|“Avoid the unforced error, nail the basics and don’t take outsized risks” might be the best advice the individual investor can follow.|
An often-underestimated influence on equity and bond markets is the heavy hand of luck. Frankly, you can do everything “right” and still get bad results. And since luck can’t be controlled, knowing how to react – whether that luck initially appears to be good or bad – can separate winners from losers. But just because something can’t be controlled doesn’t mean it can’t be managed.
We all know bad things happen that are beyond our control to foresee or influence. Fires, floods and financial crisis come to mind. So we buy insurance, avoiding home purchases in areas prone to flooding and create investment portfolios that are well diversified with a healthy dose of cash savings. But what else?
One of the best thinkers on this subject, and a terrific writer to boot, is Michael Mauboussin. The man knows how to think about how we think – especially as it relates to investing. I read his terrific 2012 book, The Success Equation, when it first came out. Subsequently, the opportunity to hear him talk about his book in person helped to clarify some of his more nuanced arguments and observations.
One of the many surprises that will be found in The Success Equation is an important reason why individual investors should look to exchange-traded funds as their best bet to achieving financial goals when using the stock markets. Discussed in many posts here at Invest-Notes, by choosing to invest in indexed funds smaller investors earn the market averages over time with much less risk or cost than owning individual stocks or traditional mutual funds. Remember, for as long as equity markets have been measured, they have gone up more often than they go down.
Let the Big Dogs Bark at Each Other Instead of You
As noted recently in The Economist, 70% of U.S. stock markets are now owned by large institutions like Blackrock, Vanguard, Fidelity, pension funds and hedge funds. That percentage was just 35% in the 1980s. This means the self-described investment professionals are competing against each other more fiercely than ever before. As Mauboussin intriguingly suggests, the more skill involved in a competition the bigger the impact of luck on the outcome.
As a reality check, the following is from the prospectus of an initial stock offering (IPO) for a high-tech company that went public in March of 2017. Hyped by many, including the original investors then in a position to sell their much-appreciated shares, this quote sounds like a fair warning in my books, “We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.” But if this is such a great investment, why would the private owners want to sell their stock in the company? If you had purchased shares at the IPO, you paid the original investors around $26 per share. Your investment is now worth about $13. So, as two of the biggest money-losing companies on the planet begin selling shares, no names but they provide ride-sharing services, best to avoid this ride.
By being honest and observant about the outcomes of our investment strategies – repeatedly and over time – we can create mental models that help anticipate the unexpected (to minimize risk) while expanding opportunities (to maximize upside). You can easily improve your overall return just by minimizing costs like fees and commissions (nail the basics). You can stay calm and remain inactive during times of great stress (avoid unforced errors). You do not have to go head-to-head with the pros (no outsized wager on a hot stock tip).
As Rudyard Kipling noted a century ago, just ”…keep your head when all about you are losing theirs…”
More on… “The Success Equation”-Michael Mauboussin:
The pursuit of wealth (and then figuring out how to keep it when successful) has a long history. The wide-ranging insights below are offered without commentary. However, where additional context is available a good source has been recommended on the pundit or their life. I have read all of the books suggested.
Circa 600 BC
“The observation of the numerous misfortunes that attend all conditions forbids us to grow insolent upon our present enjoyment, or to admire a man’s happiness that may yet, in the course of time, suffer change.”
(Nassim Taleb translates this into the vernacular by quoting Yogi Berra, “it ain’t over until it’s over” in Fooled By Randomness, 2001)
Leonardo da Vinci
“Do not undertake things if you see that you will have to suffer in case you do not succeed.”
“Trust only those who have exercised their minds not on proofs of nature but on the results of their own experiments.”
Estimated net worth in current dollars: $400,000,000,000
(J.D. Rockefeller clocked-in at only $340,000,000,000)
“When I go to bed, I face no obstacles to sleep. I remove with my shirt all the cares of battles and business.”
“I will earn a profit as long as I can.”
The Richest Man Who Ever Lived, Greg Steinmetz, 2015
Netted $3,000,000 in the 1929 market crash.
(Went bankrupt twice before and after 1929)
Cut your losses quickly.
“If a trader doesn’t know his exit before he takes the entry, he might as well go to the racetrack or casino where at least the odds can be quantified.”
Let profits ride until price action dictates otherwise.
