Disclaimer: This post is not my attempt to predict what lies in the future and where the stock market is headed, because I have a post-graduate degree in making disastrous predictions, especially about the future. What I am sharing below is what I have started experiencing around me, and why I believe you, as an investor, must be very careful of falling into the trap of people making rosy predictions about the future.
One of the key themes of my discussions with investors during my extensive travel over the past few days was that risk-taking and arrogance is back in the stock market.
I got a hint of this from a lot of people stressing on the benefits of borrowing money to invest in “great opportunities” available out there.
So one participant at my Indore workshop argued – “Why shouldn’t I borrow at 10-12% interest and invest for 25-30% returns that are there for the taking?”
Another asked in Vadodara – “Why shouldn’t I borrow when I know the opportunity to multiply money is great?”
Without doubt, I could answer these questions only to the point I understand the dangers of borrowing money to trade or invest in the stock market. Beyond a point, if someone has made up his/her mind that borrowing money is a great idea (because others have found success doing so), I have no answers to provide.
All I know about buying stocks with borrowed money is that it doesn’t make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize. And then, leverage brings destruction if things go bad…really bad. And they often do.
Anyways, related to this point about how bad things can go in the stock market, someone asked me my thoughts on the “worst-case scenario” I can imagine.
Now, here is how our brain plays tricks when it comes to imagining scenarios. We generally imagine only what we have seen or experienced in the recent past.
So my worst-case expectations would often not go beyond what I saw in 2008, for that is only what I remember from recent history.
But this is where Howard Marks brings my imaginations back to the ground. He does that through an entertaining story he shared in The Most Important Thing about worst-case expectations, or how bad things can go…
We hear a lot about “worst-case” projections, but they often turn out not to be negative enough. I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away. Invariably things can get worse than people expect.
Maybe “worst-case” means “the worst we’ve seen in the past.” But that doesn’t mean things can’t be worse in the future. In 2007, many people’s worst-case assumptions were exceeded.
Am I a Pessimist?
Interestingly, I find a lot of people these days accusing me of being a pessimist whenever I write about practicing caution amidst the ongoing hype all around.
This is especially given that all the “hallowed” investors around are suggesting that ‘this is the time to be in equities’, and that ‘this time it’s different’.
In fact, when I recently posted on Twitter how a surging stock market creates false hopes and false heroes, one person replied – “If surging markets doesn’t make one rich then what does?” – and then – “Being contrarian just for the sake of being one is dangerous.”
I think it is a big fallacy among investors that they need rising prices to create wealth from the stock market. In fact, constantly and/or rapidly rising stock prices are a detriment to someone who wants to accumulate a lot of great businesses at decent prices to benefit from their future potential and growth.
In order to create wealth from stocks, you need to accumulate a lot of them at reasonable or cheap prices (for which you need dull or falling markets) and then let the underlying business work their magic of compounding your money over the long run (15-20 years).
But if you can’t think of long term perspectives (the ‘n’ or time horizon in the compounding formula), and you are worried only about earning the highest ‘r’ (the rate of return) as fast as possible, and often borrowing money to magnify the same, you are simply on the path of ruin.
Over a 10-year period, someone who grows his money at 25% per annum for eight years and then loses 40% each in the last two (because of the risks he took earlier), will be poorer than someone who plays it extra-safe and earns just 10% annual return over these 10 years.
Of course, you should not be in stocks if you are playing for just a 10% annual return, but what I am trying to say here is that over-optimism and over-confidence that leads to blind risk-taking can wipe out your great long-term historical returns in just a year or two.
Avoid Losing Your Savings, Sleep, and Reputation
When you take on leverage and show me the math that a 25% annual return over 10 years minus 12% interest cost can still earn you 20%+ return, please remember Nassim Taleb who says that we should judge people by the costs of the alternative, that is if history played out in another way.
As he wrote in his brilliant book Fooled by Randomness…
Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).
In the same way, be very careful of judging your stock market success by the outcome you achieve, but by the decision you made.
“Leverage can help me magnify my returns” is a great statement to make. But more often now, leverage – which is a result of arrogance created by good short-term returns or a result of survivorship bias, which is concentrating on the people or things that “survived” some process and inadvertently overlooking those that did not – will not only your destroy your savings and sleep, it will also destroy your reputation.
If you think that way, you will do things differently.
By the way, here is what Howard Marks wrote in his latest memo to shareholders…
While investor behaviour hasn’t sunk to the depths seen just before the crisis (and, in my opinion, that contributed greatly to it), in many ways it has entered the zone of imprudence. To borrow a metaphor from Chuck Prince, Citigroup’s CEO from 2003 to 2007, anyone who’s totally unwilling to dance to today’s fast-paced music can find it challenging to put money to work.
It’s the job of investors to strike a proper balance between offense and defense, and between worrying about losing money and worrying about missing opportunity. Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last three years Oaktree’s mantra has been “move forward, but with caution.” At this time, in reiterating that mantra, I would increase the emphasis on those last three words: “but with caution.”
Well, I have nothing to add except that while I am an eternal optimist as far as stock market investing is concerned (or why would Safal Niveshak exist to educate you to invest), be very careful of what you are doing with your money and why you are doing it.
To re-quote Howard Marks – Move forward, but with caution.
Now that the markets are up from the lows of August 2013, my personal banker/ATM alert keeps reminding me how my credit limit for my personal loan has been raised to XXXX @ 15 per cent interest per annum. I was tempted for a moment till I remembered no one had called me in the closing months of 2013.
indeed timely reminding the way ahead even for those not indulging with borrowed money.
Was it similar in the 2003 bull run?? Like is this frothy feel typical of the early stage bull markets since earnings show up later??
