The Rules: Investing and Market Cycles

Financial intermediation reduces volatility.  In bull markets, demand for financial intermediaries drops.

Ordinary people do well if they have a budget and stay within it.  They do even better if they save and invest, but really, they don’t know what to do.  Market returns are like magic to them.  They don’t know why they occur, positively or negatively.  Life would be best for them if a mutual financial company gave them smooth returns 0n a regular basis, and absorbed all of the market volatility over a market cycle.  That would be hard for the mutual financial company to do, because they don’t know what the ultimate returns will be, so how would they know what smooth returns to credit?

There is a reason why banks, mutual funds, money market funds, life insurers, and defined benefit pension plans exist.  People need vehicles in which to park excess cash that are more predictable than directinvesting.  Set an average person free to make his own investment decisions with individual bonds an stocks, and he will make incredibly aggressive or scared moves.  Fear and greed will seize him, making him sell low, and buy high.

What can past market crashes teach us about the current one?

The markets have largely recovered since the March selloff, but most would agree we're not out of the woods yet. The COVID-19 pandemic isn't close to being over, so it seems that volatility is here to stay, at least until the pandemic becomes less severe. Q2 2020 hedge fund letters, conferences and more At the Read More


That’s why entities that reduce volatility, whether absolutely or relatively, whether short-run or long-run, exist.  But there is seasonality to this: average people seek intermediaries during and after bear markets, when they have been burnt.  After losses, they seek guarantees.  That is often the wrong time to seek guarantees, because often the market turns when average people are running.

During bull markets, the opposite happens.  When easy money is being made by amateurs, the temptation comes to imitate.

  • If my stupid brother-in-law can make money flipping houses, so can I.
  • If my stupid cousins can make money buying dot-com stocks, so can I.
  • If my stupid neighbor can make money buying gold, so can I.

First lesson: don’t be envious.  Aside from being a sin, it almost always induces bad investment and consumption decisions.

Second lesson: build up your investment expertise, piece-by-piece.  Don’t follow the crowd.  Develop the mindset of  a businessman who calmly analyzes opportunity, asks what could go wrong, and estimates likely returns dispassionately.  Pretend you are a Vulcan; if they actually existed, they would be some of the best investors, and not the Ferengi.

Third lesson: an experienced advisor can be of value even if he does not beat the market, by avoiding selling out at the bottom, and avoiding taking more risk near the top.

Fourth lesson: remember that market returns tend to be lumpy.  The economy may be volatile, but markets are more volatile, and not in phase with the economy, because markets anticipate.

Fifth lesson: if you can do it in a disciplined way, invest more during bad times, after momentum has slowed, and things cease getting worse.  Also, if you can do it in a disciplined way, invest less during good times, after momentum has slowed, and things cease getting better.

The main idea here is to be forward looking, and avoid the frenzies that take place near turning points.

 

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.