“It never was my thinking that made the big money for me. It always was my sitting.”
Control your emotions.
“All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope.”
“Buy all-time new highs.”
“We have met the enemy and they are us.”
“One investor’s two rules of investing:
- Never lose money.
- Never forget rule #1.”
“Concentrate your investments. If you have a harem of 40 women you never get to know any of them very well.”
“Investors operate with limited funds and limited intelligence: They do not need to know everything. As long as they understand something better than others, they have an edge.”
“If I had to sum up my practical skills, I would use one word: Survival.”
Money Masters of Our Time, John Train, 2000
“Excesses in one direction will lead to an opposite excess in the other direction. Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.”
“Fear and greed are stronger than long-term resolve. Investors can be their own worst enemy, particularly when emotions take hold.”
“When all the experts and forecasts agree — something else is going to happen.”
As Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”
Considered one of the most successful hedge fund managers of all time.
“Make all your mistakes early in life: The more tough lessons you learn early on, the fewer (bigger) errors you make later. A common mistake of all young investors is to be too trusting with brokers, analysts, and newsletters who are trying to sell you something.”
“Don’t make small investments: You only have so much time and energy when you put your money in play. So, if you’re going to put money at risk, make sure the reward is high enough to justify it.”
For more: More Money Than God, Sebastian Mallaby, 2010
Investor and author of What I Learned Losing A Million Dollars, 1994
“There is an inverse relationship between your threshold for pain and success in the markets, so as soon as you feel the pain: get out.”
“I am always thinking about losing money as opposed to making money.”
“No matter how you cut it, there are enormous emotional ups and downs involved.”
More Money Than God, Sebastian Mallaby, 2010
Now, who and what can you add to this list? Leave your comments below…
|Don’t let hubris or fear keep you from considering participation, even in a small way, in the world economy.|
It is a fact that the U.S. now accounts for only 40% of the world’s stock market capitalization. Yet a look at international rankings of market capitalization by country tells a more nuanced story and confirms that the U.S. remains the best bet, by a long shot, for equity investing. However, Invest-Notes has from its earliest days been an enthusiast of international equities. As with most asset classes, international exposure is best pursued through exchange-traded funds, such as VEU (discussed below). And with the recent drawdown in prices around the world, international stocks might be an interesting place to invest some retirement account money at the first of the new year.
After the U.S. the second spot of most valuable equity markets is held by Japan with 7.75%. Number three is China at 7.5% followed, surprisingly, by Hong Kong at 6.75%. Great Britain and France round out the top six with less than 5% each. More importantly, over the last ten years, the U.S. has gone from 34% to the current 39.81%. We are not losing ground to Asian or European nations, but instead growing at an impressive rate. Reports of our economic demise have been wholly mistaken. Japan, Great Britain, and France have all lost ground with the annual growth for China and Hong Kong at about 2% each. This bears taking a moment to think about. Hong Kong has a population of 7.5-million people in a land-locked area of 426 square miles; China has over a billion people occupying 3,700,000 square miles. Even New York City has more land and people than Hong Kong.
Looking behind the headlines, major S&P 500 exchange traded funds (SPY, VOO, RSP) remain the smartest choice for most individual investors to keep most of their long-term savings and investments. Again, get past the hype, and even after the big drop over the last few weeks, the S&P is still flat for the year (though when I originally started work on this article a couple of weeks ago, the S&P was up 5% for 2018). By comparison, the exchange-traded fund used as a proxy for Chinese equities, ASHR, is down over 25% year to date. Over the last 5, 10 and 20-year periods the S&P 500 has delivered annual returns of over 10%. The often-repeated idea that the U.S. is somehow losing its status as the big dog in global finance is wrong. However, hubris is always a bad approach to investing strategies.
Hubris is not an Option.
In their just-released The World in 2019, The Economist features three articles offering thoughts on how world markets might perform next year. On the one hand, there seems to be some level of confidence that the current bull market in America will see at least month 121, an anniversary of what would become the longest market expansion in U.S. history. On the other hand, these same pundits all suggest our next recession will likely begin before the end of 2019.
