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This is the reason for one of the oldest and most important investment adages: “don’t confuse brains with a bull market.”
Let’s think about investment strategies. It’s essential to grasp that nothing will work forever: no approach, rule or process can outperform all the time. First, most securities and approaches are right for certain environments and parts of the cycle, and wrong for others. And second, past success will in itself render future success less likely.
In other words, “outperformance” is just another word for one thing appreciating relative to another. And, clearly, that can’t go on forever. Regardless of how great its merits may be, “a” is unlikely to be infinitely more valuable than “b.” That means if “a” keeps appreciating relative to “b,” there has to be a point at which it will become overvalued relative to “b.” And just when the last person gives up on “b” because it’s been performing so poorly and jumps to “a,” it will be time for “b” (now compellingly cheap relative to “a”) to outperform.
It’s all a matter of ebb and flow. In investing, things work until they don’t. Or as Ajit Jain of Berkshire Hathaway told me about investing the other day, “it’s easy until it isn’t.” Cheap small-caps outperform until they reach the point where they’re no longer cheap. Trend-following or momentum investing — staying with the winners — works for a while. But eventually rotation and buying the laggards takes over as the winning strategy. “Buying the dips” lets investors take advantage of momentary weakness, up until the time when a major problem surfaces (or the market simply no longer
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In 1968, thanks to its monopolistic position, strong growth and high profitability, Xerox was a leader of the Nifty Fifty I described earlier — companies that were considered so strong and so fast growing that “nothing bad could happen” and “no stock price was too high.” But trees rarely grow to the sky, and success is rarely unending.
Let’s return to Charlie Munger’s quote from Demosthenes: “For that which a man wishes, that he will believe.” In other words, wishful thinking often takes hold. This can cause investors to believe that good times will be followed by more good times. But that ignores the cyclical nature of things, and especially of success.
Emotions operate on cycles two ways: they magnify the forces that lead to extremes that eventually require correction, and they cause market participants to overlook the cyclicality of cyclical things at just those moments when recognition of excesses is most essential and most potentially profitable: stage three of the bull and bear markets described here and here.
The following passage from The Most Important Thing may serve to wrap up regarding the outlook for cycles’ recurrence: Cycles will never stop occurring. If there were such a thing as a completely efficient market, and if people really made decisions in a calculating and unemotional manner, perhaps cycles (or at least their extremes) would be banished. But that’ll never be the case. Economies will wax and wane as consumers spend more or less, responding emotionally to economic factors or exogenous events, geopolitical or naturally occurring. Companies will anticipate a rosy future during the up
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THE ESSENCE OF CYCLES I’m going to conclude by pulling together some of the book’s paragraphs that I think hold the keys to understanding cycles, their genesis, and how they should be dealt with. I’ll alter them only as necessary to allow them to stand alone here, out of context. This won’t be a summary of the book, but rather a recap of some of its key observations. H.M.
Superior investing doesn’t come from buying high-quality assets, but from buying when the deal is good, the price is low, the potential return is substantial, and the risk is limited. These conditions are much more the case when the credit markets are in the less-euphoric, more-stringent part of their cycle. The slammed-shut phase of the credit cycle probably does more to make bargains available than any other single factor. (See here)
Exiting the market after a decline — and thus failing to participate in a cyclical rebound — is truly the cardinal sin in investing. Experiencing a mark-to-market loss in the downward phase of a cycle isn’t fatal in and of itself, as long as you hold through the beneficial upward part as well. It’s converting that downward fluctuation into a permanent loss by selling out at the bottom that’s really terrible. Thus understanding cycles and having the emotional and financial wherewithal needed to live through them is an essential ingredient in investment success. (See here)
The Most Important Thing, “we may never know where we’re going, but we’d better have a good idea where we are.”
What’s the key in all of this? To know where the pendulum of psychology and the cycle in valuation stand in their swings. To refuse to buy — and perhaps to sell — when too-positive psychology and the willingness to assign too-high valuations cause prices to soar to peak levels. And to buy when downcast psychology and the desertion of valuation standards on the downside cause panicky investors to create bargains by selling despite the low prices that prevail. As Sir John Templeton put it, “To buy when others are despondently selling and sell when others are greedily buying requires the greatest
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People have feelings, and as such they aren’t bound by inviolable laws. They’ll always bring emotions and foibles to their economic and investing decisions. As a result, they’ll become euphoric at the wrong time and despondent at the wrong time — exaggerating the upside potential when things are going well and the downside risk when things are going poorly — and thus they’ll take trends to cyclical extremes. (See here)
Cycle positioning is the process of deciding on the risk posture of your portfolio in response to your judgments regarding the principal cycles, and asset selection is the process of deciding which markets, market niches and specific securities or assets to overweight and underweight. These are the two main tools in portfolio management. It may be an over-simplification, but I think everything investors do falls under one or the other of these headings. (See here)
The recipe for success here consists of (a) thoughtful analysis of where the market stands in its cycle, (b) a resulting increase in aggressiveness or defensiveness, and (c) being proved right.
When the market is low in its cycle, gains are more likely than usual, and losses are less likely. The reverse is true when the market is high in its cycle. Positioning moves, based on where you believe the market stands in its cycle, amount to trying to better prepare your portfolio for the events that lie ahead. While you can always be unlucky regarding the relationship between what logically should happen and what actually does happen, good positioning decisions can increase the chance that the market’s tendency — and thus the chance for outperformance — will be on your side. (See here)
The reasonableness of the effort at cycle timing depends simply on what you expect of it. If you frequently try to discern where we are in the cycle in the sense of “what’s going to happen tomorrow?” or “what’s in store for us next month?” you’re unlikely to find success. I describe such an effort as “trying to be cute.” No one can make fine distinctions like those often enough or consistently right enough to add materially to investment results. And no one knows when the market developments that efforts at cycle positioning label “probable” will materialize.
