Growth vs. Value Funds: Which Have Better Returns?

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Quiz!

Which of the following are true? (May be multiple answers.)

  1. Growth funds tend to have high profitability.
  2. Value funds tend to have lower profitability than growth funds.
  3. Growth funds grow faster than value funds.

Growth vs. Value Funds: Which Have Better Returns?

Growth stocks are shares of companies that are typically profitable and enjoy high earnings. You would expect funds holding these stocks to enjoy higher returns relative to funds of value stocks. Value stocks are defined as having lower Price relative to the Book Value or intrinsic value of the company, or lower Price/Book.

Viewing the long-term returns over 100 years in the US, as well as many decades in other countries, shows the opposite result. Value indexes and funds had higher returns than growth indexes and funds on average. How is that possible?

  1. Growth stocks have higher expectations, with higher Price/Book. As companies grow, some struggle to sustain very high growth. Once growth moderates, the price goes down to bring the Price/Book lower.
  2. Value stocks have lower expectations, with lower Price/Book. As companies improve their profitability, they justify a higher Price/Book, leading to a rise in price.
  3. Once value stocks reach high Price/Book, they enter the growth category. At that point, the fund sells them and replaces them with stocks with lower Price/Book. This rotation adds another layer of gains.
  4. Growth companies don’t have the same rotation mechanism. Once the Price/Book rises too much, the only way to correct it is through price declines.

Why would anyone invest in growth funds?

  1. The most profitable companies get the most attention, with more people talking about them. This invokes the familiarity bias.
  2. As the returns mount, people experience FOMO (fear of missing out) as well as recency bias (chasing recent returns) – one of the most powerful forces I have observed.
  3. The more the gains mount, the more people believe that valuations don’t matter and that profitability can stay high forever.
  4. These stretches of high returns can last for many years.

Why invest in value funds? They provide better returns on average. In addition, when growth funds outperform for a long stretch of years, the benefit to value funds typically becomes much bigger than usual.

Quiz Answer:

Which of the following are true? (May be multiple answers.)

  1. Growth funds tend to have high profitability. [Correct answer]
  2. Value funds tend to have lower profitability than growth funds. [Correct answer]
  3. Growth funds grow faster than value funds.

Explanation:

  1. Correct: Growth funds tend to have higher P/B reflecting the higher profitability of companies.
  2. Correct: Value funds tend to have lower P/B reflecting the lower profitability of companies, explaining why people price them lower.
  3. Incorrect: Value funds tend to grow faster than growth funds, thanks to the stocks in them being priced low, and as the prices increase, the fund sells the expensive stocks and replaces them with cheaper ones. This creates excess returns beyond the profitability of the companies in the fund. The benefit gets magnified in funds that add a focus on profitable companies within the value space.
Disclosures

Optimizing Diversification

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Quiz!

Which of the following is a free lunch when diversifying? (Multiple correct answers.)

  1. Adding stock investments in Germany to a portfolio that holds France and Italy.
  2. Adding stock investments in Australia to a portfolio that holds Thailand and Mexico.
  3. Adding stock investments in Brazil to a portfolio that holds India and China.
  4. Adding bond investments to a stock portfolio.
  5. Adding a AAA bond to a portfolio of AAA bonds.

Optimizing Diversification

Diversification of investments is known as a free lunch. If you hold multiple investments (1) with similar returns that (2) don’t go up and down perfectly at the same time, you get the same returns with lower volatility – a free lunch.

Another type of diversification involves adding a lower-returns investment for the benefit of its lower volatility. A common example is adding bonds to a stock portfolio. Thanks to the imperfect correlation as well as the lower volatility of bonds, it lowers the volatility of the portfolio, but it also lowers the expected returns. This is appropriate when needing or desiring lower volatility, whether for financial or psychological/discipline reasons, and depends on your specific circumstances and preferences.

The key point when diversifying is to be aware when the lunch isn’t free and to strike the right balance of volatility and expected returns.

Quiz Answer:

Which of the following is a free lunch when diversifying?