But the most intriguing suggestion is to ask whether the gap between the U.S. and most other world markets begins to close because the U.S. economy weakens, or everyone else gets stronger or even just stabilizes. One prognosticator suggests that if the U.S. markets soften, the rest of the world will tumble in tandem. Perhaps though trade wars and U.S. federal reserve interest rate hikes could begin to bite domestically more than internationally. Reversion to the mean is not guaranteed, but it happens surprisingly often.
So, why is investing in foreign equities a good idea right now?
Because there have been and will continue to be times when in the on-going race for returns, international stocks can retake the lead position. My best bet is that most readers have not added any international exposure to retirement accounts in a long time.
An exchange-traded fund like the Vanguard All-World Ex-US Index (VEU) make very good sense as a method of diversification. First, VEU currently offers a 3.1% dividend. Second, the expense ratio is 0.1% (that’s one-tenth of one percent). Finally, the U.S. still only has 40% of the equities markets, and there are some very fine companies worth holding in your IRAs and 401Ks. Stocks like Nestle, Novartis, Toyota, Royal Dutch Shell, and Samsung are solid investments – and better owned in a fund than individually. Don’t let hubris (only local matters) or fear (the world has gone crazy) keep you from considering participation, even in a small way, in the world economy.
|The investment books most likely to improve one’s abilities to invest successfully will not be the ones providing recommendations of what stocks to buy, and right now. Most valuable are books providing information to help guide intelligent decision-making.|
The investment books most likely to improve one’s abilities to invest successfully will not be the ones providing recommendations of what stocks to buy, and right now. Nor will a book simply offering models of fund-centric portfolios based on the age, temperament or any other attributes of their intended audience. Most valuable are books providing information to help guide intelligent decision-making. Though the classic works of Benjamin Graham and Philip Fisher are often recommended, their extreme technical orientation serves mostly to alienate less obsessive investors. Below are some suggestions for the less rabid, but no less enthusiastic investor looking to get smarter.
A great place to begin is Winning the Loser’s Game by Charles Ellis, originally published in 1985. It is far too easy to be blinded by success stories like those of Warren Buffett and Peter Lynch. The simple reality – clearly demonstrated by Ellis – is that few people (or mutual funds and their managers, or individual stocks) manage to consistently beat the market over time. His explanation of how people can appear to be great investors when in fact their success is due to statistical survivorship bias is eye-opening. Understanding the damage we inflict on ourselves through preventable mistakes, high-risk gambles and most significantly the fees we choose to pay as investors is vital if we want to be successful as investors. How could have taken over thirty years for this message to sink in?
A personal favorite from 2012 and one, it should be noted that several Invest-Notes readers have been less impressed with, is Antifragile by Naseem Taleb. This investment book is a refinement of his first work, Fooled by Randomness, published about twenty-five years ago. Taleb goes way beyond the idea of a “Black Swan Event” (a term he coined, and title of his best selling book, though not a favorite of mine) and discusses not only how to avoid unexpected events, but how to benefit from them when, not if they happen. As Taleb cleverly explains: experts aren’t; things that can’t happen will; and like physical exercise, stress can be harnessed for self-improvement. Don’t let his arrogance distract you from the invaluable insights being offered. Taleb’s most recent book, Skin in the Game, published earlier this year is also terrific – but more valuable if read after Antifragile.
Another good primer is the original edition of The Millionaire Next Door published in 1996. That some of the book’s conclusions have been shown to be faulty does not take away from the value Millionaire can offer would-be Warren Buffett’s. Short of winning a lottery (and that includes the genetic lottery), fortunes are most likely to be built over time, through luck, hard work, and patience. The many stories discussed in Millionaire provide practical examples of how to make the most of our current situation. This includes the single best thing anyone hoping to accumulate significant assets can do: Live beneath your means. It also helps explain why on lists of the wealthiest Americans over three-quarters are self-made, having created a fortune rather than inheriting one. Yes, you can be the millionaire next door, just not right away.
While The Essays of Warren Buffett is on many lists (and is on my bookshelf), there is another text providing a more insightful overview of how great investors operate. This book from 2000 also demonstrates beyond any doubt that there is no one single path leading to success. Money Masters of Our Time, by John Train, provides provocative insights into the thinking of seventeen of the most successful investors of the 20th century. It is here you will see that Buffett’s earliest successes came with risk most of us would never consider and that he has never repeated. Also worth noting is that several of these investors, among them some of the richest people on the planet, don’t use their wealth as anything but a scorecard. If there was ever proof demanded that having all the money doesn’t necessarily equate to happiness, this book is it.
