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Explorer ○

Why Investors Blow Up (and How To Avoid That)

Overshoot

Howard Marks of Oaktree Capital described the market as a pendulum that rarely stays in the middle “The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc.”

What causes the market to behave this way? Delayed feedback. Most complex systems have a time delay between the inputs and the outputs. A seed in the soil takes years to grow into a tree before it produces any fruits. Paracetamol like Panadol takes an hour to work. A new machine takes months, perhaps years, to reach a utilization rate that generates profits. Jeff Bezos once said that Amazon’s earnings of any particular quarter come from investments they’d put in years ago. And in investing, you don’t see the consequences of the decisions you make today until years later.

Why does this matter? We ‘overshoot’ like the pendulum that swings from one end to the other. Think of a shower tap. Turn on the tap. Icy cold water comes out. You adjust the tap to get more hot water. After 10 seconds, the water temperature remains the same. You push it even further, nothing changes until suddenly, steaming hot water pours out. Terrified, you quickly push it in the opposite direction only to get icy cold water again moments later. We overshoot because of the time delay between adjusting the tap (input) and a change in the water temperature (delayed output). Whereas a simple system like the shower tap only has one knob, the market has thousands of interconnected knobs. 

During good times, companies lever up with more debts to grow aggressively, pushing earnings to a record high. Those earnings are used to pay out more dividends, repurchase shares, and reinvest for more expansion that results in even higher profits. Record earnings drive rosy market expectation and fuel an optimistic share price, which further allows companies to pursue more M&A to grow faster. Higher earnings are used to pay off interests, allowing companies to borrow even more to expand. This cycle becomes self-reinforcing like a pendulum catching momentum swinging upwards.

This isn’t restricted to companies. When corporate earnings hit a record high, many people like your neighbor also receive a job promotion and work bonuses. Where does that extra income go? The rolling market and other growth assets like property. Nothing sedates risk like a rising share price and a bullish sentiment. Your neighbor prefers first-tier quality stocks that have stable earnings. But he finds more undervalued opportunities that offer bigger upside in second-tier, run-of-the-mill stocks. These stocks tend to lag behind first-tier stocks during a rally. Hence a treasure trove for those who ‘missed the boat’. Having said that, nothing excites him more than high growth, disruptive third-tier stocks. He is quick to dismiss those who regard them as speculative for a lack of long-term thinking. These stocks are unprofitable startups with disruptive business models that have tremendous top-line growth. While he admits that there are lemons in this group, all you need is a few to become the next Amazon or Google to get filthy rich. And he reckons he is good at separating the wheat from the chaff; ones he bought have tripled or quadrupled in value in a short time. 

Due to the share price volatility of these third-tier stocks, he likes to get a feel of the market before the opening bell as soon as he gets into the office. What happened in the market overnight and how much he is going to make for the day. It is just easy money. And it certainly caught the attention of his stockbroker. They offered him a margin loan account at a dirt-cheap rate. He knows margin trading is a double-edged sword, it can both magnify gains and losses. But the downside will be limited by the stop-losses.   

Not everything is about work. Your neighbor and his family also spend more on shopping, dining out, and overseas vacations instead of visits to the neighborhood parks thanks to higher discretionary income and social proof. Although lifestyle upgrades result in higher credit card bills, mortgage debts, and living expenses, it doesn’t bother him because of the wealth effect: the value of his investment properties and stocks have appreciated substantially.

Volatility clusters

Now, no one, including you or your neighbor, knows exactly where the pendulum is along its arc at any point in time. It is like a clock with no hands. When the market is doing extremely well, companies executives and investors won’t regard it as extreme exuberance or think they’re taking on excessive risk because the reality fits the narrative. Robust economic data and record earnings support market optimism. So it is never easy to figure out if there’s a bubble. 

If time delay causes people to overshoot, then volatility clusters reverse the condition.

