Paul Winkler: Welcome. This is the “Investor Coaching Show.” Paul Winkler here, along with Jim Wood, a certified financial planner.
There is interesting stuff going on in the world of finances. There always is.
There always seems to be something going on. I read an interesting little piece in The Wall Street Journalabout crypto’s meltdown.
Recent Market Downturns
Now, cryptocurrency is a topic of conversation that we’ve had a lot around the office and here on the radio. When you have market downturns—and if we look at the entire period of time since the presidency was established until now—the area of the market most hammered is large U.S. stocks. It’s still a slightly positive return as of this moment, but it’s not very high.
Large U.S. stocks seem to be the most popular area of the market with American investors, and investors in general, because of familiarity. The areas of the market that have done the best recently were the ones that people don’t ever really see or think about in investment portfolios.
That area is small value stocks, which would be small, distressed companies, nobody ever thinks about. Still, it’s the area that has actually fared the best.
Small international value stocks are another area you never see or think about. But the worst faring areas were large U.S. and large international, which happen to be the areas that you see and think about the most often.
Now, when you have periods of time like what we’ve recently experienced, in general, American investors who mainly concentrate in these areas get hit hard.
This year, the area that’s been hit the hardest is large U.S. growth companies—the companies most familiar to people.
The mentality is, “Where do we hide? What do we do? Can we do something else? Is there something else I can do to protect myself?” And one of the things that came to mind for a lot of people was crypto.
They thought, “Hey, let’s just do this. It’s an alternative asset class.” This trend just reminds me of former time periods where a similar thing happened.
Jim, what are your thoughts on periods in the past when people have turned to alternatives?
Alternative Investments
Jim Wood: Well, I think it’s just the fear of missing out. People hear, “Hey, my brother-in-law made a bunch of money buying real estate, or buying gold, or buying whatever.”
Now, it’s someone buying crypto, and people do that and they hear that and think, “Well, hey, they got rich. I want to get rich too.”
PW: Do you think it’s just looking at past performance?
JW: Yeah, absolutely. But with a good story.
PW: That’s what I was thinking about. There has to be a story, there has to be something making it “good” because my theory of life is:
You can get people to do the right thing if they know why they’re doing it.
And I think that is one of those things that has been so attractive about cryptocurrency, is there seems to be a “why” behind it.
JW: Yeah, the story is that this is going to be a new way of exchanging and avoiding banks and it carries with it all these promises. But at least to this point, that’s all it’s been. It’s been a promise.
PW: Yeah, there’s been a safety aspect of it that people perceived, and it’s one of those things that I never bought into simply because it didn’t make sense. Now, the article in The Wall Street Journal talked about a fire burning beneath crypto’s meltdown.
Here is one of the things that we have seen so many times. Yet, to me, something about this is different.
I can’t quite put my finger on what was so different about it, but the author of this article, I think, puts his finger on what is different.
James McIntosh. He says, “One of the simplest lessons of stock market history is that innovations often lead to bubbles and busts from new tulip bulbs.” That example is one of the things that I’ve used and we’ve used collectively many times, the tulip bulb craze.
The Tulip Bulb Phenomenon
If you don’t know what that was, tulip bulbs went up to an unbelievable price, and people were paying as much for a tulip bulb as you could buy a house for. It got to be that ridiculous, and then tulip bulbs, root canals, and railways, to the internet.
Of course, you had the tech bubble, but the tech bubble was a different story simply because investors were buying companies. People were buying something that had a cost of capital.
What they didn’t know was how much of those earnings would come through and who would be the winners and the losers.
You can’t predict who will be the winners and who will be the losers.
JW: Yeah, and the valuations got insane from a historical standpoint. In terms of a true bubble, things like pets.com, a company that was run by a talking sock puppet, had higher valuations than major airlines that own hundreds of planes.
PW: That is insane, isn’t it? People buying individual companies. GameStop comes to mind, right?
That was one of the ones that we just shook our collective heads. Now, very rarely do I ever think that if I were a betting guy, I’d bet against it.
But the problem is you don’t know when it’s going to come back to earth. So betting against a stock and saying it’s overvalued is kind of risky.
Let’s hit that for a second, because with companies like that, you go, “This is ridiculous.”
But the question, “Can I profit from knowing something?” is ridiculous. Because you don’t know when people will suddenly realize, “Hey, this is really stupid. We shouldn’t be doing this.”
Then, the reason it’s problematic is because as an investor, what tool do I have at my disposal to bet against a company going up further? Shorting.
I mean, that’s basically it, right? But the problem is the movement has to take place in a certain period of time, and that’s what you don’t know. I mean, it’s the challenge, right?