Finally, More Money Than God by Sebastian Mallaby can do more to explain hedge funds, what they do, and how they work than other investment books you can read. The U.S. financial system, and the Wall Street crowd, in particular, have never met a good idea that couldn’t be abused and corrupted. Read in tandem with Money Managers, the world of investing will look very different when you’re done. The origins of these curious investment vehicles (and the people who created them) are fascinating, with many of the concepts still applicable, even for the individual investors reading this note.
|“All card playing is not gambling, all stock purchases are not investing…”|
– Jim Paul, What I Learned Losing a Million Dollars
What the heck is an investment plan? Open a brokerage account or interview a financial planner and you get handed a questionnaire intended to help determine what kind of investor you are – or will be, as a new client. But how do you answer a question like “Rate your tolerance for risk on a scale of 1-to-5?” A person willing to blow $1000 at the blackjack table while on a vacation in Las Vegas could be appalled at losing that same $1000 on a stock purchase. The glib advice – embarrassingly repeated at Invest-Notes on occasion – that everyone should have “An Investment Plan” isn’t really much help.
Investors must know themselves
Creating an investment plan is not complicated, but it does involve some critical thinking. First, acknowledge we have no control whatsoever over the movement of investments like equities, real estate or gold. There is no way to know if a stock is going to go up, and if it does, how high it can go. On the other hand, how much money you are willing to lose is entirely up to you. In essence, your investment plan is simply a set of rules to ensure that you never lose more money than you can afford.
As an investor, you can tell yourself that the stock you just bought is going to double in price, but that’s just a guess. Deciding that you are not going to lose more than, let’s just say 20%, while waiting to see if your guess is correct is the purpose of a plan. Conversely, suppose you are right and the stock does go up 100%. A decision made in advance to sell the stock anytime it drops more than 20% as the price goes up ensures you turn some of those paper profits into real ones. Prudent investors manage risk by making sure they never let emotions influence their decision making.
Second, you have to decide who you are every single time you make a transaction involving invested capital. You will not always be the same person, and if you become someone new in the middle of an investment episode your odds of failure grow exponentially. Along with a decision on what you are willing to spend in pursuit of a gain, you need to consider who you are. In the final analysis, it’s deciding in advance whether a piece of real estate, a stock, or a poker game (there are successful professionals in this field) is an investment, speculation or a gamble.
Invest-Notes continues to forcefully urge that individual investors anchor their investment and retirement portfolios around exchange-traded funds (ETFs). Specifically, indexed funds of the S&P 500 and international blue-chip stocks. Around this central component, it might make sense to add specialty funds, like those comprised of medical companies (for growth) or utilities (for yield). For the truly adventurous, and being mindful of the risks involved, having a handful of individual stocks can also make sense.
Individual stocks of major companies will find that on September 30, 2018, the description of what business they are in will change. This is not as odd as it might sound. Netflix started as a business to rent DVDs by mail. Disney made cartoons. AT&T was the phone company. Today Netflix has something like 125 million subscribers to a streaming video service that not only offers the same movies they used to rent but creates more custom content than the three TV networks combined. Disney now owns theme parks and ESPN. AT&T just bought Time Warner, go figure. As businesses evolve, so should the way in which we invest in them.
During the formative years of Invest-Notes, there was often discussion of specific trades. After the market mayhem of 2008-2009, not so much so. The shift in focus went from what to trade, to how to trade. This idea of talking about ways to make smart investments by thinking about our behavior will continue, but right now we’re going back to being very prescriptive about a specific investment idea.
New kid on the block
There is about to be a brand-new industry sector that will be composed of big companies coming from other sector funds. This matters, because the Big Daddies of indices, S&P Dow Jones and MSCI, use the GICS stock classifications to determine things like whether Home Depot should be identified as a Consumer Staple, or a Consumer Discretionary stock. In their turn, the Big Daddies of exchange-traded funds, like State Street and Vanguard, use these sector definitions of the S&P 500 and MSCI to decide what stocks will be included in the ETFs that individual investors are buying in ever-increasing amounts.
As a quick reminder, the Global Industry Classification Standard (GICS), is a worldwide standard for stock classification. Established in 1999 with ten sectors, the GICS started with: Consumer Discretionary; Consumer Staples; Energy; Financials; Health Care; Industrials; Technology; Materials; Telecom; and, Utilities.