  1. Adding stock investments in Germany to a portfolio that holds France and Italy. [Correct Answer]
  2. Adding stock investments in Australia to a portfolio that holds Thailand and Mexico.
  3. Adding stock investments in Brazil to a portfolio that holds India and China. [Correct Answer]
  4. Adding bond investments to a stock portfolio.
  5. Adding a AAA bond to a portfolio of AAA bonds. [Correct Answer]

Explanation:

  1. Add an international stock investment to an international stock investment – similar expected returns.
  2. Add an international developed stock investment to an emerging markets stock investment – lower expected returns (along with lower expected volatility).
  3. Add an emerging markets stock investment to an emerging markets stock investment – similar expected returns.
  4. Adding bond investments to a stock portfolio – lower expected returns (along with lower expected volatility).
  5. Adding a AAA bond to a portfolio of AAA bonds – similar expected returns.
Disclosures

Overshooting for Lower Volatility!

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Quiz!

What are benefits of overshooting your target investments (the amount needed to retire)? (Multiple correct answers.)

  1. You get to retire earlier.
  2. You enjoy a choice of shorter or shallower declines from your target, but not both.
  3. You enjoy both shorter and shallower declines from your target.
  4. You enjoy seeing your portfolio fluctuate less.
  5. You enjoy high average growth throughout retirement.
  6. You enjoy growing income during retirement.
  7. You enjoy spending more throughout your lifetime.

Overshooting for Lower Volatility!

You may think of a target investment size needed for financial independence, at which point you can transition to protecting what you have, shifting to investments with lower growth in order to reduce volatility.

What if you could reach lower volatility without sacrificing growth? This is possible by overshooting your target.

Let’s take an extreme example: Say you grow your investments by an extra 100% beyond the target needed to generate passive income for live. Benefits:

  1. Any decline smaller than 50% would keep you above the target for financial independence! Most globally diversified stock investments rarely decline by more than 50% and the time spent below that level is typically a fraction of the overall decline. By overshooting by 100%, you eliminated the bulk of declines below your target.
  1. Any gain beyond that level gives you a choice between (1) higher passive income and (2) an even lower chance of declines below your target, or some combination of the two.

There is no set target for overshooting, and you can decide and revise the decision as you go. The benefit is directly proportional to the size of overshooting.

There is a catch to this plan: It defers the timeline to drawing from the investments for full retirement, something that many people may be unwilling to accept. There are two mitigating points related to this:

  1. In the past 25 years, lifespan has increased significantly, according to this Goldman Sachs article: https://www.gspublishing.com/content/research/en/reports/2025/05/20/2d3fe290-10b1-44be-8d0e-77b8d303928f.pdf. The first chart in page 11 of the article shows a roughly 4-year increase in lifespan since year 2000, and people used these 4 years for extra work, implying an unchanged time in retirement. An extra 4 years of growth and savings makes a huge impact thanks to the overshooting principle.
  1. A modification of the plan above would have two separate targets: (1) covering base expenses that you are not willing to reduce; (2) covering total expenses. The plan would call for overshooting the target for covering base expense. How much you overshoot depends on how much you want to reduce the effective declines below your target vs. how eager you are to retire. During these declines you would scale back the total expenses towards the base expenses. As you reach higher peaks, you can gradually eliminate the scaling back of expenses, and go back to benefit #2 above – splitting the extra gains between higher passive income & higher security.

Quiz Answer:

What are benefits of overshooting your target investments (the amount needed to retire)? (Multiple correct answers.)

  1. You get to retire earlier.
  2. You enjoy a choice of shorter or shallower declines from your target, but not both.
  3. You enjoy both shorter and shallower declines from your target. [Correct Answer]
  4. You enjoy seeing your portfolio fluctuate less.
  5. You enjoy high average growth throughout retirement. [Correct Answer]
  6. You enjoy growing income during retirement. [Correct Answer]
  7. You enjoy spending more throughout your lifetime. [Correct Answer, typically if planned right]

Explanation:

  1. You sacrifice the timeline to retirement, waiting to retire later, in order to overshoot your target investments.
  2. You enjoy both shorter and shallower decline from your target, thanks to the cushion above the target.
  3. You enjoy both shorter and shallower decline from your target, thanks to the cushion above the target.
  4. The portfolio doesn’t become less volatile. But with the elevated baseline the volatility emphasizes more gains related to your target.
  5. By staying allocated for stocks (or other high growth investments), you enjoy potential growth throughout retirement (no guarantees for actual growth).
  6. Whatever reasonable withdrawal rate you can take from your portfolio (whether 3%, 4% or more), the dollar value grows as the portfolio grows.
  7. If you start saving early enough, and don’t have bad luck with a very short retirement, the growing income throughout retirement has the potential for more than making up for the deferred retirement.

