Investing

My Personal Experience with the Recency Bias

by

Quiz!

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one.

My Personal Experience with the Recency Bias

What is the Recency Bias? It is making decisions based on recent events, with the expectation that they will continue.

How can the Recency Bias hurt investors? Most investments are cyclical, while the recency bias assumes no cycles. Common harm is buying high after unusual gains or selling low after unusual declines. When done repeatedly, it can lead to long-term underperformance of a simple buy-and-hold strategy.

Are there less obvious cases of Recency Bias hurting investors? Yes. Many investors are disciplined enough to hold onto their investments at low points, but they may wait for gains before investing new money. Missing a 1% or 2% gain is nearly harmless. But some investors wait for more and more evidence. Once they see (and miss) 20% or 30% gains, some wait to buy at a dip, and some wait for more evidence of gains. Only after seeing 50% to 100% gains, some feel that the gains are here to stay, and invest after missing out on huge gains. The damage is far worse than simply missing gains, leading to a negative snowball. The delayed investment hurts their personal returns, they think that their investments are worse than reality, so they stay less committed to them, hurting their returns even further, cycle after cycle.

Did I ever experience the Recency Bias? Yes & no. When trying to think about the likely returns of an investment in the next 10 years, I know that it’s likely to be different than the past 10 years, given studies of investment cycles and valuation measures. But, in anomalous times, where a cycle gets stretched longer than usual, I am tempted to temper my expectations for the next leg of the cycle. I recognize that real life works the opposite – the longer we have an anomaly, the stronger the reversal tends to be. Examples of my recency bias:

  1. When looking at the raw data, it is rational to expect the S&P 500 to lose value over the next 10 years. But the recency bias leads me to believe it may get low positive returns.
  2. When looking at the raw data, it is rational to expect non-US Value (low Price/Book) stocks to enjoy unusually high returns over the next 10 years. But I catch myself sometimes expecting only average returns.

How damaging can the Recency Bias be? The examples I gave right above are not too harmful. They don’t lead me to make decisions that are opposite of rational, so I can live with them. The harm comes from an expectation opposite of rational, that leads to decisions that are very likely to fail. Here are examples:

  1. Expecting the S&P 500 to average more than 10% per year in the next 10 years, or even 6% or 8%.
  2. Expecting low interest rates in the next few years.
  3. Expecting AI-focused companies that reached extreme valuations to significantly outperform the rest of the market in the next 10 years.

How do I avoid big harm by the Recency Bias? I base my expectations based on a combination of:

  1. Full cycle, long-term behavior.
  2. Logic.
  3. Valuations (e.g. Price/Book) today relative to typical in the past.

Quiz Answer:

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year. [The Correct Answer]

Explanation: High growth diversified investments tend to be cyclical, with reversals being more common than not after 10 years.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one. [The Correct Answer]

Explanation: When above/below trend continues beyond 10 years, reversals continue to be the more common case, with greater odds and magnitude.

Read this month’s article to find out what leads people to pick the other option for both questions.

Disclosures Including Backtested Performance Data

7 Rules for Success With Illiquidity

by

Quiz!

Which are ways to deal with illiquidity?

  1. Illiquidity is not an issue, as long as the portfolio is diversified and designed for high growth.
  2. Design a portfolio that can generate income that grows beyond inflation, using the liquid money.
  3. Keep liquid cash for ongoing expenses.
  4. Find a few good deals to generate liquid growth.
  5. Count on income from the illiquid money using conservative assumptions.
  6. Ignore the illiquid assets when thinking about available money, until they are turned to liquid.
  7. Hold bonds, to have money aside with low volatility.

7 Rules for Success With Illiquidity

If a big portion of your net worth is illiquid, you may face unique challenges. The challenges apply whether you have $10M, $100M or $1B. People with substantial assets faced these challenges, creating stress and financial risks. Here are a couple of examples of challenges:

  1. Cash drag: you may keep a large amount in cash or bonds, ready for ongoing expenses, or available for a future investment. This creates a drag on the returns, which can be significant depending on the amount. The problem gets magnified when you depend on the liquid allocation for ongoing expenses – it may not grow enough to cover expenses until a liquidity event.
  1. Illiquidity risk: in certain situations, you may face a risk of bankruptcy. For example, say your expenses are $1M per year, and you have $1M in liquid investments along with a company worth $500M. You are in the process of selling the company. Large sales typically take time, and buyers back down more frequently than you may expect. If the sale drags for a year, and at the last minute the buyer backs down, you are left with no money to pay the bills which could lead to bankruptcy.

