Respect the Cycle

One of the first really valuable lessons I learned in my investment career was to respect the market cycle. One of my seniors at Macquarie Bank always used to say “the cycle lives on!” He was right of course.

It was the heady days of 2006/07 when the mood amongst traders as well as “Mums and Dads”, was that the party would go on forever. “This time is different” was the chorus. All the analysts were confirming this, saying: “Returns have been good, but PE’s (price earnings multiples) still look fine”. Sadly bubbles are never obvious until you look at them with the benefit of hindsight.

No matter how good governments and cental banks get with stimulating and slowing our economies, human nature continues to drive a never ending cycle of “boom and bust”.

Following each crisis there is a period of acute paranoia that eventually fades to ambivalence and finally manifests in complete amnesia. Depending on the severity of the crisis, in my experience, amnesia can take from 5 to 10 years to set in.

Indeed, former Fed Chairman Paul Volcker wittily observed “about every 10 years, we have the biggest crisis in 50 years.”
It is now five years since the end of the most recent financial crisis of 2007-09. Stocks have made record highs in most parts of the World (Australia is a notable exception), junk bonds have boomed, and house prices have risen.

Meanwhile Australian investors are scrambling over themselves to “find a way” to purchase investment properties. On paper at least, its difficult to find any plausible reason to buy a residential investment property. Yields are low, transaction costs are high and on all commonly accepted valuation metrics, prices look stretched. Yet, it seems Australians are oblivious to the catastrophic property collapses we witnessed in the US and Europe through 2007-09. It seems we are well on our way to amnesia.

The never ending cycle of boom and bust, and our propensity to try and profit from that cycle, is a root cause of what some academics call “the behaviour gap”.

The behaviour gap is the difference between the long term return of an asset class and the return the average investor actually achieves. Let’s look at an example:

A 2012 study by Dalbar found that over the 20 years to 2012 the average return on the S&P 500 (the US stock market) was 8.21%, however the average equity fund investor achieved a return of only 4.25%. The difference lies in investors’ propensity to buy high and sell low. Put simply, our senses of fear and greed work against us when we invest. They lead us to want to “get in” when we see prices rising (usually too late), and they lead us to want to “get out” when we see prices falling (also too late).

These drivers of fear and greed are precisely what make the economic cycle so difficult for regulators to manage. Whilst our understanding of the cycle has improved, and our tools for managing the cycle have become more sophisticated, we still can’t stamp out those primal human instincts. Thus, the cycle will live on!

The good news is that if you are happy to just make the market return over the long term (which is nearly twice as good as what most investors get), it’s relatively simple to devise a strategy to achieve this, and possibly a bit more. The starting point is a carefully documented investment strategy and a disciplined approach to adhereing to that strategy “through the cycle”. A well thought out strategy gives you a rudder to maintain your direction when the herd is succumbing to their emotions.