Explanations: See article for explanations.

Disclosures

Investing in the face of a War and High Oil Prices

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Quiz!

What are ways to make money by staying out of the stock market for now?

  1. Move to cash until getting clarity about Iran in the near term.
  2. Move to US stocks that are perceived as a safe-haven for now.
  3. Move to cash for as long as it takes, until a resolution for the war is in sight.
  4. Move to bonds for safety.

Investing in the face of a War and High Oil Prices

Oil prices jumped over 50% in two months given the war in Iran, which borders the Strait of Hormuz – the biggest passage of oil for the world. Higher oil prices are inflationary, since they affect the price of gas for travel and shipping, heating oil, plastics including food packaging, fertilizers for food and more. The concern is that a rapid spike in inflation may lead to a global recession. One question is whether it is safer to invest for growth beyond inflation, or keep money not invested with the hope of buying lower. Here is what it would take for a successful bet on staying out of the market:

  1. The war continues with no signs of a potential improvement in passage of ships in the Strait, and you reinvest when uncertainty is higher, or
  1. The uncertainty continues for a very long time, with a spike in inflation hurting the economy. You invest when there is more clarity, but the economic damage is big, making the declines bigger than the gains thanks to the clarity.

Here are things that could lead to a missed opportunity:

  1. You keep money on the sidelines, and reinvest when there is clarity in the near term. When you see real clarity, big investment gains are likely to be behind us.
  1. There is some resolution before serious economic damage. So far, there are at least 30 countries committed to helping open the Strait. There are various paths to success, including one-sidedly stopping the attacks in Iran.
  1. Value stocks outside the US are priced around average, when considering inflationary forces that tend to increase the steady-state valuations (as measured by Price/Book or P/B). Avoiding holding them is very different from US Large Growth stocks that are priced extremely high – potentially higher than any other time since 1929.

At this point, it is impossible to be certain that one approach is better than the other. There may be more factors beyond those presented in the article. Please don’t use this information as personalized investment advice.

Quiz Answer:

What are ways to make money by staying out of the stock market for now?

  1. Move to cash until getting clarity about Iran in the near term.
  2. Move to US stocks that are perceived as a safe haven for now.
  3. Move to cash for as long as it takes, until a resolution for the war is in sight.
  4. Move to bonds for safety.

None of the answers is correct.

Explanation:

  1. Once we have real clarity about Iran, we would likely have big gains behind us. If this happens in the near-term it is likely to offset declines leading to it.
  2. While US stocks are often perceived as a safe haven at times of uncertainty, their extremely high valuations may more than offset the benefit. In addition, the reversal for non-US stocks is likely to be significantly steeper, given the combination of lower valuations and higher growth.
  3. This could work if there is a long path to a resolution of the war, and the economic damage is big enough to offset the spike in stocks due to more clarity. Given the risk of high oil prices, the world is more likely to find a resolution before letting the damage build up, so it may be a risky bet.
  4. Bonds do poorly when inflation goes up and interest rates may increase to fight the inflation. While economic damage typically leads to lower interest rates, when having to choose between fighting inflation vs. a recession, the choice is likely to be skewed towards fighting inflation, because high inflation can worsen a recession. In addition, in case of a resolution of the war before sustained economic damage, you could miss a surge in stocks.
Disclosures

Do you Know the Real Value of your Private Investment?

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Quiz!

If you have $10M in public investments and another $20M in private investments, and spend $600k per year. What is your withdrawal rate for risk planning?

  1. 6%
  2. 2%

Do you Know the Real Value of your Private Investment?

