Irrational Exuberance: Understand Markets and Risk

Irrational Exuberance

August 13, 2018

In our most recent posts we have talked about investing either actively or passively. In both scenarios, it is important to understand where markets have been so that you can get a gauge for where we are going. Before diving deep into that ocean, consider this quote from one of the world's most successful financiers:

If you choose to sail upon the seas of banking,

build your bank as you would your boat,

with the strength to sail safely through any storm.

-Joseph Safra, Chairman, Safra Group

We can apply Safra's quote to so many aspects of life, but I will take it into the confines of investing today. I think, first and foremost, you should look at the opening line of the quote: IF YOU CHOOSE....

You don't HAVE to invest, nor do you have to invest in the ways that I talk about here on the blog. (You should invest because of the effects of Inflation and Compound Interest on your money, but I digress...) If you DO choose to do so, build your portfolio as you would build your boat. It should be sturdy enough to get through literally ANYTHING. Anything, you ask? Yes. Anything.

Well what is the worst thing that could happen? Anything. Complete market meltdown with liquidity drying up, rendering it impossible to sell your shares? Yep, happened. Market closed indefinitely, keeping you in the dark about the price of your stocks for days or weeks at a time? Happened. Some of the world's most "prestigious" institutions blown to bits by leveraging themselves to the neck with subprime-loan infested derivative securites, all while telling shareholders everything will be ok? Happened.

Anything can happen. You need to be prepared for things that you probably can't even fathom. That seems a little unfair, but that is how the cookie crumbles. We will witness the rise and fall of many businesses during our lifetime. Simply: Don't put ALL of your eggs into one business, or one sector, or one asset class, or one country. If you follow these rules, you will be protecting yourself from the inevitable tidal waves that decimate wealth.

If you are looking for the best way to build wealth over the long-term, diversification is a must. You can not put all of your eggs in one basket, I REPEAT, YOU CAN NOT PUT ALL OF YOUR EGGS IN ONE BASKET. This is the silver bullet. This one rule will give your investment portfolio the strength to sail through any storm.

If you go ALL-IN on Real Estate, you saw what happened in 2008. If you go ALL-IN on tech stocks, you saw what happened in 2000. PRICES PLUMMETED in both scenarios, wiping out irrationally exuberant investors in both cases. If you were ALL-IN and had no backup reserves to keep you running, you were screwed.

The next logical question is... "OK, well how much cash should I keep in backup reserves?" And the answer is, sadly, it depends. It really depends on your personal situation, current market valuations, etc. Here are some of the guidelines I have set for myself so that I can weather the storms:

1) Maintain 12 Months of expenses in liquid cash (Bank account, online high yield savings, etc.)

2) Keep investments diversified across sectors, assets, and countries (Stocks, bonds, real estate...)

3) Never, ever, invest borrowed money (If you are currently in debt, you are doing this indirectly.)

By following these 3 rules, you are mitigating 99% of risk. You have money to live off of, you have holdings in many different businesses across the globe, and you don't owe anyone anything. With those three qualities you can survive for a very long time in crisis mode. How do you wipe out all risk completely? You can't. It is impossible. Sure, you can bump your emergency fund to 24 months of expenses, but that would only bring you up to a ~99.5% risk mitigation level. Remember, anything can happen so you have to be ready for a lot, but you don't have to live in a bunker. Just because it CAN happen doesn't mean it WILL happen or that it is PROBABLE.

So what can YOU do to build wealth safely over the long-term? Make money, don't spend too much of it, save a lot, invest a lot, and soon you will have invested so much that you will be able to live off of your investments. Check out my post, Financial Independence: The 3 Step Process, to read more about that formula in depth.

BUT NOW, lets take a look at where we are in the business cycle, and how that impacts the markets that we invest in. There are two things that have the biggest effect on markets, inflation and growth.

Inflation is the increase of prices for goods/services in a country. Because of inflation, prices will rise over time. In addition, because of inflation, every dollar you own will buy a smaller amount of a good/service in the future. When prices rise and the value of money falls, you have inflation. Too much inflation is bad, but deflation is worse. Deflation is when all prices go down over time. If all prices are going down, why would you want to buy anything? The price will be lower next week/month/year. This is detrimental to an economy and is why we generally prefer to have a moderate level of inflation.

Growth is the increase in an economy's GDP, or Gross Domestic Product. GDP is basically the total dollar amount of goods/services produced/provided over a specific time. GDP is often referred to as the "size of the economy".

GDP and Inflation move hand-in-hand, and you can easily see why. The calculation of GDP growth itself is based on the total DOLLAR AMOUNT of goods and services, which will increase as the prices of those goods/services increase (inflation). The only way that this link is broken is if there is MUCH HIGHER production with underlying prices staying relatively constant or decreasing, which has not happened in a modern economy yet. (Yet.)

As of right now, we are in the perfect goldilocks stage in regard to inflation and GDP. The economy is not too hot and not too cold. GDP growth is healthy and inflation is right there with it. Both are just above our average historical rate and they are trending upwards. This means that growth across asset classes will continue, up until a peak, and then we will see the contraction of growth and prices begin. During the contraction stage, we have to be careful not to fall into deflation, so the U.S. Govt will print money and buy stuff, which should spur inflation again (also increasing the nation's deficit), which should spur GDP growth. This will continue until we reach sustained growth without the government's help, then the Govt will slow down their money printing/stuff buying, the economy will prosper, then peak again shortly thereafter, and so on and so forth until the world ends.

It is also important to look at the indebtedness of a nation, because those debts can come to crush it later on. How? If debt (National Debt, Personal Debt, etc.) rises faster than income, you have a big issue. It is impossible to cover all of the bases in that equation forever. Sooner or later, income will not cover the debt, then you will need to take out debt to cover the debt, it gets really messy really fast. However, that is where we are sitting as a country right now. The United States has been going further and further into debt as a % of our GDP. Currently, our federal debt is sitting at 105% of our GDP, meaning that our total government debt levels are more than the size of our economy in a given year. That is a bad sign. We would like to see deficits decrease or remain constant while GDP grows, that would be the sign of a very healthy economy.

NOTE: The above does not even consider personal debt. The U.S. population is in about $20 Trillion in debt, with the majority of that in Mortgages, Student Loans, and Credit Cards. The big issue? The amount of personal debt has increased over 133% since 2000, while GDP has only grown 115%. Meaning? BINGO, our debt is rising faster than our income.

Evaluating an economy is really quite simple. By checking the metrics we mentioned above, you can get a fairly strong gauge on where an economy is now and where it is headed. The only problem is that nobody KNOWS when the peak/trough will hit, so trying to guess is futile. The best thing we can do as investors is be prepared to weather any storm. So build a solid ship, stay diversified, and be ready for the peaks and troughs. They will happen, and you just have to be able to stick them out.

MDAS

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

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