Disclaimer: This post is not my attempt to predict what lies in the future and where the stock market is headed, because I have a post-graduate degree in making disastrous predictions, especially about the future. What I am sharing below is what I have started experiencing around me, and why I believe you, as an investor, must be very careful of falling into the trap of people making rosy predictions about the future.
One of the key themes of my discussions with investors during my extensive travel over the past few days was that risk-taking and arrogance is back in the stock market.
I got a hint of this from a lot of people stressing on the benefits of borrowing money to invest in “great opportunities” available out there.
So one participant at my Indore workshop argued – “Why shouldn’t I borrow at 10-12% interest and invest for 25-30% returns that are there for the taking?”
Another asked in Vadodara – “Why shouldn’t I borrow when I know the opportunity to multiply money is great?”
Without doubt, I could answer these questions only to the point I understand the dangers of borrowing money to trade or invest in the stock market. Beyond a point, if someone has made up his/her mind that borrowing money is a great idea (because others have found success doing so), I have no answers to provide.
All I know about buying stocks with borrowed money is that it doesn’t make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize. And then, leverage brings destruction if things go bad…really bad. And they often do.
Anyways, related to this point about how bad things can go in the stock market, someone asked me my thoughts on the “worst-case scenario” I can imagine.
Now, here is how our brain plays tricks when it comes to imagining scenarios. We generally imagine only what we have seen or experienced in the recent past.
So my worst-case expectations would often not go beyond what I saw in 2008, for that is only what I remember from recent history.
But this is where Howard Marks brings my imaginations back to the ground. He does that through an entertaining story he shared in The Most Important Thing about worst-case expectations, or how bad things can go…
We hear a lot about “worst-case” projections, but they often turn out not to be negative enough. I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away. Invariably things can get worse than people expect.
Maybe “worst-case” means “the worst we’ve seen in the past.” But that doesn’t mean things can’t be worse in the future. In 2007, many people’s worst-case assumptions were exceeded.
Am I a Pessimist?
Interestingly, I find a lot of people these days accusing me of being a pessimist whenever I write about practicing caution amidst the ongoing hype all around.
This is especially given that all the “hallowed” investors around are suggesting that ‘this is the time to be in equities’, and that ‘this time it’s different’.
In fact, when I recently posted on Twitter how a surging stock market creates false hopes and false heroes, one person replied – “If surging markets doesn’t make one rich then what does?” – and then – “Being contrarian just for the sake of being one is dangerous.”
I think it is a big fallacy among investors that they need rising prices to create wealth from the stock market. In fact, constantly and/or rapidly rising stock prices are a detriment to someone who wants to accumulate a lot of great businesses at decent prices to benefit from their future potential and growth.
In order to create wealth from stocks, you need to accumulate a lot of them at reasonable or cheap prices (for which you need dull or falling markets) and then let the underlying business work their magic of compounding your money over the long run (15-20 years).
But if you can’t think of long term perspectives (the ‘n’ or time horizon in the compounding formula), and you are worried only about earning the highest ‘r’ (the rate of return) as fast as possible, and often borrowing money to magnify the same, you are simply on the path of ruin.
Over a 10-year period, someone who grows his money at 25% per annum for eight years and then loses 40% each in the last two (because of the risks he took earlier), will be poorer than someone who plays it extra-safe and earns just 10% annual return over these 10 years.
Of course, you should not be in stocks if you are playing for just a 10% annual return, but what I am trying to say here is that over-optimism and over-confidence that leads to blind risk-taking can wipe out your great long-term historical returns in just a year or two.
Avoid Losing Your Savings, Sleep, and Reputation
When you take on leverage and show me the math that a 25% annual return over 10 years minus 12% interest cost can still earn you 20%+ return, please remember Nassim Taleb who says that we should judge people by the costs of the alternative, that is if history played out in another way.
As he wrote in his brilliant book Fooled by Randomness…
Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).
In the same way, be very careful of judging your stock market success by the outcome you achieve, but by the decision you made.
“Leverage can help me magnify my returns” is a great statement to make. But more often now, leverage – which is a result of arrogance created by good short-term returns or a result of survivorship bias, which is concentrating on the people or things that “survived” some process and inadvertently overlooking those that did not – will not only your destroy your savings and sleep, it will also destroy your reputation.
If you think that way, you will do things differently.
By the way, here is what Howard Marks wrote in his latest memo to shareholders…
While investor behaviour hasn’t sunk to the depths seen just before the crisis (and, in my opinion, that contributed greatly to it), in many ways it has entered the zone of imprudence. To borrow a metaphor from Chuck Prince, Citigroup’s CEO from 2003 to 2007, anyone who’s totally unwilling to dance to today’s fast-paced music can find it challenging to put money to work.
It’s the job of investors to strike a proper balance between offense and defense, and between worrying about losing money and worrying about missing opportunity. Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last three years Oaktree’s mantra has been “move forward, but with caution.” At this time, in reiterating that mantra, I would increase the emphasis on those last three words: “but with caution.”
Well, I have nothing to add except that while I am an eternal optimist as far as stock market investing is concerned (or why would Safal Niveshak exist to educate you to invest), be very careful of what you are doing with your money and why you are doing it.
To re-quote Howard Marks – Move forward, but with caution.