The only change to this line-up occurred in August of 2016 when the Financial sector was bifurcated to create a Real Estate sector. Discussed here at that time in our article, “The Difference Between Banks and Buildings“, it should be noted that while Invest-Notes correctly identified the pros and cons of the change, we totally whiffed on guessing the subsequent performance of the two sector funds.
The transition taking place on September 30, 2018, is more impactful since it will see three sectors facing major changes to their composition. First, Telecom Services will be renamed Communications Services. Currently, the smallest of the eleven GICS sectors composed of only the stocks in the S&P 500, when Telecom becomes Communications it will grow from 2% of the index to around 10%. The challenge for investors is determining what to do with current sector holdings when some of the biggest stocks in the S&P get shuffled around. Google, Verizon, and Disney are not niche investments. In point of fact, the top holdings in the soon to be Communications Services sector comprise about 10% of the S&P 500.
Now, what happens to the Information Technology Sector when Google, Facebook, and other heavy hitters are no longer part of Technology ETFs and become components in the new Communication Services Sector? Or the Consumer Discretionary Sector (a sizable ETF holding in my personal accounts), where Netflix, Disney, and other big companies will be moving out. And is it a good bet to add one of the big Telecom ETFs – IYZ or VOX – in advance of the reshuffle?
|”Those looking at art purely as an investment might first consider looking elsewhere.” -Melanie Gerlis|
The last line in a thoughtful book by Melanie Gerlis, Art as an Investment?, does not do her work justice, “Those looking at art purely as an investment might first consider looking elsewhere.” In fact, she makes a cautious case for those interested in fine art who also have an interest in investing. But first, full disclosure since I am biased. Both fine art and antiquities constitute a meaningful portion of my investment portfolio. As I write this note, works by Max Beckmann, Chuck Close and Sol Lewitt surround me. A visit to the San Antonio Museum of Art will find a dozen Egyptian antiquities from our collection on display.
Another quote to provide some context for the following conversation comes from another great read, The Value of Art by Michael Findlay, “A collector has one of three motives for collecting; a genuine love of art, the investment possibilities, or its social promise” (quote by Emily Hall Tremaine). Anyone not meeting all three criteria is unlikely to enjoy the rest of this note.
Gerlis undertakes a laudable enterprise by comparing artwork acquired for investment purposes with other asset classes. An editor for The Art Newspaper, she is a knowledgeable commentator on the business of art. Her book makes one-on-one comparisons of fine art to; equity markets, gold, wine, real estate, hedge funds and, intriguingly, luxury goods such as jewelry and watches. By defining each investment’s attributes – such as market transparency, liquidity, market makers, and valuation metrics – she creates a context useful in determining the differences between these investment options.
We’ll focus on the world of fine art starting from a time around 1850. However, a caveat is in order here since the art market is a complicated subject and rather than try to qualify remarks that obviously have exceptions (most of them), let’s just assume that all comments below are, “generally speaking.”
The quick and the dead in art.
Following Gerlis, it seems appropriate to use metaphors taken from the world of investing herein. Conceptually there are two distinct markets with an important overlap. On the one hand are dead artists, the majority of which have some standing in the cannons of art history and criticism. Then there are the living artists whose reputations will evolve for better and worse, as should their artistic output, over a lifetime. In between are the few long-living artists who have achieved accolades likely ensuring their place in history. This can be viewed similarly to that of value and momentum stocks, assuming a gray zone here as well.
Value artists would include names like Cezanne, Pollock, Warhol and, of course, Picasso. Like a big established multinational corporation, the price of the art will fluctuate over time, but there is an expectation of enduring intrinsic value. Both the equity and art markets experience good and bad times, but the trend over long periods is upwards. Categories having demonstrated value over time include Old Master and Impressionist works. The place of post-WW II abstract expressionists also appears to have been firmly established, with Pop Art probably not too far behind. However, much like gold, art tends to maintain value over time, also contributing to the value in art. Paintings, in particular, have a curious tangential value as insurance. During times of crisis, paintings can be quietly transported across borders, their value not being linked to any particular currency, unlike real estate or some equities.
