Making investing decisions based on current economic realities is one of the biggest investor mistakes.  And the problem with the underlying logic is pretty simple.  The markets predict the economy, but the economy does not predict the markets.  In other words, stocks start going down before the recession begins, and they start going back up before the recession ends.  So if the recession is already happening, it’s too late to prevent losses by selling stocks.

But there is more to the story.  Stock markets don’t merely predict the future, they also “over-predict”.  The markets are much more volatile than the economy itself, which is shown by the following chart:

Stock markets are far more volatile than the economy itself.

This chart does not show cumulative growth, which is why there is no upward trend.  Instead, it simply shows, year-by-year, how much the economy grew or shrank, compared to how much the stock market went up or down.  And you can easily see how much wilder the stock market is than the economy.

Are there bubbles and busts, or just a lot of volatility?

Many people will look at that question and say, “what’s the difference?”  Well, for many investors there might not be any difference.  But in technical economic terms, there is a difference.  A bubble suggests that prices are incorrect, which means that the markets are not functioning correctly for some reason.  A very volatile market is just a very volatile market–one where there are high risks and high rewards.

It is impossible to definitively answer the question of whether there are bubbles and busts, or whether markets are just very volatile.  In other sections I will provide evidence to suggest that human beings can be expected to make decisions that lead to occasional bubbles and busts.  However, that set of questions is less important than the following truths:

1. As you can see by the chart, the economy absolutely does not predict the markets.

2. If you look closely, you can see some evidence that markets predict the economy, but with dramatic over-reactions in both directions.

3. As a result, investors need to be prepared for great volatility in their investments, and need a method for dealing with those dramatic ups and downs.

A person who naively looks at the workings of the stock markets and other kinds of financial markets would come to the conclusion that there are bubbles and busts.  But how can we tell if these bubbles are really bubbles, or if they are just the result of the extreme volatility of the stock market?

One thing we can do is study how people act in laboratory settings.  These studies aren’t perfect, but they may give important insights into how markets work.

Assets with defined value

The Dutch researcher Charles Noussair has done numerous experiments on financial bubbles.  In his most common experiment, subjects are given an “asset class” that pays out 24 cents, 15 times.  Usually, the asset pays out in such a way that the subjects get an equal chance of 0, 8, 28, or 60 cents (which averages to 24).  The subjects are given some cash and allowed to trade their assets, which pay out once per round (rounds last a few minutes.)

Now the interesting thing is that the subjects know exactly how much the “asset” is worth.  It is worth 24 cents times however many rounds are left.  And if they are at all confused, the computer shows them in a corner window how much their asset is worth.  So when the subjects are allowed to trade, they should simply trade the asset for what it is worth.

But that is not what happens.  Most of the time–over 90 percent of the time, in fact–a bubble forms.  Subjects trade the assets for more than what they are worth.  This shouldn’t happen, but it does.

People learn, but only in context

Now there may be some good news.  When the experiment is repeated, the subjects eventually learn and the bubbles stop forming.  But here is the bad news.  When the experiment is changed only slightly, so that the subjects have assets that pay out 0, 1, 8, 28 or 98 cents, a bubble forms again!  And it forms even when the participants in the study are the exact same subjects who learned to avoid bubbles in previous experiments, under the old rules.

I have now been involved in finance long enough to see a tech stock bubble, a real estate bubble, a commodities bubble, and now a developing gold bubble.  And I think there are important lessons to learn from these experiments.

Experimental studies strongly suggest that we should expect bubbles and busts in financial markets.  However, there is no way to predict when bubbles will end, because they always form in “new” environments.  They form when regulations change dramatically, when investment opportunities open up that weren’t available previously, and when some “new paradigm” emerges that promises to change the way everything works.  Since they are always new, there is no way to look at previous bubbles to determine when the current one will pop.

If you want to read more about these experiments, please check out this article from the Atlantic:

http://www.theatlantic.com/doc/200812/financial-bubbles

The Prisoner’s Dilemma is an example of game theory, a mathematical language that is used to analyze and explain behavior.  In this dilemma, two people are accused of a crime.  The prosecutor does not have the evidence to convict either of them.  So, he separates them into two rooms and offers each of them the following deal:

If you confess to the crime, and your partner does not, your partner will get nine years in jail and you will get off with no years in jail.  And vice versa.  If your partner confesses, but you do not, you will get nine years and your partner will be let go.  If both of you confess, you will both get seven years.  If neither confesses, you’ll both only get one year.

Now, it’s clear that the situation in which both partners don’t confess, and only get one year each, is the best possible outcome for both of them.  And the situation where they both get seven years is the worst.  Unfortunately, in this case, we can expect both partners to choose the worst outcome.  Why?

Let’s look at the situation from one person’s point of view.  We’ll just call him A, and call his partner B.  From A’s perspective, no matter what B does, A is better off confessing.  If B doesn’t confess, A will get zero years by confessing versus one year by not confessing.  If B does confess, A will get 7 years by confessing and 9 years by not confessing.  So A is better off confessing.  But B faces the same scenario!  So what happens?  They both confess—which leads to the worst possible outcome for both of them.

But maybe things will change if they are allowed to talk to each other.  Maybe they can agree before-hand to not confess.  Unfortunately, this doesn’t solve the problem.  As soon as they are led back into their rooms to talk to the prosecutor, they are stuck with the same set of choices.  Should they abide by the agreement or cheat?  And it is in their best individual interests to cheat, even though that leads to the worst collective outcome.

Why does the Prisoner’s Dilemma matter?

This theoretical dilemma matters because in real life, there are versions of the Prisoner’s Dilemma everywhere.  Normally, when people act in their own self-interests, it leads to a better situation for everyone.  It’s self-interest that causes people to exchange with each other, after all.  But often people are trapped in Prisoner’s Dilemmas, and when they act in their own self-interest it makes things worse for everyone.

