Bubble Behavior?

This is a confession. About a week ago I caught myself starting to get caught up in the hysteria currently surrounding precious metals. As I was browsing the online store of a bullion company, looking at silver coins, it dawned on me; am I participating in bubble madness?!

Back when gold was under $1,000 and silver was wallowing in the $13-14 range, I was content with the small amount of precious metals I owned through the Central Fund of Canada (ticker symbol CEF- split evenly among gold and silver bullion) and a few assorted coins. It was enough to diversify out of equities and the dollar somewhat, but not to the extreme where I expected society to collapse at any moment. Just last week though, with gold and silver hovering near $1,200 and $20 respectively, I suddenly felt the urge to consider adding more. Then, as I thought back to the principles of Graham, I realized how illogical my thinking was.

I like to poke fun of market bubbles and the people who perpetuate them, many of whom end up buying high and selling low. Last week served as a good reminder of how incredibly easy it is to fall in this trap though.

“It’s different this time…”

So goes the dangerous reasoning that ensures that bubbles happen repeatedly. And who knows, maybe it is different this time. Maybe gold is headed for $2,000+ in a matter of months, $5,000 by the end of next year, and hindsight will tell me I’m mistaken for not buying now. That doesn’t change this fundamental fact though- those who become more attracted to investments as the prices rises are doomed to eventually lose big. That’s like rushing to the store to load up on cereal because the price was jacked up. Ridiculous, right? Investments get riskier as their price rises and less so when the price falls, but we often act in the exact opposite of this truth.

The problem is that the “it’s different this time” argument sounds more and more appealing as the bubble continues to inflate. We fear that we’re missing the boat. The market gets more press time, further making us want a piece of the action. It starts to seem fail-proof. The fundamentals between $1,200 gold and $1,000 gold a few months ago weren’t that much different; a weakening dollar, an ever-growing federal deficit, financial industry worries, central bank gold-buying, etc. But more people want gold now than they did several months ago mostly because it has been thrust into the spotlight, even though it’s riskier now than it was earlier. If it’s not already in a bubble, my prediction is that this self-perpetuating cycle will continue until it does pop somewhere down the line.

I heard a commercial for some gold company claim- “with gold is setting record highs, there has never been a better buying opportunity”. I wonder how many gold coins they’ve sold with this completely backwards reasoning?

If you were bearish tech stocks in ‘99 or housing market in ‘04, you might have been considered loony at the time. Fast forward to today, and now you seem like a genius. Could the same thing happen with metals?

Thankfully I came to my senses before I bought anything. In fact, I decided to take a small profit on some (but not all) of my CEF holdings- about 17% in roughly 16 months. If it turns out we are in a bubble, I’ll get to reenter at a much better price. If metals continue their incredible run, hopefully I can avoid doubting my decision to sell and safely ignore the growing frenzy.

Are Stocks Worth It?

With diligent research, rational and emotionless decision-making, and unwavering persistence, it’s possible to manage a portfolio that regularly ‘beats the market’, whatever market you may be referring too. Beating the market is the name of the game in the investing world. If you can do it on a consistent basis, you’re winning…right?

Not necessarily.

There are several important, but often overlooked, factors to ponder.

1.) Time-

If you aren’t actually passionate about deeply researching investments, then the use of that time must be justified by other reasons. I myself am not particularly fanatical about poring over financial statements and slogging through annual reports. Therefore, I’m not going to spend 5-10 hours a week doing just that unless I reap significant rewards because of it.

Let’s assume the benefit of foresight. Over the next 10 years, the S&P 500 will return an average of 8%. With my 5-10 hours of weekly research and active investing techniques, I average 10%. Was that worth it? For me, the answer is probably no; I’ve sacrificed far too much time for a result that isn’t all that much better than I could have gotten by simply buying the indexes. However, if I were to average 20%, easily trouncing the market return, the decision is a bit more interesting.

Time is the most precious, finite resource we have. It needs to be accounted for. Passive investing is attractive because you can match the market with a very, very small time investment.

If you outsource your investing to a financial advisor, you save time for yourself, but your advisor will make sure his or her time is adequately compensated for through substantial commission costs, far higher than what you will pay through a quality online discount broker.

2.) Stress-

A buy-and-hold index fund strategy is about as stress-free as investing can be. The global economy as a whole, as well as any sectors you may be playing with ETFs, are your sole concern (admittedly, worrying about the global economy can become stressful).

If you hold individual companies though, you clearly have an interest in the general health of the economy as well, but there are also many smaller variables at play; management decisions, lawsuits, recalls, patents, competitors, acquisitions, mergers…the list goes on and on. It’s a tedious (and pretty much impossible) process to stay informed of all the important developments related to your investments, and all these extra variables are a potential source of stress.

If Merck is a cornerstone in my portfolio, I’m naturally going to be alarmed when a newly released drug leads to a recall and widespread lawsuits. I might even lose some sleep when my shares plummet 10-15% in a single day. On the other hand, if I own every single publicly traded stock in the United States, these micro-variables aren’t worthy of my concern.

Needless to say, many investors thrive on the thrill that active investing can be. I’ll be the first to admit, putting money down on stocks is far more exciting than dollar-cost-averaging in index funds, and for many the higher risk is part of the fun. For others though, working to beat the market isn’t worth the added stress; they have no desire to burden themselves with unnecessary worries.

3.) Taxes- (for taxable brokerage accounts)

An actively managed portfolio will include more transactions than a passive one, as the investor takes profit on winners, cuts losses on losers, and rebalances from time to time. This means a more time-consuming and pricey experience come tax season. Uncle Sam gets to enjoy your success as well.

With a strict index buy-and-hold strategy, the only taxes you have to pay on a yearly basis are on any dividends received or the occasional capital gain distributions. If you do sell some shares at some point, it’ll probably be a long-term capital gain (> 1 year), meaning a much lower rate. In contrast, a heavily managed portfolio is bound to incur much higher short-term capital gain taxes.

Then there’s the time and money spent on actually having the taxes prepared, which isn’t insignificant either.

Unless your returns beat the market by a fairly sizable margin, the government’s cut can ensure that you do no better than the indexes. Never forget to leave taxes out of the equation; the IRS sure doesn’t.

Also keep commissions in mind. For both taxable and tax-advantaged accounts, those commissions will add up over time depending upon how much trading you do. Between taxes and commissions, a big chunk of profits from active investing can be quickly eaten up.

~

All in all, I think there is more than enough reason to question the standard of investing, especially when so few people have a proven track-record of beating the market. This is a bit troublesome for someone who not all that long ago could see myself working one on one with clients in a fairly typical financial advisor position. How many financial advisors do you expect are out there advocating strictly passive investing? Probably none that are still in business- it’s hard to earn much in the way of commissions doing that!

Personally, I don’t have any desire to pore over financial statements and annual reports for hours on end, looking for often deeply hidden clues that could indicate the difference between a successful and a poor investment. There’s a reason why I quickly dumped accounting after briefly considering it as a second major; I find it boring. I love studying fundamental economic variables, but I lose interest quickly in a sea of data.

At this point, unless I knew I had a high probability of significantly trouncing the market on a consistent basis, I’m not going to consider active investing to be worth my time. I’m not suggesting that everyone automatically do the same. What I am recommending is a thorough consideration of this issue.