Good Times Teach Only Bad Lessons

I like to say, “Experience is what you got when you didn’t get what you wanted.”

Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk.

The most valuable lessons are learned in tough times. In that sense, I’ve been “fortunate” to have lived through some doozies: the Arab oil embargo, stagflation, Nifty Fifty stock collapse and “death of equities” of the 1970s; Black Monday in 1987, when the Dow Jones Industrial Index lost 22.6 percent of its value in one day; the 1994 spike in interest rates that put rate- sensitive debt instruments into freefall; the emerging market crisis, Russian default and meltdown of Long- Term Capital Management in 1998; the bursting of the tech- stock bubble in 2000–2001; the accounting scandals of 2001–2002; and the worldwide financial crisis of 2007–2008.

Howard Marks, 'The Most Important Thing Illuminated'

I don’t mean to start 2015 off on a sour note, but there’s something I should say – particularly for the benefit of my younger readers and for those who are newer to investing. As the Howard Marks quote above illustrates, enduring pain in the markets provides the very best lessons we can learn as investors. The trouble is, it’s been awhile since we’ve been able to learn anything useful.

The S&P 500 has just finished its sixth year of positive returns and its third straight year of double-digit gains. According to FactSet via the Wall Street Journal, “The S&P 500 index now trades at 16.4 times forecasted earnings over the next 12 months, compared with 15.4 a year ago…the average over the last 10 years is 13.2.” Regardless of where we are in the cycle, now’s probably a good time to remember the better lessons we’ve learned during the bad times of the past.

If you’ve only been investing for a few years, I can share a few of these lessons that I’ve learned in my 17 years of market experience – most of which were spent during a secular bear market.

The first is that whomever is winning now will appear to be invincible (to paraphrase Orwell), but stay tuned – because the leading investors of today will most assuredly get creamed when the worm turns. It always goes that way. Just look at what happened to the vaunted value kings of the aught’s decade or the internet investing pioneers of the 1990’s. As Raekwon the Chef so eloquently phrased it on ‘Incarcerated Scarfaces’, You rollin like Trump, you get your meat lumped.

The second is that consistent, seemingly relentless gains are pushing your friends and neighbors to expect even more gains in the near-future. Humans are extrapolative in nature and rich humans have a tendency to believe that they are entitled to more, always more. They do not read articles about the windfall returns of others and think “good for them.” They come away from these stories, instead, with the idea that they are not getting as much as they deserve out of the markets. This is prompting them to take on more risk, make changes where none are necessary and, generally do stupid things they would not be doing in a more challenging environment. This includes borrowing against their stock and bond holdings with margin loans or with non-purpose loans. It also includes makingdirect investments into Uber and other venture deals through investment banks. The chips are being pushed further out on the table.

The third and final lesson I’ll impart on this topic is that, while we are extrapolative, we are also forgetful. This is because of the Recency Effect bias, which was first documented by psychologist Herman Ebbinghaus in the 1880’s. Ebbinghaus, who is referred to as the Father of Memory, determined that people tend to remember the first and last events in a series the best, with a very murky recollection of the stuff that happened in the middle. He called this the Serial Positioning Effect. Taking his work a step further, psychologists have discovered that, as humans, we weight our most recent experiences very heavily and often use them as a baseline for what should happen next. This explains why the investing public – both amateur and professional – is stubbornly bearish in the first years of a market recovery after a crash, only gradually allowing any optimism to creep in to the consensus forecast. This is despite the fact that expected returns increase after a bear market mathematically. Now that six years of stock gains have been recorded, we find the opposite condition setting in as The Street is uniformly bullish and the bears have all capitulated or been fired. We are mentally over-weighting our most recent experience with stocks and coming up with the justifying technical / fundamental / economic reasons so that everything fits neatly in our minds.

To sum up:

1. Today’s biggest winners are next in line for the guillotine.

2. The expectations of the masses are growing and their risk-taking proclivities are expanding.

3. The gains of last year and the year before are front and center in our minds.

As you head into 2015, keep these lessons close at hand. They will serve you well.

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