JW: Absolutely. The thing is, whatever you know about that company, everybody else knows as well.
The Market Is Always Unpredictable
So you might have your definite opinions on it, but everybody else has those opinions, and those opinions should be priced into that stock’s current price. You don’t know it’s a bubble until you are looking backwards.
There was lots of talk of the tech bubble and things like that, but nobody really knew it was a bubble until it burst, and there’s the famous example of the irrational exuberance comment.
PW: And the market kept going, kept going, kept going. Yeah, that’s a really good example.
Yeah. It kept going, and if you had sold, even with a crash, stocks didn’t go down to the level that they were at.
I said I was tempted to bet against something like that, and the reason I said that was because you’d be tempted to do it, but what you don’t know is other people’s responses.
How long will they continue to push the thing up, and then you’re shorting it? You have to cover it because you end up covering at a higher price, and you’re still sunk.
JW: Well, there’s a great comment: “The market can stay irrational longer than you can stay solvent.”
PW: I don’t know who that is, but that’s funny. I like that line. That’s really good.
Betting on the market is as likely to hurt you as it is to help you.
JW: And that’s why you don’t make bets and stuff like that because they’re just as likely to hurt you as they are to help you. In fact, they’re more likely to hurt you.
PW: He goes on to say, “Less well understood is that financial innovations count for double as new tools expand the supply of what looks like money, allowing the bubble to grow larger and the bust to be even more serious.”
Cryptocurrency is currently underway, the implosion currently underway, followed by the rampant creation of new digital money.
As I’ve said, you have so many different versions of this thing. So many different cryptocurrencies out there.
Our Failure to Learn Lessons
Asking which one would be the winner was my big thing as this was all taking place. But the writer says to start with a positive view, such as, there was a massive bubble in Bitcoin and in crypto in general, as speculators piled in with a hope of getting rich.
It was accentuated by the failure to learn lessons from history as decentralized finance, or DeFi, as he calls it, reinvented many of the problems of excessive leverage and liquidity mismatches that have bedeviled traditional finance for hundreds of years.
One of the things that we find if we look back to the depression, and we’ve heard about people losing everything during the Great Depression, is that it still scares people to think about how the stock market is so risky, about how you could lose everything.
Investors increase the risk of losing when they fail to learn from past mistakes.
Look at the depression, for example, when people lost everything. The thing I point out is they owned individual stocks, number one.
Think back to GameStop or to companies like Kodak or Sears or Kmart. Look at companies where people said, “This is a great idea. We think this is wonderful. We’re going to lay fiber optic cable across the ocean, and it’s going to be the future of the world, and it’s going to be wonderful.”
And then, of course, you find out that is not necessarily the case. Then that’s where people lose everything as individual stocks.
Patterns Are Recognizable to Everybody
JW: It’s one of the hardest things sometimes to talk people out of, when they come in here. If they’ve inherited it from a loved one and it’s got emotional attachment, or if it’s the company they’ve worked for forever, or whatever the reason is, trying to get people to understand the amount of risk they’re taking is difficult.
PW: “I know this company.” This is one reason that always gets me, “You know, around every spring, it does this. The stock does this,” or, “Every time this happens, this is what goes on.”
There may be a bonafide pattern to the stock, maybe it does do that every single spring—or it has in the past—but as an investor in it, you’re not the only one that recognizes a pattern as it takes place.
So if it goes up every spring, if it goes up every March, then it’ll start going up in February in anticipation that it’s going to go up in March.
Then, if we start to see a new pattern, that it goes up every February in anticipation of it going up in March, then people will start to buy it, and they will have to pay a higher price for it in January because the current owners know that it’s going to go up in February.
So they’re going to sell it to you for a higher price in January in anticipation of it going up in February because it used to go up in March.
Anything you know about a company, someone else knows too.
JW: Anything you know about a company, you know because you have access to really good information on the internet with all the search engines and things like that. But there are professionals out there who have million-dollar budgets and can go out and talk to companies.
They have trading programs. They have all kinds of advantages over individual investors, which makes it that much harder, and those people tend to underperform markets.
PW: Yeah, and that’s why the only thing that they’ve been able to do is some of these traders with arbitrage. When they’re trying to arbitrage things, it switches.
Has Arbitrage Ruined the Market?
Basically you have two assets that are linked to each other. The idea being that the price is linked to each other, and then if they’re supposed to be linked to each other, they’re supposed to be the same exact price.
But then there’s a price difference and they’ll sell one and buy the other, and then bring them back together again. Well, arbitrage is something that professional traders do make money at, but they do make money in a way that is minuscule.