Here are 7 solutions:

  1. Establish lines of credit (LOCs) or loans that are readily available for temporary cash needs, especially when waiting for an upcoming liquidity event. The first target is LOCs backed by the illiquid assets, when possible, but it could be any asset or business you own. Be very careful of this solution – if used incorrectly or abused (used for long-term spending), it can lead to catastrophes.
  1. Aim for a low withdrawal rate from your liquid investments. Calculate your typical annual expenses, deduct any conservative income you can get from your illiquid assets under tough circumstances, and divide by your liquid investments. A withdrawal rate of 3%-4% can put you in a strong position depending on the allocation of your liquid investments. At higher rates, your risk level goes up.
  1. Don’t count on money from the sale of illiquid investments until the money is in the bank. People get nervous with large purchases, and far too many deals fall through.
  1. When selling a company to a private company, in exchange for shares of the buyer, don’t count on the money until an exit (cash sale or IPO) of the buying company.
  1. Allocate your liquid money to investments that are designed to provide income that can grow with inflation. While cash & many bonds improve stability, they can lose money to inflation.
  1. Prepare for difficulty with liquidating your illiquid investments. Allocate your liquid money for high enough growth for as long as you may wait for liquidity.
  1. Subject to the points above, keep your liquid investments diversified, so you are not dependent on a small collection of companies to help pay for your living expenses.

Illiquidity involves risk, and the solutions above are ideas to help with this risk, to create a successful outcome. They require very careful planning, with serious pitfalls to watch out for. Many liquid investments that grow beyond inflation are volatile and require discipline to stick with through the ups and downs of a cycle. Lines of credit and loans can easily be abused, shifting them from protectors to tools for hurting liquidity.

Quiz Answer:

Which are ways to deal with illiquidity?

  1. Illiquidity is not an issue, as long as the portfolio is diversified and designed for high growth.
  2. Design a portfolio that can generate income that grows beyond inflation, using the liquid money. [Correct Answer]
  3. Keep liquid cash for ongoing expenses.
  4. Find a few good deals to generate liquid growth.
  5. Count on income from the illiquid money using conservative assumptions. [Correct Answer]
  6. Ignore the illiquid assets when thinking about available money, until they are turned to liquid. [Correct Answer]
  7. Hold bonds, to have money aside with low volatility.

Explanations:

  1. No matter how fast your illiquid portfolio grows, if you don’t have enough liquid money to cover your expenses, you can go bankrupt, even if you are a billionaire.
  2. Inflation is a risk that applies even to very wealthy people. Having liquid (accessible) income that grows beyond inflation helps.
  3. Liquid cash is great for a while, but it loses money to inflation, and doesn’t generate growth for long-lasting income.
  4. Liquid growth is great. The issue with this answer is the phrase “a few”, implying a concentrated portfolio that may lead to irreversible declines in case of bad luck.
  5. While illiquid investments may not be accessible easily, some generate income. You can count on the income you expect to get even under tough scenarios to stay conservative.
  6. Very wealthy people got into trouble counting on illiquid money in the process of selling a large asset, just to see the sale fall through. Don’t count on it, until the money is in the bank.
  7. Depending on your overall picture, bonds may be helpful and even necessary. But, similar to cash, they are not strong at generating income that grows with inflation and may give diminishing security for longer lasting needs.
Disclosures Including Backtested Performance Data

The Latte of Investing

by

Quiz!

Are you likely to make money on waiting to invest until conditions become better than today?

1. Yes, the negative news can lead to continued declines. Waiting allows you to buy lower.

2. No, as conditions improve, stocks tend to go up.

The Latte of Investing

You may have heard how a daily $5 café latte can add up to significant money over time. Many people see it as a small daily cost that makes no difference in the big scheme. They ignore the fact that it is recurring, leading to a much bigger total. While different people value the store-bought latte to different degrees, it demonstrates how some people may overspend on small recurring items.

There is an analogy in investing. Many people get nervous about investing after declines (that involve negative news), and delay investing until things calm down. They feel that whatever gains they may miss on the small amount is dwarfed by the gains they will enjoy with the big remaining portfolio. While the logic may sound convincing at first, when repeated, the small, missed gains can add up to very big money.

What can you do? Operate consistently: invest money as soon as it is saved.