Bluerock Total Income+ Real Estate Fund was a private fund, until going public (symbol BPRE) on 12/16/2025. On that day, shares were traded at a loss of about 38% to the private share price. What happened? Private shares may not have ongoing trading information, so their stated price is not always reliable. In contrast, public investments typically exchange hands multiple times each day, creating the most reliable pricing data – what actual buyers are willing to pay.

This exposes an issue of private investments. Not only could they be locked for years, but their stated price may be flawed. This is not a reason to avoid all private investments at all times. It is a reason to do very careful risk planning around private investments. Examples of risk planning include:

  1. Making sure you have enough public investments that you can sell on a dime to buy food and pay your bills whether in retirement, between jobs or during a slowdown of your business.
  2. When calculating your withdrawal rate for risk planning, use annual spending divided by liquid investments (excluding private investments). This matches daily spending with investments that can be sold at any point, and at a reliable price.

Once you are able to and choose to sell your private investment, it can be used for spending with a known value and can be added to your risk plan. While this may seem harsh, I witnessed too many surprises with waiting for a liquidity event that failed on timing, value or both.

Quiz Answer:

If you have $10M in public investments and another $20M in private investments, and spend $600k per year. What is your withdrawal rate for risk planning?

  1. 6% [The Correct Answer]
  2. 2%

Explanation: You can’t reliably sell a private investment at its stated price to cover current expenses. For risk planning, it is safest to ignore it until sold. This means that your withdrawal rate is not $600k/($10M+$20M) = 2%, but $600k/$10M = 6%.

Disclosures

How to Benefit from AI (Artificial Intelligence) Without a Lost Decade

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Quiz!

Which of these investments can do well thanks to the AI revolution? (There may be multiple answers.)

  1. An Asian renewable energy company generating very cheap electricity.
  2. A company whose stock went up 1,000% in recent years.
  3. A trucking company using AI to improve many aspects of its operation.

How to Benefit from AI (Artificial Intelligence) Without a Lost Decade

AI is having a big impact, with an expectation for a transformation that would improve lives all around the world. The promise of AI led to outsized gains for technology companies. The excitement pushed prices higher much faster than actual earnings and book values (intrinsic values) of some of these companies. The effect surpassed the dot-com boom, with S&P 500 Price/Book (P/B) even higher than the peak of 2000, and is now the biggest seen since 1929, the onset of the Great Depression.

This creates a dilemma: Do you buy companies that are involved in a worldwide transformation, hoping to benefit from earning growth, or do you avoid them given that the price growth surpassed the actual earnings many times over? The most recent case when prices (relative to book values, or P/B) reached close to the extreme of today, was during a lost decade – a 10-year decline of 30% for the S&P 500, and a 14-year decline-to-recovery for the Nasdaq. The Nasdaq lost 78% over a grueling 2.5 years. This was the result of very successful companies continuing to be successful while adjusting prices to be more in line with reality.

While different bubbles pop at different levels, the current bubble has a solution that avoids the big risk while still aiming high. The reason it is possible is that there are plenty of stocks and entire stock markets (countries) that are not priced high. One solution is to invest in deep-value (much lower than typical P/B) companies around the world, emphasizing non-US stocks (international and emerging markets), and diversifying across sectors. The benefits:

  1. Efficiency broadly:  AI makes companies across all sectors and economies more efficient, increasing their values.  The benefit depends on the speed of adoption, and the ability to adopt.  With company and sector diversification, you can enjoy an overall benefit, without the risk of a company- or sector-specific bet.
  1. Spread:  As happens typically in tech cycles, the world will transition from a few early AI developers, to competition (e.g. DeepSeek).  This punishes companies with valuations that reflect expectation for eternal dominance, and rewards new entrants that start with low P/B.

Quiz Answer:

Which of these investments can do well thanks to the AI revolution? (There may be multiple answers.)