Tiny, tiny fractions of pennies is how they do it, and the reality of it is so interesting because people have yelled, “This isn’t fair. This is terrible. All that computerized trading is awful, and it’s destroying the stock market.”
One of the news channels did a whole program on how these people are destroying the stock market. And I actually did a video on it, and I pointed out all of their transactions.
Number one, they’re competing on minuscule portions of a penny, and the way that they’re actually outcompeting each other is literally moving their computers closer to the center of trading on Wall Street to pull it off.
You and I, we don’t have that ability.
We ought to look at arbitrage and see it as good because it has reduced trading costs for all investors.
It has reduced costs because of the fact that there’s more trading taking place and the arbitrage is done more rapidly.
It actually has created less mispricing in stocks, which is what we’re talking about here. Now, back to his point, talking about how DeFi has changed everything.
The writer says, “Crypto supporters point to previous crypto winners.”
This is the thing I was talking about where you have guys like Edelman that were very, very vocal in the financial planning community, saying, “You know, this is just a winner. It’s bad. It’s going to come back again.”
Decentralized Finance
He’s saying here that it’s going to come back again and prices will recover. He says, “But this blow out and bust is different because it’s DeFi.”
It’s decentralized finance. He said changed everything by creating a parallel crypto banking system without any of the limits and safety nets that have been introduced in the real world response to past busts.
Only now are we starting to find out some of the problems as brokers and lenders freeze withdrawals. I mean, that’s a problem.
If they’re going and saying, “Nah, you can’t get your money. Nah, we’re not going to let you do that,” then all of a sudden panic starts to ensue, and it’s really not cool.
He says, “Multi-billion-dollar stablecoin designed to hold a fixed value vanish.” I mean, that was supposed to stay right with the dollar.
JW: I think that was one of the most significant, if not, the most significant hit to crypto certainly in the near past.
Stablecoin was supposed to be like a money market account. It holds a stable value, and all of a sudden, a couple of them have broken their base.
PW: And it sort of surprised me quite frankly, because I thought, “Well, maybe this one has some merit because it could be used as a currency.” But again, as I looked at it, I thought, “I am not going to invest in that” because I had no utility for it.
I really personally didn’t have any use for it, so I never did it. But I could see where somebody in a country where they don’t have a good currency found it to be an easy way to utilize the dollar, and it may have made some sense for them.
But that one going kerplunk was really interesting to me. Here’s the point of this:
If you are looking at a crypto, look at what gives it its value.
I think it comes down to people searching the world over—and gold was one that was talked about a lot, and silver is another one—they search the world over for something that they can do that will get them away from risk.
They ask, “Can I do something, anything, to get myself away from risk and protect myself as an investor?” The reality of it is that the world is a dangerous place.
You Cannot Escape Risk
Now, let’s just face it, there are things you can do as an investor. And I’ve often talked about this, as you get older, fixed income investments, even intermediate fixed income investments, can be negatively affected by markets.
Interest rates go up and they can go down, but it’s temporary. Because if those interest rates go up and you’ve got a bond that is only five years into maturity, you’re going to get all that money back.
If it’s a government bond and it’s a five-year bond and it’s intermediate, yes, it can go down in value. It will go down in value if interest rates go up, but as long as it’s held to that maturity, it will come back to value.
In other words, if I sell it, when it’s down, I’m giving up the higher yield to maturity by doing that. Not a smart idea, but what if I need the money?
Well, that’s why you keep it short-term. One of the things I used to do is make sure there was cash in portfolios.
And people would ask, “Why do we have to have cash in the portfolio?” And I would say, “Because such and such can happen.”
You can have a situation where interest rates go up, bonds go down, and stocks go down, and you must have a port in the storm.
I know the return is stinky and the interest rate is really low. I know after inflation you’re guaranteed to lose money, but you have to have that in a portfolio because of these other gimmicks you think will protect you.
I’ve seen so many portfolios with commodities thrown in. Investment advisors fell over themselves to throw commodities funds into portfolios that made no sense in my mind whatsoever.
Now, we’re starting to see that crashing, and the long-term bonds, and the intermediate bonds, and the high-yield bonds, and all of these things were supposed to be safe.
Suddenly, you start to see the genius of having cash in a portfolio and why it is so critical. This is a world with risk.
Safety is a myth, an illusion.
As an investor, we need to answer the question of how to mitigate broad diversification.
I mean, it’s not just the U.S., but U.S. investors really totally focused on U.S. large stocks, and that’s what’s been really, really hit recently.
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