Momentum artists, on the other hand, remain an unknown entity as far as their long-term valuations are concerned. A look at the dot-com stock era is a good context for thinking about contemporary art – where hopes and dreams intersect with savvy marketing to create the “next big thing.” Or not. As one professional dealer put it, the worry is whether a work of art is even worth displaying five years from now.
With the rise of mega-dealers like Gagosian and Zwirner, who make a lot more money than many of the artists they represent, the hype is an ever-present danger. We hear about the unknown artist who finds their work suddenly fetching high prices at auction, but not their peers watching prices drop in the same market space. The books listed at the end of this essay give many examples of just how far a new superstar can fall. And how fast. There is a difference between a fad and a trend. Fads come and go, often with little in the way of residue. Trends are indicative of long-term shifts in taste or behavior. People generally tend to “get” Impressionist paintings. Not so much with “video art.” With contemporary art, the winner can more often be the dealers rather than the artists.
Currently, there is much conversation – and sales activity – being defined by issues unrelated to the value in art. Contemporary art originating in the Middle East and Latin America are hot art commodities right now even if their shelf life is unclear. A decade ago contemporary Chinese art was a market darling, just as the Aboriginal art of Australia had been twenty years before that. On the cutting edge in trendy art markets like New York is work by the alternative lifestyle crowd who now enjoy accolades instead of opprobrium for being LGBTQ. There is also a geographic risk when discussing a “local” artist as these tend to more often be about the person instead of their art. So, what is the value in art?
The idea that being a part-time investor is going to bring you wealth and make you rich enough anytime soon to retire and enjoy the life of as a country squire, tending grapes at your chateau in France is delusional. Better to assume that your efforts as an individual investor will leave you in a position “down the road of life” to enjoy long stretches of time doing things you enjoy. Maybe even months or years pursuing interests for their own sake, regardless of whether you get paid or not. I’m a big fan of the notion we should be able to take time to pursue activities simply because we want to – without worrying about any financial ramifications. That’s the point of this blog, to help ensure you have the means to create and enjoy a full life.
|Ask yourself, is it the wealth, or what you can do with the money, that interests you most? I’m a big fan of the notion that we should be able to take time to enjoy ourselves without worrying about financial constraints; as money simply represents the potential of what can be achieved by spending it.|
The wealth of Croesus isn’t waiting for anyone diddling in the markets, or looking to make a fast buck off of gold or real estate. If you want to make the Big Money, then you had better be prepared to put the fun stuff on hold and get busy doing Big Work. Do you really believe that you can play competitively on the same court as any of the 491 players currently in the NBA? What this meant for an individual investor really hit home for me many years ago, after reading John Train’s book Money Masters of Our Times.
A collection of interviews with 17 of the best investors alive, including the usual suspects like Buffett and Soros, the relentless drive, and focus of these individuals is breathtaking. And their idea of fun is to be relentlessly driven to focus on wealth accumulation. When one of the billionaires Train interviewed is asked about his very pedestrian lifestyle he replied that money was the scorecard. If he actually spent money, his score would go down. Ask yourself the tough question; is it the money, or what you can do with the money, that interests you?
After an explosive move up in January, we were subsequently reminded that stocks (and indexes) can still go down. This is a time when it is especially important to avoid emotional reactions and focus on intelligent decision-making. Here are a few investment thoughts, offered up once before, that might be worth considering.
1. Don’t make more predictions than your data can support. A collection of just four or five exchange-traded funds (ETF) is all most people need for a successful retirement account. If you own individual equities then understand the basics: what does the company do, how does it make money from that and what does it do with the profits? Beyond this, short of being a member of the company’s management team, there’s not much else you can know for sure. Assume nothing and avoid the temptation to believe a business is holding a winning lottery ticket. As Warren Buffett once noted, “You should invest in a business that even a fool can run, because someday a fool will.”
Focus on the not-too-distant future
2. Near-term forecasts are more certain than 10-year projections. Remember all of the investment analysts who were predicting a big drop in February with an immediate rebound? Me neither. The future has always been hard to predict and this fact is unlikely to change just because investors wish it would. Always be suspicious of undue emphasis on the long-term, especially when the short-term isn’t looking so good.
Understand your assumptions
3. Be aware of the weakest links in your argument. Without doing this, it is pretty much impossible to know when it is time to exit an investment position. When a key assumption changes, or more likely proves incorrect, it may be best to exit the investment and move on to the next good idea. Put another way, keep a lookout for what you didn’t think about when entering an investment.
