Bitcoin

Quiz

You hold a diversified investment that performed poorly for 10 years and want to make a change. What should you do? (Multiple answers may be correct.)

1. Very gradually diversify into more proven investments.
2. Very gradually diversify by including stable investments.
3. Compare the valuation of the investment along with the investment you are considering for diversification, and avoid selling low to buy high.
4. Compare the valuation of the investment relative to the long run, and also the returns relative to full cycles. If both are below typical, don’t make changes, and keep saving new money into it.
5. Track the valuations and recent performance relative to the long run / full cycles. Be ready to diversify from a point of strength – at a high point, adding investments that are not at a very high point.
6. Avoid making changes due to cyclical forces.

One of the Most Destructive Forces in Investing, and How to Fight it

Have you ever experienced any of the following:

1. Had some money to invest and looked at the past 1-, 5- or 10-year performance, to help choose?

2. Heard from someone that she/he made big money in an investment in recent years and felt the urge to put some money there?

3. Lived through a long period (as long as 10 or more years) of poor performance relative to other investments and felt that it’s time to diversify?

4. Learned about an investment that grew phenomenally for the past 10 years, felt that it is a solid investment, and felt secure to put money there?

5. Saw your investment go through a big crash (50%+), with economic news giving a thorough explanation for a disastrous future, leading you to seek safety in solid investments (e.g. bonds or CDs)?

From my experience talking to people over the years, the scenarios above are very common. Why is that? In most avenues of life you can use experiences from recent years to project the future. Examples:

1. If you get hungry, you learn to eat and then feel better. It was true today, one year ago, and any day.

2. If you cross a street without observing the traffic, and nearly get hurt, you learn to always look for traffic before crossing the street. This will never be bad advice.

It turns out that investments involve cycles of various lengths. This means that learning about past years can be counterproductive. Examples:

1. US Large Growth (high Price/Book or Price/Earnings) stocks outperformed US Value stocks from 1982 to 2000. You would expect 18 years to be plenty long to establish the trend. In the following 2 years, the entire benefit of Growth stocks over Value stocks was wiped, and Value outperformed Growth for the full 20 years! This brought the relative performance of the two groups in line with the long run. Imagine the devastation of a person who made a change in early 2000 – something that many did. Today’s P/B of the S&P 500 is right near the peak level of 3/2000, early in its latest 10-year decline!

2. Real estate had unusual gains from 1995 to 2006. Some people became multimillionaires by buying many houses with huge loans. By 2006, you could have taken a 106% loan on a house, with no verification of income. In the following 5-6 years, home prices declined by varying degrees, depending on location, taking as long as 10+ years peak-to-peak. In California, typical declines were 30% from peak to bottom. Some loans in 2006 led to more than 100% loss on the original investment, unless you had the income and discipline to keep paying the mortgage for years until recovery. This brought some of those millionaires to bankruptcy.

It is surprising to realize how many investment mistakes are rooted in a single cause – underestimating and misunderstanding cycles. So, how can you avoid the traps above?

1. Always look for logic – not just past returns. Companies bring value through efficiently providing products and services. Real estate offers a place to live or run a business. Bonds are a loan to a company or government, allowing it to spend money that it doesn’t have with the hope of adding value beyond the cost of borrowing (or print money in the case of a government).

2. Be highly suspicious of investments that don’t generate value or are too new to have at least one clear full cycle. Cryptocurrencies, including Bitcoin, have both issues. Educated opinion: only after completing the next tech downturn, you may reach a full crypto cycle.

3. Study the long history of investment types that you are considering. If you notice unusually good or bad returns for an investment, compare them to the full cycle. If there is an unusually large deviation, at least prepare for the potential of a reversal. Do not move money out of an investment that did poorly for 10 or even 15 years relative to its full-cycle average, and into an investment that did very well in the past 10 or 15 years relative to its full-cycle average.

4. Most common investments have a way to value them. Stocks have Price/Book Value (P/B) and Price/Earnings (P/E), representing what people pay for the stock relative to the intrinsic value or earnings of the company. For diversified collections of stocks, you can compare the current values relative to the full-cycle average, and don’t expect an anomaly to last forever. There are valuation measures for different types of real estate, small businesses, and other investments. Use them instead of looking at the recent past.

5. Never judge an investment by the length of an unusual period – always view valuation measures. The longer the anomaly, the more violent the reversals tend to be, and the bigger the damage in counting on persistence after the anomaly sustained for a long time. If an anomaly continues another year, or multiple years, there is a growing temptation to take it as proof that it is a new normal, and so does the damage, when the reversal does come. You can observe the returns of Japanese stocks for nearly 30 years after 1989, or gold for nearly 30 years after 1980.

6. Imagine that a diversified investment you are considering went through 10 terrible or phenomenal years of returns. If the terrible years make you want to avoid the investment and the phenomenal years make you want to put money there, recognize that you may have fallen into the traps above. Go back to logic, valuation measures and full cycles.

Quiz Answer

You hold a diversified investment that performed poorly for 10 years and want to make a change. What should you do? (Multiple answers may be correct.)

1. Very gradually diversify into more proven investments.
2. Very gradually diversify by including stable investments.
3. Compare the valuation of the investment along with the investment you are considering for diversification, and avoid selling low to buy high. [Correct Answer]
4. Compare the valuation of the investment relative to the long run, and also the returns relative to full cycles. If both are below typical, don’t make changes, and keep saving new money into it. [Correct Answer]
5. Track the valuations and recent performance relative to the long run / full cycles. Be ready to diversify from a point of strength – at a high point, adding investments that are not at a very high point. [Correct Answer]
6. Avoid making changes due to cyclical forces. [Correct Answer]

Explanations:

1. You already hold a diversified investment. Not all extra diversification is good. If you sell low to buy high, the added risk and harm to the expected returns can outweigh the benefits of extra diversification. See all explanations below to help decide. Also note that reversals after 10 unusual years are the norm, not the exception.
2. Buying a stable investment can prevent the damage of buying high in #1, but it still keeps the potential damage of selling low, and introduces the additional damage of low growth (that is typical for stable investments).
3. Future returns do not always repeat recent years – reversals are the norm. A much better predictor of future returns is valuations (P/E, P/B, various real estate ROI and affordability measures). Valuations may fail for a streak of years, testing the discipline of investors, but the longer they fail the bigger the reversal tends to be. It is difficult to win by buying high.
4. See explanation right above + stick to the foundations: high long-term returns for the asset class in which you are investing.
5. See explanations above + you can add diversification without the damage of selling low and buying high, by being as patient as needed. Being impatient with this can create lifelong damage.
6. There is always a compelling story justifying low points. While it may explain the past, it may not explain the future. Be extra wary of mistaking cyclical forces for permanence – it may be the most common mistake that people do at extremes (lows and highs).

Disclosures Including Backtested Performance Data