Investor Insanity Strikes Again
By Don Schreiber, Jr. - WBI Founder and CEO
(Printable PDF available below)
Over the weekend I read John Hussman’s “The Arithmetic of Risk” in Advisor Perspectives. Hussman is a noted economist who warns: “The collapse of major bubbles is often preceded by the collapse of smaller bubbles representing fringe speculations.” He sees the recent collapse of the short-VIX trade and Bitcoin as the beginning of investors waking up to the extreme risks posed by the extreme overvaluation of markets. He makes several other salient points that every advisor and investor should heed. I suggest a careful study of the piece.
While reading the article, it struck me that in late-stage bull market rallies investors tend to repeat the same investing mistakes. A good definition of investor insanity is doing the same thing over and over again but expecting a different result. Human survival instincts and emotions tend to cause investors to think this time it will be different. Maybe the bull market will continue to run forever. Maybe this time we’ll get to keep our gains by selling to cash before we lose most of our money in the bear market. Or maybe low-cost passive funds won’t go down like the indexes. You could literally come up with dozens of self-deceptive rationalizations.
Investor greed seems to be very difficult for people to overcome when stocks are at extreme valuations, and markets have been moving higher for an extended period of time. It’s confounding to me because I would think investors would stick to the most basic and proven theorem of investing — to win all you need to do is buy low and sell high. I think the reason investors overlook the obvious is the industry and media spend so much time and effort telling investors to build diversified portfolios with low-cost passive products and then to buy and hold, no matter what.
The media’s constant messaging has created a herd mentality among investors and has caused a crowded trade into indexes like the S&P 500, Dow, and NASDAQ. Prices rise because of the tremendous amount of capital rushing into the largest capitalization weighted stocks. As prices rise, returns increase, so people pour in more money. Sounds like a self-fulfilling proposition, until investor optimism turns to pessimism and capital flows reverse.
Bubbles are dangerous because they tend to unwind quickly and always end badly for investors who choose to ignore market valuations as well as economic trends and corporate fundamentals. Debunking media and industry brainwashing regarding passive index investing is important to protect investors from losing their life savings again!
Passive products look and feel good as bull markets lift prices higher. But when markets fall passive products can move in symmetry. The next bear market rampage is likely to hurt investors even worse than the Dot Com bubble bursting or the Financial Crisis. As the pendulum of overvaluation swings to the extreme, the ensuing bear market is likely to fall faster and further than normal. It is important investors understand the level of risk in the markets and to have an exit plan that will prevent them from selling low and then sitting on the sidelines too long, failing to participate in powerful bull market rallies off the bottom.
Buying stocks just because they are rising doesn’t make sense if they are overvalued to the extreme. The tremendous late-stage bull market rally in tech in 1999 looked a lot like what has been going on recently. Sooner or later valuation and fundamentals matter and it usually takes a Fed rate hike cycle to bring them into focus for investors.
One of my favorite Wall Street adages is don’t fight the Fed. When the Fed starts a rate hike cycle, it typically ends with the economy in recession and turns a bull market into a bear market. To ignore these warning signs while aggressively chasing returns is insane behavior, but unfortunately, as we said, it’s just human nature.
Investors pile into stocks because of fear they will miss out on return. Greed drives them to buy high, not low, all the while setting them up for possibly large bear market losses as speculative bubbles burst. It happened in 2000 as the “Tech Wreck” bear market ended with the tech-heavy NASDAQ Index crashing by just under 80%.
Taking large losses in bear markets is just about the worst thing you can do. Our market research of market cycles clearly shows that bear market losses since 1950 were seven times more powerful than bull market gains. Let’s not forget that the once high-flying NASDAQ took more than 15 years to get back to the March 2000 high. Did anyone really buy and hold tech stocks down 80%? Why would you even try?
In our experience, few investors buy and hold when faced with losses of 25% or more, much less the tremendous losses experienced by the NASDAQ. Based on the Investment Company Institute fund flows report, investors not only don’t hold, they actually sit on the sidelines after taking large losses and frequently miss the strongest recovery rallies that occur in the first few years of a bull market. Unfortunately, history also shows that bull market bubbles caused by excess speculation always end badly and it’s just a matter of when, and not if, the cycle will end.
Market trends are starting to show the signs of speculative strain as investors begin to pay attention to negative news trends. With the collapse of fringe bubbles, we may be seeing speculation and excess optimism start to come apart at the seams. I hope that investors are waking up to the extreme risk/return tradeoff of continuing to pile into passive index products. Before it’s too late, investors should embrace the value and dividend-paying stocks. They tend to provide a lower risk and loss profile than the more overvalued growth, tech, and momentum stocks that have been driving passive indexes higher.
WBI has always focused on selecting the best quality dividend-paying stocks to build portfolios. Dividends provide a positive source of return in both bull and bear market cycles. The return from dividends represents approximately 40% of the markets’ historical return profile (S&P 500 Index over the past 80 years). When reinvested, dividends can accelerate compounding dramatically, increasing your chance of investing successfully.
The easiest way to win is to not lose too much in bear market cycles. WBI’s mission is to protect capital from large losses first and focus on return second. Einstein said that compounding is the eighth wonder of the world and the most powerful financial force in the universe. By preserving capital in bear markets, we can compound more effectively in bull markets because we start with a larger capital base than many other alternatives. We actively manage risk and return in an effort to optimize capital growth by tightening risk controls as valuations become excessive. This helps us to protect capital by raising cash as prices begin to decline. To avoid bear market losses, you must raise cash early and be willing to hold cash if market trends continue to deteriorate.
Over the past 25 years, we’ve built an unemotional quantitative management system to remove the dangerous human emotion factor from investing. We believe that math will tell you the truth and that the truth can help you avoid losses while improving returns.
It is time to develop a plan to take risk off before the next bear market begins. WBI has a time-tested risk management system that can help you invest more successfully so you can achieve your goals. The time is now to put emotion aside and put your trust in a math-based unemotional system. WBI’s management approach can help you Tame the Bear and Run with the Bull.
Past performance does not guarantee future results. Don Schreiber, Jr. or clients of WBI may own stock discussed in this article. All economic and performance information is historical and not indicative of future results. This is not an oﬀer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or proﬁtable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request.
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