of pessimism. A simpler way to say this is that we seek to avoid stampedes. We believe these things run in cycles.

More recently, we found another use for the concept of animal spirits. History suggests that rising tariffs and trade barriers around the world are a detriment to economic growth and prosperity. These kinds of trade troubles could emerge from the current discourse among nations. And there are differences of opinion on the economic impact here in the U.S.

Some analysts have calculated that the actual amount of goods and services directly affected by proposed trade actions is some very tiny percentage of the overall economy. Their conclusion is that the potential for economic mischief from trade issues is small.

At the same time, business leaders are becoming concerned about the possibility of reduced export sales and lower incomes and sales in the U.S. due to these same trade issues2. These concerns could dampen the animal spirits. Facility expansions, hiring, orders for inventory or raw material…all these things could be affected.

If business activity declines, jobs and personal incomes will not be far behind. The economic impact would be negative. You see, the effect on animal spirits, a second-order effect of trade disputes, could have a much larger impact than the direct effects.

We do not change our principles or strategies based on headlines of the day. Of course, we are always looking for ways to improve our tactics. If you would like to talk about this or anything else, please email us or call.

Notes and references:
1John Maynard Keynes. The General Theory of Employment, Interest and Money, 1936.
2Business Roundtable, CEO Economic Outlook Survey Q2 2018. https://www.businessroundtable.org/resources/ceo-survey/2018-Q2


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

It Works Until It Doesn’t

© Can Stock Photo / joebelanger

Money poured into tech stocks in the late 1990s. Then it went into residential real estate in the middle 2000s. No wonder: prices marched higher, year after year—until they didn’t.

We humans usually believe that recent trends will continue. When friends and neighbors and coworkers are getting in on the action, it is easy to join them.

A powerful narrative that seems to be creating a lot of wealth is hard to resist. “We have entered a new era.” “This time is different.” “You can’t lose money in real estate.”

Popularity pushes values farther and farther away from the underlying economics, and a reversal usually follows. The bubble pops; a great number of people are surprised. Some end up with losses instead of the gains they felt sure about making.

Our analysis suggests that a new kind of bubble is upon us. The zero interest rate policy or ZIRP of the Federal Reserve Board for most of the past decade led to a scramble for yield. This moved the valuation on many kinds of investments that pay income into very rich territory, in our opinion.

For example, we were recently pitched on a “cash substitute” with a 5% yield, in a supposedly liquid form. Sounds great, right? Perhaps too good to be true.

Indeed, when we took the proposition apart, we found it was made largely out of corporate bonds in financially weak companies—junk bonds, in other words. To make matters worse, the manager pursued opportunities in a thinly-traded part of the market—odd lots, small amounts of each bond that are unattractive to other buyers.

This idea will work until it doesn’t. When the next economic slowdown creates cracks in the theory, investors who believed they owned a “cash substitute” may be sensitive about losses of any size. As they cash out, the manager may be forced to sell into a market with even fewer buyers.

The silver lining for us is that dislocations bring opportunities. Prices overshoot in both directions. One of our roles is to try to spot these anomalies, and figure out which ones are attractive opportunities for you. (We have no guarantees of success in this.)

Clients, if you would like to talk about this or anything else, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

All investing, including stocks, involves risk including loss of principal.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

 

You Are Somebody, Not Everybody

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Our pursuit of effective strategies for successful investing covers a wide range of disciplines. Economics and mathematics are obviously needed, but history and psychology play surprisingly large roles.

As contrarian investors, avoiding stampedes is a fundamental principle for us. We often find ourselves going against the crowd. It turns out that there is a lot of conventional wisdom with which we disagree.

The world is complex; humans use shortcuts all the time to keep things simple enough to handle. The problem arises when characteristics of a group are ascribed to each individual within the group, as a shortcut way of dealing with people.

For example, Americans on average are sedentary and overweight. But if you watch who enters the door of the YMCA at 6 A.M., you know that the group characteristics do not apply to every individual. We use this same principle to find clients who will not sell out at low points or fall for the latest overpriced fad.

Behavioral economics indicates that humans tend to behave in counterproductive ways when it comes to investing. But just as the “Y” does not treat each member as if they were overweight and sedentary, we know that counterproductive behavior is optional at the individual level. We choose to try to avoid it.

We were reminded of this recently in reviewing some studies about happiness. The studies show that people quickly take new things for granted, homes and cars for example, so the initial happiness soon wears off. But in our experience, this is a matter of choice.

When in Louisville, I live in the humblest quarters ever since I graduated from college. I am grateful to have an abode that meets my modest needs. In Florida, my days are spent in a nice home that is wonderfully suited to our family. My gratitude and appreciation and happiness about that never flags. This just puts me right in the middle of the pack of the greatest clients in the world. (Our opinion.)

When we read studies about behavior, we will always remember that you are somebody, not everybody. Economists and psychologists can prove all they want about human tendencies, but we will not accept their findings as your fate or ours.

Clients, if you would like to talk about this or anything else, please email us or call.

Why Not Both?

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We keep reading a curious idea promoted by some in the financial industry. It goes like this: “Managing investor behavior is the key task for advisors, not managing investments.”

That framework assumes there is a choice between one or the other. There are two flaws in the assumption. It does not have to be an either-or deal. And some fraction of people don’t require babysitters for their natural investment behavior, which is effective.

We believe in BOTH of these roles. It may be true that raw human nature is generally counterproductive to sound investing. (Behavioral economists tend to think so.) Our theory and experience says that the attitudes and behavior of individuals can be deliberately shaped to their benefit—and ours.

What may apply as a general principle to all people does not necessarily apply to you as an individual. You have free will. And we believe people can learn.

So we spend a great deal of time and effort talking to you, and communicating about the mindsets and strategies and tactics we believe are effective. But that is only part of the job.

Legendary investor Charlie Munger said, “We wouldn’t be so rich if other people weren’t wrong so often.” By avoiding stampedes in the market, we may sidestep a poor situation that others are getting into. And by seeking the best bargains, we are looking for holdings that others may be wrong about.

In other words, two of our fundamental principles about investment management are founded in a belief that investment selection matters because people are often wrong. We see investor behavior as a creator of opportunities for our clients—not a problem to be managed. Clients, we keep saying you are special: this is why. We believe your investment behavior is exemplary.

Knowing what you own and why you own it, operating in accordance with sound principles and strategy, makes it easier to behave effectively. These things reinforce each other.

Manage behavior, or manage investments? It isn’t either-or—we need to pay attention to both. Clients, if you would like to discuss this at greater length, please email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.