Bull markets are a wonderful thing for your portfolio. Less so for your ego. Yet the interplay between the two is not always to your portfolio’s benefit.
John Kenneth Galbraith recognized this flaw in human nature when it came to investing from studying the bull market that ended in the 1929 crash.
The anatomy of the self-destroying speculative boom is rather simple. Over a period of time with advancing technology, an increasing national product, and a reliable tendency in the economy to inflation, most common stocks will rise in value. As this happens people are attracted to the market and this causes the stocks to rise more. This further gain attracts yet more people and gradually, perhaps over some years, the purchases of people looking for this increase in value come to determine what stocks are worth. Prospective earnings are still mentioned but as an afterthought — or to show that there is still some tie to reality…
Then, at some stage, the supply of buyers runs out — or dries up. Or there may be public action to dry up the spring. The increase falters. This causes the more knowledgeable or the more nervous to get out. This causes the market to falter more. More decide to get out and the slow upward climb is replaced by a precipitate drop. As I suggested earlier, there usually will be some earlier episodes of nervousness before the climatic fright arrives. The greater the preceding buildup, the more stocks have come to depend on a continuing influx of buyers attracted by the prospect of the capital gains, the more violent will be the eventual collapse.
This simple design is, on the whole, less interesting than the secondary insanity which it induces. Because the market is going up, almost everyone associated with the market makes money. Almost anyone can thus look like a financial genius with a minimum of qualification or none at all.
Reviewing the boom/bust cycle is important because not every investor has experienced one before. Some of those that have may not remember how the last one ended either. It can lead to two things in booming bull markets: the belief that losses are not worth worrying about and a growing confidence in your investing ability. The result is greater risk taking.
Galbraith recognized the risk-taking behavior in 1929, but it wasn’t specific to that moment. Risk taking is a recurring theme in every bull market that takes on some combination of the following:
- Investors over-allocate to equities — they own more stocks than they should own in their portfolio.
- Investors concentrate their portfolios — they own too few stocks to diversify investment risk in their portfolio.
- Investors leverage their portfolios — they use debt to boost returns in a rising market because they ignore the fact that leverage has a similar effect on losses when the market falls.
- Investors, collectively, target similar stocks — they chase the hot stocks or the “meme” stocks or the stocks behind the new innovation of the time. Prices get bid up so high that a fall is inevitable.
And the above works for a while thanks to a rising bull market. Your growing confidence might not allow you to see it that way, though. Who credits the bull market for their rising portfolio instead of themselves?
Your investment strategy makes money. The stocks you pick are doing great. So, you and your strategy must be brilliant? Or is the bull market making your flawed strategy look brilliant?
The answer to that last question determines whether your strategy will work over multiple market cycles or end up in the long list of “strategies” that worked once, then never again.
How do you know if your strategy is brilliant or flawed?
First, you never really know. Randomness in markets eliminates certainty of anything. Investing is a game of probabilities and luck plays a role. The shorter the time period, the bigger the role of luck. That’s why a flawed strategy can work in one bull market but is unlikely to work beyond that. It’s why a brilliant strategy stops working for a while too. It was good or bad luck in a booming market.
Second, it’s repeatable. Not over a few months or years but multiple market cycles. The longer the time period, the less likely luck is behind your strategy’s success. That means its data driven, back tested, and has a rational (arguably behavioral) explanation for why it works.
Third, you’re comfortable with the strategy’s risks. Repeatability only gets you so far with a good strategy. At some point, bad luck leads to underperformance or even losses. No strategy works all the time. Are you comfortable losing to another strategy or actual losses? Repeatable strategies require discipline on your part. If you’re not comfortable with it, then it’s a bad strategy for you.
Here’s what you need to remember. Markets change. New patterns emerge. On rare occasions the pattern persists. Most times it’s temporary – a byproduct of many investors’ actions that drive stock prices higher but ends with the bull market.
When you buy a stock that fits that new pattern and it goes up, then you do it again and again, be careful not to let that success go to your head.
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