Hedge fund managers are trapped in a Prisoner’s Dilemma with regard to their use of leverage.  (To use leverage means to borrow money to make investments with—so when you use leverage, you can lose more than what you have.)  When the market goes up, hedge fund managers who use excessive leverage get better returns.  So what do the investors in more poorly performing hedge funds do?  They go to their managers and say, “Hey, that guy over there is using more leverage than you are, and getting much better returns.  What’s wrong with you?”  As a result, when markets rise, each hedge fund manager is pressured to use more and more leverage, because if they don’t they will lose immediately.  If their clients go, it doesn’t matter how good their returns would have been, because they won’t have any more money to get returns with.

However, this excessive use of leverage eventually leads to financial catastrophes, as we witnessed in 2008.  When markets drop, those managers who invested with more than what they have often can’t pay back their loans.  Even worse, when they try to sell all at once, it actually causes the downturn to be more severe because there are so many sellers and so few buyers.  The price of what is being sold has to really drop to entice people to buy.

Despite these negative outcomes, the institutional investors who use so much leverage won’t slow down, because to do so is not in their individual best interests.  So they keep hurtling, faster and faster, towards the worst possible outcome.

All sorts of managers, especially managers of balanced and target retirement funds, are stuck in similar Prisoner’s Dilemmas.  They have to chase higher returns and take on more risk, or else they fear they will lose investors now.  But their chasing returns leads to bubbles, which make the inevitable crashes even worse.

Individual investors are not literally stuck in Prisoner’s Dilemmas, but psychologically they often can be stuck in an Investor’s Dilemma, where they feel the need to keep up with other investors.

The fact that many active managers, especially hedge fund managers, can get trapped in Prisoner’s Dilemmas is one good reason to avoid active management.  But it is also a good reason to expect bubbles and busts, and to be prepared to deal with them.

Financial markets are normally pretty efficient because they are so competitive, and the price of any given security is normally a pretty good estimate of its true value.  If the price gets too far out of line, competitive traders will bid the price up or down until it is “just right”.  However, bubbles and busts can be expected to form occasionally, and this is justified by experimental science and market history.  So what should we do about them?

There are basically two ways to deal with financial bubbles–one method that I do not recommend for do-it-yourself investors, and one that I do recommend.

Momentum

One method of dealing with bubbles is to try to profit from them.  A vast array of research suggests that stocks do exhibit momentum–stocks that have gone up in the recent past tend can be expected to go up in the short term future.  Also, stocks that have been going down in the recent past tend to keep going down (in fact, for some reason there seems to be more negative momentum than positive momentum.)  So you can try to profit from momentum by buying investments that display positive momentum and selling ones that display negative momentum.  Hypothetically, at least, there should be methods of doing this that will work.

I’m not going to discuss those methods, and for good reason.  Experience has shown me that they don’t work in the real world.  People start of with a system, but like all investment systems it doesn’t work every time, or every year.  But because they are tracking day-to-day or week-to-week momentum in the markets, they see their successes and failures on a day-to-day or week-to-week basis.  This is just too much for most people.  Emotions get involved and people eventually ditch their system, often at the worst possible time.

Additionally, it is very easy for momentum investing to just turn into old-fashioned performance chasing and market timing, and investors tend to fail at those activities.  Also, momentum investing is obviously not something that everyone can succeed at, because profiting off of bubbles requires you to profit off of another investor’s mistakes.  So I can’t rationally recommend it to everyone.  Finally, I think the very, very few Tiger Woods-like investors who are capable of momentum investing are probably not going to come to this site looking for help.

Rebalancing

The method I recommend is rebalancing.  When you rebalance, you return your portfolio to its original form.  So if you have a 50/50 stock/bond portfolio, and stocks have a great year, maybe now your portfolio is 55/45 stock/bond.  Rebalancing means returning that portfolio to a 50/50 split, perhaps by selling stocks and buying bonds.  Or, if you are retired, you might rebalance by taking your withdrawals from stocks and leaving bonds alone.  If you are working, you might add new money to bonds and leave stocks alone.  Whichever method you use, the point is to return the portfolio to its original form, with the risk/reward tradeoff that you prefer.

Let’s say a stock market bubble is forming.  When you rebalance during this bubble, you constantly sell off some of the stocks that are becoming inflated.  So you are selling high, but not as an all-or-nothing proposition, which means that you don’t have to worry about calling the bubble’s exact bursting point.  After the bust, you are buying low, but doing it according to an automatic plan.  Rebalancing forces you to buy low and sell high, but in small percentages, not all-or-nothing.

You might have noticed that rebalancing is essentially the opposite of momentum investing.  This is because momentum investing attempts to profit off of bubbles, whereas rebalancers merely try to avoid big losses.  Rebalancing reduces your risk by making sure you never have too much exposure to any one asset class.

Additionally, rebalancing works even if markets are perfectly efficient and there are not bubbles or busts, whereas momentum investing only works if there are bubbles.  Rebalancing still works because even in a world with no financial bubbles you still will want your portfolio to stay in line with your risk/reward preferences.  And rebalancing will work even if everyone does it, while momentum requires the investor to profit off of the mistakes of others.

Finally, the very few Tiger Woods-like investors who can profitably trade off of momentum are probably not going to come to this site for education or advice anyway.

An Important Lesson

I wish I could say I was smart enough to know this when I first started in finance, but in fact, it is something I have learned only through harsh experience.  Investors should avoid any strategy that requires them to profit off of other investors’ mistakes.  Instead, stick with strategies that can work for everyone, because these are the strategies that will work for you.