Thinking about bubbles.

I just spent a couple of days in New York attending a ‘Behavioural Investing’ conference. We talked about how to help people through the emotions of investing, and how to counteract human nature, which always wants to do the wrong thing at exactly the wrong time.

A topic of discussion was bubbles. The psychology of a bubble is fascinating, and I have written about it before. As I write the media seems to be telling us that an apocalypse is around the corner - terms such as “carnage” and “blood bath” have appeared with increasing frequency. As someone who tries to take a more contrarian view, my mind is increasingly thinking about how I counsel my clients when (not if) we see the next big bubble in the stock market.

Before we get there, it is useful to think about how people get sucked into bubbles. Even the smartest people on the planet get sucked in (Sir Isaac Newton and Stanley Druckenmiller are two totally different examples). They get sucked in because they can’t remember the last one. Big bubbles tend to be a generational thing.

We often talk about fear and greed driving the markets. But I don’t think greed really captures what is happening when an otherwise sensible, rational, and smart human being gets sucked into a bubble. It’s fear. It’s always fear. The fear is a deep, terrible fear that there is this once in a lifetime thing happening and that you are not in it. We certainly saw that play out with bitcoin last year for many young people who had never seen a bubble before.

The thing to remember is that no one is immune from a bubble. Lord Overstone (a 18th Century British banker) famously said ‘No warning on earth can save people determined to suddenly grow rich’. After the dotcom bubble, Stanley Druckenmiller (one of the best performing hedge fund managers of all time) said “I bought $6 billion worth of tech stocks, and in six weeks I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basketcase and I couldn’t help myself. So maybe I learned not to do it again, but I already knew that.”

There is a defence however. That simple thing called diversification. It protects us on the downside and it saves us on the upside. There is a diversification mantra that says ‘never own enough of one thing to make a killing in it, and never own too much of any one thing to get killed by it’.

I have realised lately through interactions with clients that diversification is really misunderstood. It’s a pretty simple concept - don’t put all your eggs on one basket. But (as with everything in the investing world) it’s far more complex in its application.

The way to think of diversification is as an expression of our humility. We don’t know what will happen next. We look back with hindsight and think we did know, but we didn’t. If we knew what the thing is that is going to outperform everything else for the next year, we could put all our money into it and not worry. But that’s an impossible thing to know. So, we do the only rational thing, and we buy a bit of a whole bunch of different things.

We know when we do this that some things are going to do well while others do less well. That is the point of diversification. You only know that diversification is working when you have something that is clearly and identifiably underperforming.

And you know what that means? It means human nature hates it! Human nature never really wants to be diversified. What human nature wants to do is get rid of the thing that is down and put it into the thing that is up. But we know that good investing is about buying low and selling high, so literally the last thing we want to do is sell the thing that is down and buy the thing that is up.

The other really important point about diversification is that it protects you over entire market cycles, i.e. over decades. What we are attempting to do is mute the short and medium-term volatility in order to fully capture the return of all the components over the long-term.

Recently, the US stock market has outperformed every other market. Emerging markets are now officially in a bear market (they have fallen 20% from the high), as are some European markets and many other European markets are now in correction mode (defined as a 10% or more fall). Growth stocks have outperformed value. What I do know is that at some point this will flip. I don’t know when, but emerging market stocks, European stocks and value stocks will have their day in the sun once again, and that’s why my clients own them.

Think about it as a zig and a zag. Emerging markets zig while the US zags.

What this means is that properly diversified investors don’t necessarily have great years, but they do have great lives (paraphrased from Nick Murray).

Take a hard look at your portfolio. If there isn’t something you hate, then you almost certainly are not diversified. If you are not diversified, you are missing the holy grail and the first golden rule of investing.

georgie@libertywealth.ky