Be wary of precision
4. It is better to be vaguely right than precisely wrong. Too much detail gives a false sense of security. This explains why successful panhandlers always ask for an exact handout, like sixty-three cents. It’s just human nature to think someone predicting that earnings for the S&P in 2012 will be $107.63 must know more than someone who simply suggests that earnings will be less than $100. Yet a prediction of a range – less than $100 – can prove more helpful in understanding the underlying assumptions, such that the S&P will struggle to achieve growing earnings.
Leave yourself an intellectual paper trail
5. By definition, our memories are terribly biased. During my 13-month experiment as a day trader (using a Scottrade account specifically for this purpose), I kept a spreadsheet documenting every trade, the cost to trade and the profit or loss on every position. While I ended up with about an 8% return (this was way back in 2007, when it was pretty hard to lose money in the markets), the amount of work involved as well as some of the risks assumed, made it obvious that market timing isn’t a good strategy. Being able to revisit the actual data has been a valuable reminder for staying focused on what works for me. I keep remembering how wildly successful I was, a notion difficult to reconcile with the actual data.
That Bitcoin and its ilk are experiencing a “Netscape Moment” should serve as a cautionary note on many levels to investors. The practical similarities between the web browser Netscape Navigator as an investment, and Bitcoin as an investment are obvious. Netscape made using the World Wide Web practical for the average computer user. Bitcoin is the first application to make blockchain technology accessible for the average computer user. But with technology stocks, it does not usually payoff to be the first person at the party. So, it should come as no surprise if the “Bitcoin Moment” ends badly.
How the web was like blockchain
The World Wide Web was for much of its early years an intriguing idea without any widespread application beyond the military and academia. It took the creation of a universal access tool, initially Netscape Navigator, to make a sprawling, but difficult to access network something everyone could find a use for. Navigator made it possible for anyone to get aboard what is now called the Internet and communicate (email), connect (Facebook), share information (Google) and offer a platform for commerce (Amazon).
Long story short: Navigator launched in late 1994 with an IPO in late 1995 being one of the most successful ever, up to that time. Additionally, Netscape set what many investors would still consider a bad precedent by also being unprofitable when it went public. Long story short, by 1997 Microsoft’s Internet Explorer was the hand’s down winner in the so-called “browser wars” and Netscape never recovered. In 1998 AOL acquired Netscape. Its fate was the canary in the dot.com coal mine.
For our conversation today, let’s sum up the browser analogy this way. When Netscape opened up access to the Internet, few people were thinking about e-commerce or online bullying. The evolution of the Internet browser was trial-and-error in its purest form. Where blockchain ultimately ends up taking us remains unknown and we are still very early on a long journey.
So, what’s up with the futures exchanges?
What grabbed my attention was the announcement of the two Chicago options exchanges now offering futures contracts on Bitcoin. And there is some irony to the fact the contracts can only be bought and sold using dollars – you can’t actually short your Bitcoin collection, just gamble on its price variations. Yet the speed with which the options exchanges embraced the blockchain left me baffled until reading about a couple of projects MIT is working on in collaboration with two very different consortiums. Herein might be the next phase of blockchain implementation with the potential for serious impact on the global financial system.
One powerful application of blockchain is to create a viable currency to be shared among fringe economies. Think of Eastern bloc countries like Bulgaria, Romania, Albania, and Hungary creating a shared currency for use on par with the Euro and Ruble. Or of the many marginal countries in central Africa, also challenged by failed economies. In theory, the open nature of blockchain ledgers would make it possible for everyone – both inside and outside of the currency network – to see when a government is, for lack of a better term, cheating the system and exclude just their blocks from commercial use. Here, the transparency of an open ledger creates value and stability, making allies of adversaries.
Another interesting idea is using blockchain to create a cryptocurrency tied to physical commodities like gold, oil, sugar or wheat. This would eliminate the necessity of having to price commodities in dollars, Euros or rubles, reducing the amount of friction and cost in transactions by moving toward a true barter system. For international trade, this would be a huge shift in the balance of power away from the major currencies. To my mind, this scenario provides a perfect explanation for the rush to embrace blockchain by the futures exchanges.