There are several great con jobs that come in the form of economic theory. The greatest, and possibly most devastating in terms of damage, is the theory that markets are rational and will naturally seek equilibrium. If you look back through our financial history bubbles and bust cycles keep happening with persistent regularity. If markets were rational, we wouldn’t be putting ourselves through regular and painful recessions. It is, in fact, stability in markets that breeds bubbles. You can’t have a bubble without confidence and you can’t have confidence without stability.
After the parade of depressions and recessions, you’d think we’d finally admit that they’re just part of our market dynamics. The boom and bust cycle is baked in to how we measure returns, which is why stocks and funds publish a ten year return. Busts and market crashes are so much a part of investing that the average investor spends the bulk of his or her time in the market making up losses.
Those Who Don’t Learn From History
The next great market crash, the next recession, will happen again. In the wake of the Great Depression we, as a nation, saved more money and avoided debt. There was a feeling that we really learned our lesson about buying stocks on margin and taking on too much debt. And yet the boom and bust cycle continues and for many of the same reasons. Every single time there’s some market pundit on television or print suggesting that things will be different this time. We learned our lesson! That hasn’t been true anytime in history, there’s no reason to think it will be true today.
Cheap Money Fuels Speculation
We are currently riding along in another market bubble, this one fueled by cheap money from central banks, including our very own U.S. Federal Reserve. Cheap money fuels speculative behavior as banks are forced to make ever more risky loans in order to make money.
What Small Investors Should Do
The road to financial ruin is lined with people who think they can call tops and bottoms in the stock market. You can’t predict the markets and you don’t have high speed trading computers working for you to minimize losses, so small investors need to develop a system that plans for the next bust while staying at least partially invested. If you sell all your stock, ETFs or mutual funds, you might well miss out on the next bubble. Remember, bubbles are as much a part of our market as busts. If you average out the bubbles and busts over a long period of time, including capital gains and dividends, you come out ahead. That suggests the optimum strategy is to skim some profits from high flying markets, like we’re seeing today, but stay invested for the long term.
This strategy even has a name, it’s called rebalancing. Normally you would use that cash to purchase assets that are out of favor but, right now, there aren’t any out of favor assets. Personally, I’m skimming profits and building up cash reserves right now. If I’m buying anything in this market, it’s liquid hard assets.
Today the S&P 500 reached a new high, so this is a good time to look over my portfolio and think about selling some of my best performing assets. I will continue selling off well performing assets as long as the market continues higher. I know that seems counterintuitive, taking money out of the market when it’s booming, but the bust will come. When it does, I want to have some free cash to buy beaten down stocks and mutual funds.
Yes, you will miss some gains following this strategy; you will leave money on the table. But you’ll also be buying equity instruments at steep discounts when the bust finally comes. If you want to learn more about the boom and bust cycle, I’d recommend Boom, Bust, Boom available on Netflix.