In the last article, we told you how you should deal with Risk. In this article we will highlight the importance of the awareness of cycles.
If you’ve been an investor long enough, you know by now that the one similarity it has to life is that, there are very few sure things. You can be wrong about the value of the company, your assumptions and estimates, sometimes the circumstances may itself change and sometimes even a sure shot event may not occur. However, as Marks points out, there are two things that will always be true in the world of investing:
Rule # 1: Most things will prove to be cyclical
Rule #2: Some of the greatest opportunities for gain and loss come when other people forget rule number one
Sure, we don’t know what will happen in the future, but we can at least be prepared. Very few things will move in a straight line. The main reason for this cyclicality is the involvement of us humans! Because we humans are emotional and inconsistent. And it is the investor’s reaction to events that determines the degree of cyclicality. While the occurrence of a cycle is subject to many factors, the correction is not necessarily dependent on external factors. Cycles are self-correcting!
Here’s how a typical cycle would go:
- Economy prospers and people start feeling more optimistic about the future.
- They save less and spend more; in fact many start borrowing to increase their profits by indulging in highly risky bets.
- As there is no bad news, risk averseness disappears
- Credit standards are lowered and financers start lending to projects not worthy of being financed
- This then leads to capital destruction, reaching to a point where entire capital is lost
- And eventually the cycle is reversed
- Losses start increasing, risk averseness returns
- At the extremes, capital is made available to only highly qualified borrowers.
- Borrowers eventually start defaulting, declaring bankruptcies
- And finally the cycle is reversed again!
What is important for a value investor to understand is that the extremes provide a great opportunity of earning high returns. Also important is to remember that cycles will never stop occurring. Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.
Remember to never get caught up in these four words ‘This time it’s different!’ Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it’s the opposite that’s most likely true.
It’s understandable for a first time investor to make this mistake, but a seasoned investor should realize that this is never going to happen and turn it in into their advantage.
A perfect example to describe the mood swings of the market is a pendulum. The pendulum spends very little time at the centre, which is its average, but whenever it is at the extreme, it is inevitable that it will return to the centre! Investment markets follow this swing – between euphoria and pessimism, between being overpriced and underpriced, between risk tolerance and risk aversion.
In fact, the swing between investor’s attitudes towards risk is a key contributor to market bubbles and crashes.
So how do you identify these cycles?
Marks makes it easier for us by giving the three stages of a bull and bear cycle:
A typical bull cycle:
- Stage 1: Few people begin to believe things will get better
- Stage 2: Most investors realise, improvement is actually taking place
- Stage 3: When everyone concludes things will get better forever
And similarly, a typical bear cycle:
- Stage 1: When few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy
- Stage 2: Most investors realise, things are deteriorating
- Stage 3: When everyone concludes things will only get worse
The significance of all this is the opportunity it offers to those who recognize what is happening and see the implications. At one extreme of the pendulum— the darkest of times— it takes analytical ability, objectivity, resolve, even imagination, to think things will ever get better. The few people who possess those qualities can make unusual profits with low risk.
Of course, we cannot know, how much into the extreme a particular cycle may go or when the cycle will actually reverse. But there is one thing we can be sure of – that the cycle will eventually reverse! And those of us investors who can understand this cyclicality can benefit immensely!
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