When I studied Economics and Finance in business school, I learned many useful things about investing, but over time I have discovered that they were not nearly enough. Here are the exceptions to what I learned in graduate school, as well as some new realizations. Sometimes, what you think you know is incomplete or just plain wrong. And sometimes, you learn things you never knew you never knew.
Yes, Virginia, bubbles do exist. Years ago my professors downplayed the importance of speculative bubbles, but I think the evidence is clear. In the last 15 years I would argue that we have had (at least) four separate bubbles. Two of those bubbles have already popped, and of those I am sure there will be no disagreement. Bubble #1 was technology stocks (remember all of the dot-com companies?) of the 1990s and bubble #2, housing prices, which from 2001 – 2006 went sky high, simply because people fell in love with the sure-fire benefits of owning them.
Now, I cannot prove it yet, because prices are still high, but I believe we have had a bubble in gold, and to some extent, silver prices. (I wrote about this last November.) The phrase “as good as gold” has a long history and a certain charm, but I would not bet my own money, nor my clients’ money for that matter, on whether gold will continue to do so well.
A Bond Bubble?
I believe that we have also had a bubble in bonds. Admittedly, bonds have done extremely well in the past, but you don’t win a race by looking backwards. Are too many people flocking to the supposed “safety” of bonds? We will see.
Diversification works, but not always. It is foolish to concentrate your investments in a narrow selection of securities. Because we cannot predict the future, we diversify. But in a crisis, when investors are panicking, most assets fall, in lock step.
There have been some exceptions; we can count on cash to be stable, and money market funds have been a safe, if not very profitable, bet. U.S. Treasury bonds usually rise when other riskier assets are falling, but even this may change at some point in time.
A fairly quick recovery of the economy usually follows a recession, but not if it is caused by a financial crisis. This is something Carmen Reinhart and Kenneth Rogoff demonstrate in their book: This Time Is Different: Eight Centuries of Financial Folly. We are living through a very slow recovery, which should not surprise us, given the financial crisis that started the Great Recession.
Decisions by the Federal Reserve are very important but not a sure thing and, certainly, not always the right thing. The Fed can influence interest rates, the economy and people’s expectations. They can slow the economy down when it is overheated, and they can give it a boost when the economy is not growing, but there are limits to just how much they can accomplish. We will learn more about this in the next few years, as events are still unfolding and history is still being written. And, speaking of history, it has shown us (witness the Great Depression) that the Fed’s decisions are not always the right ones. The hope of course, is that they, and other central banks, have learned from past mistakes.
Those in the know, don’t always know. Economists are not very good at predicting anything useful: the growth in the economy, interest rates, exchange rates, stock prices. Top management of a publicly traded stock may be buying their company’s shares like there is no tomorrow, but they can be wrong. Hedge fund managers who have had spectacular results can make bets that turn out spectacularly wrong. Investment “experts” are right some of the time, but are wrong frequently. (See this post.)
Investor behavior is more important than investment returns. To get the long term returns that stocks have delivered over time, you cannot periodically panic, sell your stock investments, and “go to cash.” If your strategy is to “get back in” at a safer time, you will undoubtedly miss the rebound in stock prices. (If you were out of the stock market in 2003 or 2009, you cannot get those large returns back.) Just because the media and your friends are telling you how terrible things are, don’t go along with the “end of the world” story. (See this post.) If you do panic, you will almost certainly hurt your results.
I am thankful that I learned Micro Economics, Macro Economics and Monetary Economics from some wonderful professors. Knowing what incentives drive producers and consumers and how markets work is very helpful. But it is not enough.
In graduate school, I loved studying Modern Portfolio Theory. MPT was so new that we read the original groundbreaking work, before it was even in textbooks. But I am always looking for practical ways to implement it.
Understanding risk premiums and historical returns of various investments is useful, but it is not sufficient. Mathematical models are helpful, but they are not foolproof. To me Portfolio Optimization is a useful framework in theory, but not very practical in application.
We should always remember that people and events are not as predictable as we would like to think. Economics is a social science not a physical science. Psychology frequently plays an important and changeable role. We should not forget that our crystal ball is always cloudy.