What if it’s tough to do? Recognize that if you are uncomfortable investing at the current low level, you are likely to be even less comfortable investing at an even lower level. You are very likely to wait until the news is better than today, leading to buying higher, and missing gains. Past experience of investors supports this theory – investors tend to significantly underperform the investments they use.

Initially, it may be tough to be consistent. Once you form a habit, you may enjoy the automatic action, without a need to debate often.

Quiz Answer:

Are you likely to make money on waiting to invest until conditions become better than today?

1. Yes, the negative news can lead to continued declines. Waiting allows you to buy lower.

2. No, as conditions improve, stocks tend to go up. [The Correct Answer]

Disclosures Including Backtested Performance Data

What Moves Interest Rates?

by

Quiz!

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

  1. A decline in Inflation.
  2. A mild recession in the US.
  3. Core PCE Inflation reaches the 2% goal.
  4. A slight increase in unemployment.
  5. A severe recession in the US.
  6. Very high unemployment.

What Moves Interest Rates?

For a long time, some experts predicted a decline in interest rates. How could they be so wrong for so long? What really drives the Fed’s decisions?

Topic

Expectation

Reality

What are normal interest rates?

Very low, after 0% for years

Closer to the current 5.5%

What inflation is needed?

Declining inflation

An absolute level of 2%

What is the target inflation?

Higher than 2%, maybe 3%

2%

How does inflation change?

Linearly

The decline typically slows down as it approaches 2%

How are employment & inflation balanced?

Employment isn’t a big factor.

As long as inflation isn’t very high, we deserve low interest rates.

With unemployment so low, the main goal is to lower inflation

What are the Fed’s biases?

They want low interest rates

They don’t want to repeat the 1970’s where prematurely lowered rates let inflation spike again

What is good?

Low interest rates

Maximum employment with 2% inflation

Explanations: It seems that some people are driven by wishful thinking more than reality. Investors used the extremely low interest rates of the 2010s to justify extreme large US stock valuations, and they are eager to see interest rates go down. They hope to see very low interest rates as both the norm and the target. The Fed thinks very differently. They have two goals in mind (based on their job description): maximum employment and 2% inflation. With the employment goal in place, their focus is on getting inflation down. They saw inflation spike out of control in the 1970’s, and they are trying to avoid a repeat. The Fed said clearly that they will go as far as needed to reach their inflation goal.

What should we expect? Inflation is still nearly double its target: 3.5% vs. 2%. With inflation declines typically slowing down as we head towards the target 2%, we may have a long period with high interest rates. It is reasonable to expect the Fed to space out the rate increases further and further apart, as long as inflation keeps moderating. It may keep the interest rates the same for an extended period until inflation gets close to its target 2%.

Are there other scenarios? Yes. If the economy slows down and unemployment surges, the Fed will go back to a balancing act between employment and inflation, and could lower interest rates for a while. In that case, stock prices could do the opposite of mainstream expectations – they may decline. This could be most pronounced for stocks with the highest valuations (as measured by Price/Book).

Should we welcome lower interest rates? At first thought, lower interest rates are compelling, making it easier to fuel growth with cheap borrowing for companies & individuals. When considering the drivers of the Fed’s actions, lower interest rates without much lower inflation may be bad news – reflecting a response to a recession.

What can you do? You can structure your investments to benefit from high interest rates, and welcome the reality. Value stocks (with low price/book) tend to do unusually well with sustained high interest rates (not every month and not guaranteed). Note that your ideal investment allocation depends on your overall risk profile and goals.

Quiz Answer:

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

  1. A decline in Inflation.
  2. A mild recession in the US.
  3. Core PCE Inflation reaches the 2% goal. [Correct Answer]
  4. A slight increase in unemployment.
  5. A severe recession in the US. [Correct Answer]
  6. Very high unemployment. [Correct Answer]

Explanations:

  1. The Fed seeks 2% inflation, not just a decline in inflation. Declines can moderate interest rate increases and space them out more, but less likely to lead to a reversal long before approaching the target 2%.
  2. The Fed said repeatedly that it will accept a mild recession if needed to control inflation.
  3. When Core PCE Inflation reaches its 2% goal, interest rates don’t need to stay elevated and would likely move down.
  4. Slightly higher unemployment would still be low historically, and wouldn’t justify lower interest rates without much lower inflation.
  5. A severe recession would likely lead to lower interest rates, though not guaranteed if inflation spikes very high.
  6. Very high unemployment would likely lead to lower interest rates, especially if inflation isn’t very high.
Disclosures Including Backtested Performance Data

Building Credit for Kids under 18

by

Quiz!