  1. An Asian renewable energy company generating very cheap electricity. [Correct Answer]
  2. A company whose stock went up 1,000% in recent years.
  3. A trucking company using AI to improve many aspects of its operation. [Correct Answer]

Explanations:

  1. AI consumes substantial energy. A company with competitive pricing along with the appeal of renewable energy can enjoy growing market share in a market with growing overall demand.
  2. Just because a company’s stock surged, we can’t know what its future will be. It could still be underpriced, or it could have become overpriced through people chasing past gains without studying the merits of the investment, including the company’s earnings and book value relative to its current price.
  3. Many companies may benefit from AI in multiple ways. Those who implement it smartly can get a big benefit, regardless of their sector, including trucking companies.
Disclosures

The Tax Bomb of Many Tax Strategies for Investments

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Quiz!

What are downsides of Separately Managed Accounts (SMAs) that are used to lower investment taxes? (There may be multiple current answers.)

  1. Extra risks.
  2. Extra costs.
  3. Higher taxes.
  4. Distraction from after-tax returns.
  5. Greater complexity.
  6. An eventual tax boomerang.
  7. Lower expected returns.

The Tax Bomb of Many Tax Strategies for Investments

There are many strategies that claim to avoid taxes on investments or greatly reduce them. Some have an obvious benefit without much of a downside. One example is Roth IRAs. Many more recent strategies come with a big catch: they don’t avoid taxes but only defer them, leading to a large future tax bill. This tax bill may come sooner than you expect as explained below.

What strategies have this catch? These are a collection of strategies that are typically housed in Separately Managed Accounts (SMAs). SMAs can be used to sell investments at losses to offset gains, creating an effect of lower (or no) investment taxes. A variant called direct indexing can start with an index and does the same to minimize taxes. Other variants go further with bets against investments using short positions or various derivatives. Some names are 130 / 30 (130% long + 30% short), and option overlay SMA (uses various derivatives to gain a short effect).

How is the tax bomb formed?

  1. Low basis, high gains: After a few years, the long positions end up with a very low basis and large unrealized gains and cannot be used to harvest losses.
  2. Lower returns: While you hold the strategy, there are many forces hurting the returns:
    1. There is an added annual cost to these strategies for the manager, plus financing cost for short leverage.
    2. The short positions and derivatives add risks. To manage the risk, portfolios often get tilted towards safer but lower-return allocations.
    3. Limited investments options, excluding the highest returning ones.
    4. The increased focus on taxes could create a distraction from maximizing after-tax returns.
    5. Over time, the portfolio holds increasingly overpriced stocks and gives up undervalued ones. This is the opposite of selling high and buying low.
  3. The tax bomb: After a few years (5 years according to product providers), the potential tax benefit diminishes so much, while the expected returns go so far down, that you would want to unwind these positions. Unless your goal is to never use the money on yourself (you hold till death or donate), you would have to pay the substantial built up tax.

Should you rule out all of these strategies in all cases? No. With the right set of circumstances these could make sense. Analyze the results over a full market cycle. This may require simulations given that many of these products existed for less than a cycle.

 

Conclusion: Be skeptical of tax strategies that promise to “eliminate” investment taxes. Often, they’re only postponing the pain, while lowering your returns in the process.

Quiz Answer:

What are downsides of Separately Managed Accounts (SMAs) that are used to lower investment taxes? (There may be multiple current answers.)

  1. Extra risks. [Correct Answer]
  2. Extra costs. [Correct Answer]
  3. Higher taxes.
  4. Distraction from after-tax returns. [Correct Answer]
  5. Greater complexity. [Correct Answer]
  6. An eventual tax boomerang. [Correct Answer]
  7. Lower expected returns. [Correct Answer]

Explanations:

  1. Without the extra focus on taxes, you can optimize for a combination of returns and diversification. The tax strategies can hurt both.
  2. These tax strategies typically involve extra costs.
  3. Taxes are expected to be lower, at least in the first few years.
  4. Given that higher returns often end up being taxed, the focus on taxes can distract from the ultimate goal, leading to lower after-tax returns.
  5. Tax strategies can add complexity in planning, implementation and tax reporting.
  6. The tax benefit can deplete within 5 years, with an allocation that targets much lower returns, leading to a big tax bill to unwind the unprofitable strategy.
  7. See #4.
Disclosures

The Failure of Investment Products with Downside Protection

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Quiz!

Which strategy offers the best downside protection?