The case in 2003 was much more clear. PEs were low and India looked ready to take off. This time, PEs are already looking healthy. Most of the rise from now should come from earnings growth.
However, the rise in stock prices had the same unsettling feeling in 2004/5…but it continued for another 2-3 years.
Hi
Thanks for the response
I just checked the earlier records on BSEindia…Apparently the sensex PE is about 19 as on 20th nov 2014….Now comparing this to the 2003 bull market – It was 19 in Jan 2004 as well….After which in early 2004, the PE’s fell but the earnings expanded, keeping the markets at similar levels until the next uptake in earnings
Sorry I was only looking at the high’s…..From Jan 2004 high, markets corrected by about 30% before the next upmove (from sensex 6200 to 4300)
The other key difference between 2003 and now is that at that time the markets were ready to ignore govt. issues and move ahead.
This time, if the right govt. had not been voted in, Vishal would have been writing – “Falling stock prices and the lack of arrogance”
Thank you for the very timely post – even apparently “conservative” people seem to have thrown all caution to the wind.
Since Aug, “long term” for many “long-term investors” has come down from 5,3,2 years (that they were espousing earlier) to months, weeks and days. Apparently all companies can now be bought because of “strong fundamentals”.
Whenever faced with such “improved sentiments” and optimism, I recall what my father (a veteran investor) always says – “hard days are ahead”.
Good article Vishal. A year back people were so dead afraid of equities when it was a fantastic time to invest in them. My software was having companies in Platinum and Gold categories which has now reduced to Silver and Bronze. But people are waking up now when we should be concerned about valuations going beyond the fundamentals in the hope of fundamentals catching up next year. Whether that will happen or not, only time can tell, not us mortals. But people are so sure about it as if they are themselves running the company and macro environment. I think Robert Rubin put it best “Some People Are More Certain of Everything Than I Am Of Anything.”
“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” WB
Think of this
it is said that the current rise is due to FI money flow to indian markets . domestic institutes are said withdrawing from the market. are FI greedy , and DI are fearful? or something else?
Great work Vishal. It helps us to stay on track.
Thanks
Thanks for your post Vishal. Since everything is moving many people get a feel that they are smart…this happens in every market cycle and will continue to happen. Whatever you say this breed will not listen and come to the market thinking that they can double/triple their money in no time. Their discussion will start with price and end with price. They don’t have time to even look/think about the business behind the stock they buy/sell. They will ultimately loose shirt and go away till the next cycle is back.
On leverage I have a different take. Why not treat investment as a business. Since no business(especially in the starting phase) can run without leverage, hence there is no harm in using it. The problem comes when you do not have capacity to service the leverage. You need to be in control and know where to stop.It always helps improve the return.
Thanks again for the caution, as rising markets need some but one need to definitely be in the game. Finally I would like to quote Peter Lynch ” The real key to making money in stocks is not to get scared out of them.”
Regards,
Raj
@Raj,
I think a loan should be taken when a business has fairly good idea about when the money will start rolling in.
This is why using leverage in stocks is dangerous. We don’t know when the returns would come. We have a general idea but nowhere close to be enough to employ leverage. Already the pressure to cut losses or to book profit is too great for most people. Extra pressure of repayments only makes matter worse….
if you are worried about cutting losses or booking profits, then you should not take leverage. after all if you are not confident of your 100%, you cant be confident of 120%. I am not advocating to take loan, but taking loan is not such a bad thing if you know how to manage it. if you are confident of making 25-30% annual returns why not pay 12% and take loan since we are in bull market. after all capital is scarce, so managing it wisely is important
arrogance, bad behavior will not help in any market. true character will be revealed in bear market.
I can’t be confident about things I have no control on. I am confident that I will buy a fantastic stock which will most likely outperform the market. But there is always a possibility that whole market goes down. You have no control on that. So it makes no sense to be confident about it. As far as earning 25-30% per annum is concerned, it is ambitious but certainly possible over a long period but not every year. It is wise not to try to walk across a river which is on an average 4 feet deep.
@Abhijeet
Who knows the future. I even do not know if my organization will go through the downsizing in next one year and I will be rolled off. Who knows that India and China can have a brief war over border issue. Bottomline is that Future is always unknown and you have to take calculated risks in life.
“The way to make money in stocks is not to be scared out of it” – Peter Lynch. I follow this but make sure that put my money where the business is solid and will not have too much downside(generally resist the urge to get on a quick multi bagger) and I have got very decent growth.
PS: Every individual is different and one need to follow a strategy which he/she is comfortable.
Regards,
Raj
Good counsel Vishal.
2003-2007 bull market had 4 corrections, each taking the market down by 30%, 20%, 15% and 17% approximately.
So even in this ‘supposedly long bull run phase’ anyone can get some lower entry points. Its not like one has to buy all he can as if there is no tomorrow.
Well , just a different take from my side…I did take leverage and borrowed money ( at 1.99% interest rates ) to invest in equity…but during the time of April – September 2013 , not now :)….I figured the risk reward ratio was in my favour and applied it accordingly:)
It’s easy to get carried away with the trend, specially when everyone else around you are cheering the market. We need someone to remind us to stay sane 🙂 Thanks for doing just that. As munger says you get paid investing for sitting and waiting not for acting.
Dear Vishal,
Just go by the asset allocation. Let it be bull or bear market doesnt matter. Asset allocation will allow you to book profits and also will determine when to re-invest. It is a simple thing to practice to be healthy financially, yet most of us dont follow (similar to daily simple exercise).
Regards
Ajay
Boss – thanks for reminding, when people who know well all these too start turning and looking for justification to put more into stocks. accumulating cash for some time and waiting in anticipation of the 15%-30% correction…. the higher it goes the steeper the fall… let me sit tight again. 🙂