At what age can a person in the US get a credit card?

  1. 0
  2. 16
  3. 18
  4. 21

Building Credit for Kids under 18

If you have kids under age 18, there are steps you can take to introduce them to the world of credit:

Build credit: You can add them as authorized users on your credit card(s). I tested this on Chase Freedom Unlimited. This can start building up their credit history, without them ever using the card. By the time they are 18, they should have a credit history.

Access to credit: In their teen years, you can have a separate credit card in one of the parents’ names, add your child as an authorized user and let them and only them use it. This goes around the age limit of 18+ for getting a credit card. There are multiple benefits:

  1. Enabling them to pay anywhere that requires a credit card for payment.
  2. Your child experiences the power & risk of using a credit card under your supervision. By the time they are adults, they have a chance to form healthy habits, and learn some pitfalls of credit cards.
  3. You can see 100% of their credit card transactions separately from yours, allowing for a full learning experience, while identifying clearly all of their transactions.

Remember that you do this at your own risk – whatever they feel like doing with your credit card, you are on the hook.

Quiz Answer:

At what age can a person in the US get a credit card?

  1. 0
  2. 16
  3. 18 [Correct Answer]
  4. 21

Explanation: The official age is 18, but this month’s article presents a way to get access at a lower age.

Disclosures Including Backtested Performance Data

Should I buy or sell Apple Stock?

by

Quiz!

What is the impact of Apple’s share buybacks on its P/E, and should you adjust for it?

  1. The share buybacks lowered Apple’s P/E in the past 3 years. At this rate, Apple’s cash will be gone in less than 3 years. Since this is not sustainable, you should adjust for it.
  2. Apple is a highly profitable company with desirable products. Its profits should keep generating cash to support share buybacks for the long run. There is no need for adjustments.

Should I buy or sell Apple Stock?

Apple is a very successful company, with strong demand for their products.  As an investment, I see conflicting messages in their financials:

  1. The Price/Earnings (P/E) of 21 is not extremely high (https://www.macrotrends.net/stocks/charts/AAPL/apple/pe-ratio).
  2. The Price/Book (P/B) of 41 is stratospheric, about x20 higher than the average for the S&P 500 (https://www.macrotrends.net/stocks/charts/AAPL/apple/price-book).

The problem?  Apple did massive share buybacks, reducing its cash on hand by 55% within about 3 years (https://www.macrotrends.net/stocks/charts/AAPL/apple/cash-on-hand).  Share buybacks reduce the number of shares, increasing the earnings per share, and lowering the P/E.  At the current rate, Apple’s excess cash will go down to $0 in less than 3 years.  Assuming continued success, with no change in earnings growth, something has to give within the next 3 years: a drop in the stock price, or a big increase in the P/E, resolving some of the current anomaly.

The solution? You can estimate the annual impact of share buybacks on Apple’s P/E in the past 3 years, and adjust for it, as part of a full analysis of the stock. QAM focuses on value investing based on the more reliable, stable and thoroughly studied P/B, and diversifies stock portfolios into 1,000s of stocks.

Quiz Answer:

What is the impact of Apple’s share buybacks on its P/E, and should you adjust for it?

  1. The share buybacks lowered Apple’s P/E in the past 3 years. At this rate, Apple’s cash will be gone in less than 3 years. Since this is not sustainable, you should adjust for it. [Correct Answer]
  2. Apple is a highly profitable company with desirable products. Its profits should keep generating cash to support share buybacks for the long run. There is no need for adjustments.

Explanations:

  1. Please read this month’s article above for an explanation of this point.
  2. While Apple is profitable, a realistic valuation should reflect a sustainable future, including a stable level of cash. With cash dropping fast in recent years, an adjustment is needed.
Disclosures Including Backtested Performance Data

What Does a High Dollar Mean for US and non-US Investments?

by

Quiz!

Since 1970, what was the impact on the 3-year return of US and non-US investments, when the dollar reached high levels like today?

  1. It helped the returns of US investments and hurt the returns of non-US investments.
  2. It hurt the returns of US investments and helped the returns of non-US investments.

What Does a High Dollar Mean for US and non-US Investments?