  1. Defined Outcome Strategy
  2. Derivative Income
  3. Options Trading, Equity Hedged Strategy
  4. Stocks + T-Bills
  5. Buffered ETFs

The Failure of Investment Products with Downside Protection

If you are approaching retirement, you may be especially interested in limiting the downside of your investments. There are various strategies that fall into 3 Morningstar categories: Derivative Income, Defined Outcome, and Options Trading – Equity Hedged. Another common name you may have heard is buffered ETFs. What they have in common is a structure that limits the downside in exchange for giving up some upside.

Sounds great, right? The following article compares them to a simpler combination of Stocks and T-Bills (very short duration government bonds): https://www.aqr.com/Insights/Perspectives/Rebuffed-A-Closer-Look-at-Options-Based-Strategies. It turns out that the sophisticated strategies do worse than the simple stock / bond combo, not only in terms of returns, but even in terms of downside protection. There is a follow-up article with more details, especially for the skeptics: https://www.aqr.com/Insights/Perspectives/Buffer-Madness.

Why do these well-designed sophisticated strategies do worse than the simplest asset allocation? They are a form of insurance, with multiple costs. The costs reflect the big desire of people for protection, negating more than the entire benefit.

Is there an even better solution? Yes, a focus on diversified stocks. The cash / bond component introduces inflation risk – one of the toughest risks in retirement. The ultimate solution is reaching the point of low spending/investments (requires advance planning), eliminating the need for substantial cash or bonds. How? Say you withdraw 3% per year from your investments, and they declined by a dramatic 50% for a year, the cost is an extra 3% (6% total). Diversified stock portfolios enjoy growth that can make up for the penalty of withdrawals in down times. Such a strategy requires great discipline at all points in the cycle – otherwise, the entire plan can get derailed.

Quiz Answer:

Which strategy offers the best downside protection?

  1. Defined Outcome Strategy
  2. Derivative Income
  3. Options Trading, Equity Hedged Strategy
  4. Stocks + T-Bills [The Correct Answer]
  5. Buffered ETFs

Explanation: Stocks + T-Bills avoid the insurance-type costs of the other strategies. The article demonstrates the benefit based on a historic analysis.

Disclosures

One of the Most Destructive Forces in Investing, and How to Fight it

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Quiz

You hold a diversified investment that performed poorly for 10 years and want to make a change. What should you do? (Multiple answers may be correct.)

  1. Very gradually diversify into more proven investments.
  2. Very gradually diversify by including stable investments.
  3. Compare the valuation of the investment along with the investment you are considering for diversification, and avoid selling low to buy high.
  4. Compare the valuation of the investment relative to the long run, and also the returns relative to full cycles. If both are below typical, don’t make changes, and keep saving new money into it.
  5. Track the valuations and recent performance relative to the long run / full cycles. Be ready to diversify from a point of strength – at a high point, adding investments that are not at a very high point.
  6. Avoid making changes due to cyclical forces.

One of the Most Destructive Forces in Investing, and How to Fight it

Have you ever experienced any of the following:

  1. Had some money to invest and looked at the past 1-, 5- or 10-year performance, to help choose?
  1. Heard from someone that she/he made big money in an investment in recent years and felt the urge to put some money there?
  1. Lived through a long period (as long as 10 or more years) of poor performance relative to other investments and felt that it’s time to diversify?
  1. Learned about an investment that grew phenomenally for the past 10 years, felt that it is a solid investment, and felt secure to put money there?
  1. Saw your investment go through a big crash (50%+), with economic news giving a thorough explanation for a disastrous future, leading you to seek safety in solid investments (e.g. bonds or CDs)?

From my experience talking to people over the years, the scenarios above are very common. Why is that? In most avenues of life you can use experiences from recent years to project the future. Examples:

  1. If you get hungry, you learn to eat and then feel better. It was true today, one year ago, and any day.
  1. If you cross a street without observing the traffic, and nearly get hurt, you learn to always look for traffic before crossing the street. This will never be bad advice.

