Don’t Insult Warren Buffett
Warren Buffett has been instructing investors for decades to buy low and sell high. Yet the vast majority of investors across the globe tend to do the opposite, and that is unlikely to ever change. Although it appears irrational to buy high and sell low, there is a very logical explanation for this irrationality: herd behavior. After all, we are herd animals. We live in herds (families, towns, etc.), we hunt (these days we call it work) in herds, and as evidence has shown, we also like to invest in herds. Through the evolutionary process, herding has become ingrained in our DNA. In most instances related to our survival and success as a species, herding tends to work to our benefit. Therefore, as much as we like to think we are rational and able to make good independent decisions, herd behavior is nearly impossible to counteract. Herd behavior becomes especially prevalent when we have little knowledge of the subject matter ourselves, and as such the only comfortable course would seem to be following the herd.
The problem with herd psychology as it relates to investing, is that it tends to cause us humans to make poor investment choices in the long run. Investing is a strange discipline where most common human traits do not often work to our advantage. Most humans, if given the choice, would rather invest in something that has recently generated positive returns, especially if they know and trust others who have made money in the same investment. In fact, there are many herd emotions at play in investing: anxiousness about missing out, social pressure to participate, greed, fear of loss. The herd, however, offers psychological comfort, because if one is suffering losses, everyone is suffering together.
This herd behavior has been academically proven to contribute to investment bubbles and the inevitable boom and bust cycle of the economy. When a trend starts, it is the early investors, those with extraordinary knowledge to exploit the opportunity, who are the first movers. As the trend builds and those first movers start generating positive returns, more and more investors are drawn in until eventually prices are far above rational levels only to then reach the point when there are no more buyers. A crash ensues and the herd runs for the door, stomping prices into the ground.
All human investment decision-making is subject to herd behavior and a number of other hard-wired behavioral biases, which, if left unchecked, will lead to poor long-term investment results. To demonstrate that point, we recently conducted some micro-research on how buying at new market highs affects long-term returns here.
The most effective weapons to defeat the “Buy High Sell Low” Army are qualitative logic or quantitative models. Neither is perfect but if applied over longer time periods both are vastly superior to applying unfiltered human behavioral biases to financial decision making.
From a behavioral perspective, human logic and quantitative models can become incredibly difficult to follow when the intuitive investment system of “Buy High and Sell Low” has recently done better than the logical or mathematical choice of responding to favorable odds instead of emotions. From an odds perspective, new market highs represent the moment of greatest risk instead of greatest opportunity. In the long run, what matters is how much of those new highs investors get to keep.
Therefore, allow us to make the logical case for considering downside protected investment strategies such as our Smart Wealth Indices for the core of your portfolio, in particular at or around new market highs, as is the case presently.
With the earnings season for publicly traded companies firmly under way, a few interesting observations stand out. Most companies continue to beat the earnings numbers forecast by outside analysts who cover those companies. Usually, this activity of covering a company and making short-term predictions about their earnings and other financial metrics is done by analysts of investment banks and other financial service firms. The company in question will guide the analysts’ expectations low, so that their projections can be beat, and then both the company and investment bank can celebrate the “earnings surprise” and create buying activity.
Therefore, reading the headlines of “ABC company beat expectations” is not good news. It simply does not matter. Instead, it is much more meaningful to analyze what those reported earnings actually were compared to a trailing period, usually one year ago. This is where the trouble starts: At present, we are in the fifth consecutive quarter of contracting earnings. This phenomenon has been dubbed the “earnings recession.” Earnings reported so far for the second quarter of 2016 have declined by about 5.5% year on year. This is the first time since the financial crisis that companies found themselves in such a continuous downward spiral of earnings for five consecutive quarters. Revenue has also declined for the last six quarters on a year over year basis.
When purchasing stock in a company, we do not primarily pay for their inventory, fixed assets or liquidation value if dismantled and sold off. Instead, investors pay for the future amount of earnings a company is likely to produce with those assets.It is easy enough to understand that nobody in their right mind would want to pay $100 now for $90 of future earnings potential. That would be a bad deal. And if we could pay $50 for $100 of future earnings potential, then we likely cut a good deal. This analysis led to the invention of the Price/Earnings ratio, a measure of how good a deal in terms of price now versus future earnings potential we can cut ourselves.
The graph below shows the Shiller PE ratio, a modified Price/Earnings Ratio invented by Professor Shiller, the Nobel laureate, which shows the general level of expensiveness for the US Stock market.
Stocks are now as expensive as just before the 2008 financial crisis. In other words, we now have to pay about the same price per unit of future earnings potential as in 2008. In the entire history of the data set reaching back to the late 1800s there are only two periods, the Roaring ‘20s stock market bubble and the Tech Bubble, during which stocks were trading at a higher Price/Earnings Ratio, each of which ended with a spectacular crash. The graph above does not imply a crash is imminent Prices could rise further. However, the odds are stacked against equity investors at present.
Carden Capital’s Smart Wealth Indices offer a good solution at a time of new market highs. While they participate should the market keep moving up, they also offer embedded downside protection to help investors keep more of the recent gains should the market reverse course.