Stock Cycles – Quality Asset Management

The Latte of Investing

You may have heard how a daily $5 café latte can add up to significant money over time. Many people see it as a small daily cost that makes no difference in the big scheme. They ignore the fact that it is recurring, leading to a much bigger total. While different people value the store-bought latte to different degrees, it demonstrates how some people may overspend on small recurring items.

There is an analogy in investing. Many people get nervous about investing after declines (that involve negative news), and delay investing until things calm down. They feel that whatever gains they may miss on the small amount is dwarfed by the gains they will enjoy with the big remaining portfolio. While the logic may sound convincing at first, when repeated, the small, missed gains can add up to very big money.

What can you do? Operate consistently: invest money as soon as it is saved.

What if it’s tough to do? Recognize that if you are uncomfortable investing at the current low level, you are likely to be even less comfortable investing at an even lower level. You are very likely to wait until the news is better than today, leading to buying higher, and missing gains. Past experience of investors supports this theory – investors tend to significantly underperform the investments they use.

Initially, it may be tough to be consistent. Once you form a habit, you may enjoy the automatic action, without a need to debate often.

Quiz Answer:

Are you likely to make money on waiting to invest until conditions become better than today?

1. Yes, the negative news can lead to continued declines. Waiting allows you to buy lower.

2. No, as conditions improve, stocks tend to go up. [The Correct Answer]

Disclosures Including Backtested Performance Data

Quiz!

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

You hold a company with a strong track record.
You hold a company with market dominance.
You take some risk off, and switch to bonds.
You take some risk off, and switch to cash.
You take some risk off, and switch to a well proven investment that did well over an entire decade.

Can you be Happy with your Volatile Stock Portfolio Whether it is Up or Down?

High investment growth comes with volatility, and is treated as the price for enjoying the high long-term gains. What if you could stay happy even during declines?

Conditions:

When working, live according to your income. Don’t spend beyond what you make.
When retired, spend a small percentage of your portfolio every year. Don’t plan on running out of money in your lifetime. 3%-4% is appropriate for most diversified portfolios with a high enough stock allocation.
Invest in a highly diversified stock portfolio, without any specific bets (specific companies, countries, etc.).
Structure the portfolio for high growth (emphasize stocks, value investing, small stocks, fast growing countries).
Maintain iron discipline to stick with your portfolio for life, and never make changes at low points (unless you move to another investment with at least equally low valuations and equally high long-term returns).

If you follow the conditions above, you can be happy in up and down times, as follows:

By nature, you have a fast growing portfolio in the long run, a cause for underlying happiness.
When you enjoyed high past gains, you can be happy with the past results.
When recent returns have been poor and valuations (price/book) are low, you can be happy about the high expected returns.
If you have any new money to invest (savings from work, inheritance, money elsewhere), you can be very happy, because investing this money at a low point turns a temporary decline into a permanent excess gain (the gains on buying low).
Over the cycles, the dollar value of the percent spending can go up as you reach higher peaks, leading to happiness about growing cash flows.

Most people struggle with such a plan, because the media pushes them to think about parts of the cycle, e.g. 5-10 years. This leads investors to be unhappy during downturns, and sometimes even destroy their life’s savings by selling low and buying something else high. Any high-growth investments can go through downturns of 5-10 or more years (e.g. the S&P 500 lost 30% of its value in the 10 years from 3/1999-2/2009), so it takes strength to stay disciplined. The best tool to maintain discipline is to watch valuations (price/book). After your high-growth investment goes through a long tough stretch, you can compare it to another investment that performed very well in recent years, and you are likely to see that your investment is enjoying substantially lower valuations, leading to substantially higher expected returns in upcoming years. While there is no guarantee for a specific turning point, you enjoy the nice combination of lower risk and higher expected returns.

Quiz Answer:

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

You hold a company with a strong track record.
You hold a company with market dominance.
You take some risk off, and switch to bonds.
You take some risk off, and switch to cash.
You take some risk off, and switch to a well proven investment that did well over an entire decade.

Explanations: None of the answers are correct!

1-2 depend on concentrated investments. History taught us repeatedly that single companies aren’t immune to irreversible downturns.
3-4 may feel good at the moment, but they turn a temporary downturn (assuming your investment is diversified and consistent) into a permanent loss.
5 may also feel good at the moment, but investments are cyclical, and the best performer of the past 10 years is likely to underperform your poor performing investment in the next 10 years. A glance at the relative valuations (price/book) of the investments can confirm this risk.

Disclosures Including Backtested Performance Data