It turns out that investments involve cycles of various lengths. This means that learning about past years can be counterproductive. Examples:

  1. US Large Growth (high Price/Book or Price/Earnings) stocks outperformed US Value stocks from 1982 to 2000. You would expect 18 years to be plenty long to establish the trend. In the following 2 years, the entire benefit of Growth stocks over Value stocks was wiped, and Value outperformed Growth for the full 20 years! This brought the relative performance of the two groups in line with the long run. Imagine the devastation of a person who made a change in early 2000 – something that many did. Today’s P/B of the S&P 500 is right near the peak level of 3/2000, early in its latest 10-year decline!
  1. Real estate had unusual gains from 1995 to 2006. Some people became multimillionaires by buying many houses with huge loans. By 2006, you could have taken a 106% loan on a house, with no verification of income. In the following 5-6 years, home prices declined by varying degrees, depending on location, taking as long as 10+ years peak-to-peak. In California, typical declines were 30% from peak to bottom. Some loans in 2006 led to more than 100% loss on the original investment, unless you had the income and discipline to keep paying the mortgage for years until recovery. This brought some of those millionaires to bankruptcy.

It is surprising to realize how many investment mistakes are rooted in a single cause – underestimating and misunderstanding cycles. So, how can you avoid the traps above?

  1. Always look for logic – not just past returns. Companies bring value through efficiently providing products and services. Real estate offers a place to live or run a business. Bonds are a loan to a company or government, allowing it to spend money that it doesn’t have with the hope of adding value beyond the cost of borrowing (or print money in the case of a government).
  1. Be highly suspicious of investments that don’t generate value or are too new to have at least one clear full cycle. Cryptocurrencies, including Bitcoin, have both issues. Educated opinion: only after completing the next tech downturn, you may reach a full crypto cycle.
  1. Study the long history of investment types that you are considering. If you notice unusually good or bad returns for an investment, compare them to the full cycle. If there is an unusually large deviation, at least prepare for the potential of a reversal. Do not move money out of an investment that did poorly for 10 or even 15 years relative to its full-cycle average, and into an investment that did very well in the past 10 or 15 years relative to its full-cycle average.
  1. Most common investments have a way to value them. Stocks have Price/Book Value (P/B) and Price/Earnings (P/E), representing what people pay for the stock relative to the intrinsic value or earnings of the company. For diversified collections of stocks, you can compare the current values relative to the full-cycle average, and don’t expect an anomaly to last forever. There are valuation measures for different types of real estate, small businesses, and other investments. Use them instead of looking at the recent past.
  1. Never judge an investment by the length of an unusual period – always view valuation measures. The longer the anomaly, the more violent the reversals tend to be, and the bigger the damage in counting on persistence after the anomaly sustained for a long time. If an anomaly continues another year, or multiple years, there is a growing temptation to take it as proof that it is a new normal, and so does the damage, when the reversal does come. You can observe the returns of Japanese stocks for nearly 30 years after 1989, or gold for nearly 30 years after 1980.
  1. Imagine that a diversified investment you are considering went through 10 terrible or phenomenal years of returns. If the terrible years make you want to avoid the investment and the phenomenal years make you want to put money there, recognize that you may have fallen into the traps above. Go back to logic, valuation measures and full cycles.

Quiz Answer

You hold a diversified investment that performed poorly for 10 years and want to make a change. What should you do? (Multiple answers may be correct.)

  1. Very gradually diversify into more proven investments.
  2. Very gradually diversify by including stable investments.
  3. Compare the valuation of the investment along with the investment you are considering for diversification, and avoid selling low to buy high. [Correct Answer]
  4. Compare the valuation of the investment relative to the long run, and also the returns relative to full cycles. If both are below typical, don’t make changes, and keep saving new money into it. [Correct Answer]
  5. Track the valuations and recent performance relative to the long run / full cycles. Be ready to diversify from a point of strength – at a high point, adding investments that are not at a very high point. [Correct Answer]
  6. Avoid making changes due to cyclical forces. [Correct Answer]

Explanations:

  1. You already hold a diversified investment. Not all extra diversification is good. If you sell low to buy high, the added risk and harm to the expected returns can outweigh the benefits of extra diversification. See all explanations below to help decide. Also note that reversals after 10 unusual years are the norm, not the exception.
  2. Buying a stable investment can prevent the damage of buying high in #1, but it still keeps the potential damage of selling low, and introduces the additional damage of low growth (that is typical for stable investments).
  3. Future returns do not always repeat recent years – reversals are the norm. A much better predictor of future returns is valuations (P/E, P/B, various real estate ROI and affordability measures). Valuations may fail for a streak of years, testing the discipline of investors, but the longer they fail the bigger the reversal tends to be. It is difficult to win by buying high.
  4. See explanation right above + stick to the foundations: high long-term returns for the asset class in which you are investing.
  5. See explanations above + you can add diversification without the damage of selling low and buying high, by being as patient as needed. Being impatient with this can create lifelong damage.
  6. There is always a compelling story justifying low points. While it may explain the past, it may not explain the future. Be extra wary of mistaking cyclical forces for permanence – it may be the most common mistake that people do at extremes (lows and highs).
Disclosures

How Do Tech Bubbles Pop?

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Quiz!

How long did it take the Nasdaq to reach a new peak after the 3/10/2000 peak?

  1. It kept on going up – the Nasdaq doesn’t decline given the solid technologies produced by the companies in it
  2. 3 years
  3. 6 years
  4. 10 years
  5. 14 years
  6. It is unknown yet – it is still recovering.

How Do Tech Bubbles Pop?

On 1/27/2025, Nvidia and Broadcom stocks declined 17%. Why would the stocks of two of the leading AI companies in the world get hit so hard? This was in response to Chinese DeepSeek’s AI competing with ChatGPT, while its API access (access for programmers) is offered at less than 1/50th (2%) of the price of the ChatGPT API.

This is a common step in tech bubbles, going at least as far as the Roaring 1920’s (commercialization of the radio, TV and more) that were followed by the Great Depression. Here are typical phases of tech bubbles, from formation to popping:

  1. A new technology is introduced offering great value.
  2. As the technology gets demonstrated and improved, adoption increases, providing great profits to the companies offering it.
  3. The stock prices of companies offering the technology increase given their profitability.
  4. At some point, many investors buy the stocks given past returns and the future promise, while ignoring valuations, such as Price relative to Earnings and Book Value (P/E and P/B). That is when the gains form a bubble and can be seen with a spike in valuations.
  5. In the meantime, two effects happen:
    1. Economies of scale lower the cost to produce products with the technology.
    2. Competition, with a focus on efficiencies, offers the technology at much lower costs.
  6. As competition increases and costs go down, the entire industry lowers the prices. This includes the original companies offering the technology.
  7. With much lower prices, profitability of the producers of the new technology goes down, and the prior valuations become disconnected from reality, leading them to decline.
  8. That leads to a crash in those technology stocks, all while offering a very valuable service.
  9. While there is a logical progression, the timing isn’t easy to identify in advance.

Was 1/27/2025 the peak of the current tech bubble? It is tough to say, before reaching the depths of the decline. In 2022, we got a false peak with the tech-heavy Nasdaq declining a mere 33% (vs. the 78% decline in the dot-com crash that started in 2000). After 1 year, it bottomed and reached new highs less than 2 years later.

Once the real decline starts, how long can it take to recover? As typical, there are no guarantees in investing. Having said that, there has been a correlation between the excess valuations (relative to the typical) and the length of the decline.

  1. In the 2000’s the S&P 500 took over 10 years to recover, with a 30% decline a decade after its peak.
  2. In 1989 Japan reached significantly higher valuations that led to a decline to recovery of over 30 years, given much higher peak valuations.
  3. Fast-forward to 2025: The P/B (or Price/Book) of the S&P 500 on 1/27/2025 was slightly higher than the highest point in 2000, so another “lost decade” shouldn’t surprise us.

Quiz Answer:

How long did it take the Nasdaq to reach a new peak after the 3/10/2000 peak?

  1. It kept on going up – the Nasdaq doesn’t decline given the solid technologies made by the companies in it
  2. 3 years
  3. 6 years
  4. 10 years
  5. 14 years [The Correct Answer]
  6. It is unknown yet – it is still recovering.

Explanation: The Nasdaq declined by 78% over a span of 2 years and 7 months, followed by a long road to recovery, with a total of 14 years peak-to-peak.

Disclosures