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More Than You Know

 

Pull out a chart that shows the historical market daily percentage change, and you’ll notice what Mandelbrot described as “large changes tend to be followed by large changes, of either sign, and small changes tend to be followed by small changes.” Volatility, or price changes of similar magnitude, are tightly packed together rather than spread out evenly over the long-term. A 10% daily swing is likely to be followed by another swing of similar magnitude the following day, for example. Volatility cluster is not only a stock market feature. It is a feature of life. As the saying goes “correlations go to one in times of stress”. This also reminds me of a quote from Vladimir Lenin, “There are decades where nothing happens; and there are weeks where decades happen.” All it takes is a change in narrative.

Morgan Housel of Collaborative Funds puts it this way, ”On January 1st 2009 the U.S. economy had roughly the same number of people, the same number of factories, machines, office buildings, computers, data centers, trucks, trains, patents, schools, creativity, and ideas as it did on January 1st 2007. But it was $16 trillion poorer and employed 10 million fewer people in 2009 than in 2007. What changed was the narrative. Optimism to pessimism – snap your fingers, that’s all it takes.” 

When the economy goes bust and the market falls, that’s the perfect time to buy stocks right? Your neighbor thought so too. But he can’t. He got margin calls from his broker. As a weak economy dampens companies’ growth rate, most businesses are forced to reduce growth capital expenditure to survive the recession, which in turn puts even more pressure on growth. This rattled the market’s confidence and sent stocks into a tailspin. As everyone heads to the crowded exit door, buy-side liquidity dried up, any stop-loss would fail precisely at a time when it needed to work the most. To make matters worse, he lost his job. His company, one of many that had blockbuster earnings a year ago, is forced to slash jobs and sell non-core assets to address a bloated balance sheet following years of reckless acquisitions. As a result, he had to sell off all of his positions to conserve cash. He couldn’t have sold at the worst possible time. But that’s the least of his worries right now. With a bleak job prospect and mountain credit card bills, personal loans, and mortgage debts, he is considering selling his investment properties at a fraction of their purchase price to avoid bankruptcy. 

Tight-coupling

It is understandable why people are obsessed with the market. If a market recession causes blow-ups, then the only way to avoid that is to keep a watchful eye on the market. However, this obfuscates the truth that not everyone blows up in a recession. So what’s important is not when there will be a recession but what separates those who blow up from those who didn’t. What did they do that puts themselves in a vulnerable state? The answer is ‘overshooting’ because of delayed feedback. And when you mix that with volatility clusters, you get an idea why people that have done well for many years (especially those who did extremely well) can suddenly blow up.

Nassim Taleb describes reality as a revolver with a thousand chambers that delivers the fatal bullet infrequently, “after a few dozen tries, one forgets about the existence of a bullet, under a false sense of security.” During good years, people take on more risk in the absence of fear by getting into a position that maximizes rewards. This behavior creates tight-coupling, an engineering term used to describe how accidents happen when there’s not enough ‘slack’ in a system. Like placing dominos close to one another, small failures can quickly cascade into large accidents. It is like removing spare tyres from your car to improve fuel mileage because you never had punctured tyres. Or decide to drive home after a few beers because you never had a car accident while sober. All is well if nothing happens. But when things go wrong—an intoxicated driver with a punctured tyre on a rainy night—it often turns disastrous.

To be clear, volatility itself is not a risk for long-term investors; big changes during a market turmoil can present itself as an opportunity. What makes it deadly is when it causes a domino effect—a single problem creates another which causes another—that ends up forcing your hand (as it did to your neighbor) if there isn’t enough buffer to withstand that amount of shock. As Buffett once said, “We don’t prepare ourselves for a single problem, we prepare ourselves for problems that sometimes create their own momentum. There are things that trip other things, and we take a worst-case scenario into mind that probably is considerably worse than most people do.”

Were the premiums adequate?

In When Genius Failed, Roger Lowenstein wrote that “All insurance companies make good profit during good years, when there’s no major disasters or whole lots of claims; but the question is were the insurers good, or mere lucky? Were the premiums adequate? or are they writing inexpensive policies for wooden houses built on top of the fault lines with little thought to the potential claims?”

Investors require the same introspection. After a string of good years, one requires an intellectual honesty to ask if he is good because he is skillful, or just lucky? Am I adequately compensated for the risk I’m taking? Or am I taking an immeasurable risk for a decent return? What is the worst-case scenario? Do I have enough margin of safety to survive that? Or am I pushing the envelope as if nothing can go wrong? You want to avoid doing things that look great in the short-term at the cost of long-term performance. Don’t be the guy that drown crossing an average 4ft deep river.