Recently, the dollar reached a very high level last seen in 2002 and 1986. What does this mean for US vs. non-US investments? Since 1970:

  1. Very high currencies suffered from a drag during the following 3-year returns
  2. Very low ones enjoyed a boost to the following 3-year returns.

While these past results don’t guarantee a repeat in the future, today’s conditions are encouraging for non-US investments relative to the US ones.

There are two explanations for this behavior when the dollar was unusually high:

  1. The low currencies increase the growth of non-US companies, by attracting US consumers, who get to buy more cheaply.
  2. The currencies increase back to fair value, increasing stock prices as measured in dollars.

Quiz Answer:

Since 1970, what was the impact on the 3-year return of US and non-US investments, when the dollar reached high levels like today?

  1. It helped the returns of US investments and hurt the returns of non-US investments.
  2. It hurt the returns of US investments and helped the returns of non-US investments. [Correct Answer]

Explanation: Please read the article above for an explanation.

Disclosures Including Backtested Performance Data

What is the Impact of High Inflation on Stock Returns?

by

Quiz!

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations.
  2. Growth stocks.
  3. Value stocks.

What is the Impact of High Inflation on Stock Returns?

We are experiencing very high inflation, last seen in the early 1980’s. What is the Impact of High Inflation on Stock Returns?

  1. Negative: It hurts stocks, by reducing stock valuations (Price/Book) to reflect a lower value of future earnings. It hurts growth stocks with high valuations especially hard. Examples are S&P 500 and Nasdaq.
  2. Positive: It ultimately helps stocks, because high inflation = higher prices => higher earnings for the companies.

The bigger the spike in inflation, the more stocks are likely to decline in the short run, because the negative forces can be greater than the positive ones. Once stock valuations adjust to higher inflation and higher interest rates (that are used to combat inflation), the positive impact tends to be much stronger, especially for value stocks.

Key takeaways:

  1. When inflation spikes, you should be especially cautious of stocks with very high valuations. Now the largest tech stocks are priced extremely high, something familiar from past cycles. In the 1970’s, we had the nifty-fifty, also called “one-decision” stocks. Counter to expectations at the time, they crashed badly despite being the most prominent of US stocks (https://en.wikipedia.org/wiki/Nifty_Fifty). Stock returns adhere to the formula, price = book value x (price / book value). If the valuations (price / book value) are very high, even the best company in the world can see its stock price drop.
  2. Value stocks (with low valuations, or price / book-value) are better positioned for high inflation, for 2 reasons: (1) Immediate: there is no big correction necessary to valuations; (2) Ongoing: more of their earnings are from the near-term, with a smaller needed discount to future earnings.
  3. Even value stocks can be expensive at times. For example, US Large Value stocks are currently very expensive (but still less than the S&P 500 and Nasdaq). In stark contrast, non-US Value stocks are priced low.

Quiz Answer:

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations. [Correct Answer]
  2. Growth stocks. [Correct Answer]
  3. Value stocks.

Explanation:

  1. While value stocks tend to have low Price/Book, sometimes an entire collection of stocks becomes expensive, including value stocks. A current example is US Large stocks.
  2. Growth stocks tend to have earnings far into the future, that need to be discounted by high interest rates (the tool used to combat high inflation).
  3. Value stocks are priced lower and have nearer-term earnings that not impacted as much by higher interest rates. The increase in income (along with inflation) can become the dominant force.

See article for more explanations.

Disclosures Including Backtested Performance Data

Does a High Dollar Lead to Poor Emerging Markets Returns?

by

Quiz!

What does a dollar far above average do to future emerging markets returns?

  1. It hurts emerging markets returns.
  2. It helps emerging markets returns.
  3. There is no correlation between a very high dollar and future emerging markets returns.

Does a High Dollar Lead to Poor Emerging Markets Returns?

I’ve seen articles explain how a high dollar hurts emerging market (EM) economies. With the dollar recently reaching the highest level since late 2002, some articles gave concerning messages related to emerging markets investments.

Historical evidence for the opposite: The history of EM investments shows opposite results. When the dollar reaches high levels, future returns of EM tend to be stronger than when the dollar is low. For example, the recent time we had such a high dollar (2002) was around the beginning of phenomenal 5 years for diversified EM stocks.

Explanations: Once the dollar is at unusually high levels, the negative effect of the dollar is priced into EM stocks, with lowered valuations (price/book and price/earnings). Given that the dollar is cyclical, at some point we got a reversal, with a declining dollar. Some of the logic of the articles can be used to explain the benefits of the declining dollar, helping EM stocks.