Notes

Morgan, H. (2019). The Laws of Investing: A couple foundations that guide billions of outcomes. Retrieved from https://tinyurl.com/yy4xru6c

Marks, H. (2004). The Happy Medium. Retrieved from https://tinyurl.com/y5cd3bw4

Institute of Medicine & Committee on Quality of Health Care in America. (2000). To Err Is Human. Why Do Errors Happen? Retrieved from https://www.ncbi.nlm.nih.gov/books/NBK225171/

Berkshire Hathaway 2020 Annual General Meeting: https://news.yahoo.com/warren-buffett-cant-handle-fear-001029253.html

8 Replies
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Frequent Contributor

Re: Why Investors Blow Up (and How To Avoid That)

bump...

R48

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Frequent Contributor

Re: Why Investors Blow Up (and How To Avoid That)

Lots of narrative but I could not find one actual hands on idea how to avoid it.

 

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Highlighted
Frequent Contributor

Re: Why Investors Blow Up (and How To Avoid That)

Interesting read, but as FD said, not much actionable advice. A few things I have learned over the years:

1) save/ invest aggressively.

2) start as early as possible (use the power of compounding to your benefit).

3) avoid concentrated bets (specific companies, sectors, etc.).

4) diversify.

5) as Buffett said, think through the “worst case scenarios” before investing.

Win
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Participant ○○○

Re: Why Investors Blow Up (and How To Avoid That)


@Win1177 wrote:

Interesting read, but as FD said, not much actionable advice. A few things I have learned over the years:

1) save/ invest aggressively.

2) start as early as possible (use the power of compounding to your benefit).

3) avoid concentrated bets (specific companies, sectors, etc.).

4) diversify.

5) as Buffett said, think through the “worst case scenarios” before investing.


+1

In short, do fairly much the polar-opposite of what is kicked around on a daily basis on the hyper-conservative Bond Forums. That's why you have been soooo successful and why your eventual retirement will be luxurious.

There are many ways to invest. Your way is what separates the "Fat Cat" from the "Skinny Cat". You're eating at the big-boy table, not under it, pawing for drops.

Highlighted
Frequent Contributor

Re: Why Investors Blow Up (and How To Avoid That)


@VA-Tech wrote:

@Win1177 wrote:

Interesting read, but as FD said, not much actionable advice. A few things I have learned over the years:

1) save/ invest aggressively.

2) start as early as possible (use the power of compounding to your benefit).

3) avoid concentrated bets (specific companies, sectors, etc.).

4) diversify.

5) as Buffett said, think through the “worst case scenarios” before investing.


+1

In short, do fairly much the polar-opposite of what is kicked around on a daily basis on the hyper-conservative Bond Forums. That's why you have been soooo successful and why your eventual retirement will be luxurious.


Another "funny" post.  I made most of my money in stocks too but I after I made it there is no need to risk it but the numbers show I'm not far from 60/40(VBINX).  While VBINX 3 year SD=10.8 my portfolio is at 2.2 and when most portfolios were down so quick in 03/2020, mine was up.  It's obvious you can't compete.

Luxurious? mmm.  If you spend $50K on a vehicle instead of 30K that's not luxurious that's showing off.  A 30K vehicle is all I need to make me happy.  Actually, 30K is too much but if I want a bigger vehicle I don't have a choice.  My other vehicle is a sedan.  Camry LE or Honda LX  should be even cheaper which is probably what I will buy in several years.  BTW, I made more than $150K than my needs, it's pretty easy to be "luxurious" and spend another $20K but I why would I do it.

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Participant ○○○

Re: Why Investors Blow Up (and How To Avoid That)

Fat Cat - Skinny Cat.jpg

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Explorer ○

Re: Why Investors Blow Up (and How To Avoid That)

nice one, using SD to measure risk. 

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Explorer ○○

Re: Why Investors Blow Up (and How To Avoid That)

Nice write up & analysis. Thanks!

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