Caveats: This quick read shows counter evidence + logic to many articles you may read in some prominent sources. There are still big unknowns. The dollar may have just peaked, or it may go up further. The goal of this article isn’t finding the exact peak, but looking at odds for further increases vs. decreases. When a cyclical measure is above average, you would expect higher odds for the measure to go lower than higher.

Quiz Answer:

What does a dollar far above average do to future emerging markets returns?

  1. It hurts emerging markets returns.
  2. It helps emerging markets returns. [The Correct Answer, but read explanation]
  3. There is no correlation between a very high dollar and future emerging markets returns.

Explanation: A rising dollar lowers the value of emerging markets (EM) returns as measured in dollars. So, the past EM returns leading to the dollar highs are hurt. Future emerging markets returns depend on the future movement of the dollar. From a level above average, the dollar is more likely to decline in the future. That would lead to above average returns. A caveat is that this simply reflects odds, not guarantees or specific timing.

Disclosures Including Backtested Performance Data

The Anatomy of a Lost Decade

by

Quiz!

What leads to lost decades? (There may be multiple answers.)

  1. Wars.
  2. Pandemics.
  3. High valuations, as measured by price/book or price/earnings.
  4. Extreme economic distress.
  5. Euphoria.

The Anatomy of a Lost Decade

In the 2000’s, the S&P 500 experienced a 10-year decline, on a total return basis (including dividends), and much worse after counting the negative effect of inflation. This was not the first time – the decade ending in 1974 had +1.2% return per year, while inflation averaged 5.2% per year. This article describes what may lead to such long declines, and how they look.

What led to lost decades? A diversified portfolio of companies that produces products and services for entire countries is not likely to shrink its production for 10 years. What led to the 2 recent lost decades was high valuations (high price relative to the earnings of the companies or book values) of the companies. During the decade, the valuations declined by more than 50%, to correct (and typically overcorrect) the unusual pricing.

How did they look? The two most recent lost decades involved a series of gain periods followed by big declines, erasing substantial gains.

Can you avoid lost decades? There is no way to perfectly time the market, since turning points vary between cycles, with highs sometimes (but not always) leading to higher levels. There are various approaches with varying levels of success, involving getting out of diversified investments that did far above average for 10 years, or selling when valuations reach extremes. The easiest one is to diversify and include investments with lower average growth. While it involves a sacrifice to the returns, it gets around so many strategies that fail.

Why most people fail at timing? Once you find a strategy that stood the test of time, and has sound logic to it, you still have a major obstacle to overcome. Selling high and buying low involves going against the grain. It involves selling the most loved investment of the time, that people believe will just keep going up, and buying battered investments that underperformed for many years.

Can you avoid lost decades? While it is very difficult to time the market, or at least soften the blow of tough stretches, there are several principles that can improve your odds:

  1. When you hear gloomy news, along with scary predictions, and the investments are very low (low valuations / low 10 year returns), get excited about the investment.
  2. When you see euphoria all around you, with the most positive news, and the investments are sky high (high valuations / high 10 year returns), have the ability pull the trigger and sell and switch to an investment that most people hate.
  3. Whatever strategy you choose, make sure that it passed 2 tests: the test of time & the test of logic. While these are not enough, I would not move forward without these in place.
  4. Don’t expect to successfully time within one day, week, month or even year. Short-term timing strategies are far more difficult than long-term ones.
  5. Have a very robust risk plan, accounting for cases much worse than experienced in the past, allowing you to stick with the plan in some of the toughest times.

Quiz Answer:

What leads to lost decades? (There may be multiple answers.)

  1. Wars.
  2. Pandemics.
  3. High valuations, as measured by price/book or price/earnings. [Correct Answer]
  4. Extreme economic distress.
  5. Euphoria. [Correct Answer]

Explanations:

  1. Wars end up leading to increased economic activity. Declines tend to be far shorter than a decade.
  2. Pandemics tended to create short-term shocks, not very long lasting.
  3. High valuations typically get corrected. When valuations reach extremes, such as x2 the typical or more, it takes a prolonged period of poor performance to correct those.
  4. Extreme economic distress can lead to declines, but without high valuations, they tend to get resolved in far less than 10 years.
  5. Euphoria tends to lead to very high valuations – see #3 above.
Disclosures Including Backtested Performance Data