When word gets around that you understand a little of the black art of investing, friends and family start to ask you about it.
Which is flattering, but it can also be rather scary and a little frustrating.
We’re not financial advisors for one thing. Also you’ll discover it’s a bit of lose-lose proposition.
People want two-minute solutions, not a reading list [1]. They want to know how to get rich quick, not how to get comfortable in 30 years.
Some seem to believe you’re holding the good stuff back from them.
And even if your boring passive investing advice [2] is implemented nothing good will happen quickly enough for most people to remember why you suggested it, whereas if a hot tip rockets to the moon and you swore someone off it they will remember that for the rest of your days.
Still, we get letters. Here’s a mildly re-jigged one I received very recently from a friend, who shall remain nameless, and my reply, which is more or less as sent.
(If this sort of thing is interesting perhaps we could make it a semi-regular feature?)
Hi [The Accumulator],
How’s life?
Anyway remember that time in The Fox and Duck when someone loud – probably [person X] but maybe [geezer Y] – went off about The Wolf of Wall Street and burning capitalists, and you sort of defended the bankers?
Which nobody expected, because most of the time you’re like us, but you sounded like you knew what you were talking about when it came to betting on the stock market.
WELL I was impressed anyway, and vaguely made a mental note to ask you if any opportunities came up.
So that day has come and I wondered if you had heard much about this block chain stuff…?
A mate was saying he’d already made a few thousand and that his next move was going to be into [obscure cryptocurrency venture redacted to protect the innocent] and I have to say investing in it sounds like a one way ticket to The Sunday Times Rich List…
But maybe it’s not… and perhaps that’s where you come in!?
What do you reckon? Deal or no deal?
Cheers,
[A friend]
Dear [friend],
Please be very careful when you get these kind of tips. One-way trips to El Dorado are mirages 99.9% of the time.
Blockchain is hot. As in, off the back of Bitcoin [3], cryptocurrency is big news and everyone thinks they’ll make out like bandits.
Unfortunately, it’s more like a gold rush. A few early movers make it big and mostly everyone else gets buttons.
This sort of thing happens regularly. The process relies on a compelling story along these lines: investors believe that a particular section of the economy has excellent prospects and so bet big on firms that operate in that sector.
Early investors see success, latecomers get jealous and double or triple down. A few converts even ‘bet the farm’. (Luckily for our stomachs mostly farmers are less flighty folk).
Recent examples include green energy, robotics, 3D printing, and bitcoin. Back in the day it was gold, computing firms, and telecoms.
Go back far enough and it was railroads.
This kind of bet has historically been a bad one for most regular Joes.
Precisely because everybody thinks there’s huge profits to be made in a particular technology, firm, or sector, capital floods in.
This raises share prices. Share prices get so high that even fairly solid future returns can’t justify the prices paid. And so returns in the future are low, flat, negative, or CRASH.
Also, all the capital that’s pumped in is gladly accepted and put to work by those operating in the hot space. Most of them spend the millions as fast as they get it in an effort to outdo their rivals who are doing the same.
Competition is intense, but capital is wasted. There’s often plenty of innovation – but not enough to justify the gazillions pumped in. Bubbles can be good for humanity, but they’re bad for most investors.
This sort of thing happened in railroads, airlines, computing, the Dotcom crash of 2001 and most recently in crypto-currencies.
Essentially you have too much cash chasing the shares because of over-optimism about future prospects. The smart money identified the trend and got in early. The dumb money comes in later and gets burned.
The dumb money is ordinary mortals like you and me who can’t compete with the inside knowledge, research, analysis and computing power of the 24/7 City players that are the smart money.
It’s very hard to compete with people who were incredibly lucky, too. Buy your friend a congratulatory pint, but I’d talk about the football or the theater, not about his next hot tip.
High returns depend on the unexpected, not the expected. For example, everyone expected Facebook to soar into the distant future. Its share price was bid high.
When the Cambridge Analytica scandal broke, the share price fell because there was seen to be an increased chance of politicians imposing regulation on Facebook. That was unexpected news and the market for Facebook shares moved on it.
Today, some regulatory fear is in the price. How much? Haven’t the foggiest. But if you buy Facebook now then you’ll do well if that regulation does not happen – because some sort of regulatory cost to the company is expected. Conversely, you’ll do badly if the regulation has a bigger impact on Facebook’s prospects than predicted by the market.
There’s no sure way of predicting that outcome. That’s why everyone with experience diversifies. It’s also why a company can report amazing profits but the share price falls if they’re lower than expected. It’s fresh news and changing expectations about the future – good or bad – that truly moves the share price.
Over the very long-term it’s often unfashionable and boring sectors – for example tobacco companies – that have done well because nobody expects anything from them. Everybody was too busy throwing cash at the hot sectors. The unfashionable shares fall further than is warranted and strong profits can be made.
Academics have made careers out of showing we humans pay a premium for the new and shiny and overlook the unloved that’s available on discount.
Because we can’t predict, and to confound our natural inclinations, it’s generally better to spread your money across every sector, including all the snore-fests. That is, to invest in a total market index fund [4] which basically buys and holds everything.
With an index fund you have exposure to hot sectors (they may do even better than expected after all) but also you’re snapping up bargains among the unfashionable sectors, too.
Tips from mates are dangerous because we trust our mates. But they’re usually acting on the same duff information and compelling story as anyone else is.
If you’re inexperienced and operating on the basis of a this-is-amazing story then that’s a massive red flag. It typically means you’re shark food for somebody else.
If you do venture into this then put in no more than you can afford to lose. And by that I mean if the entire investment went to zero. I am not saying it will. I’m stressing it could.
Even if block chain is a success as a technology (that’s not totally clear at the moment), nobody can predict whether this company will eventually be the Amazon of Blockchain or just another failed start-up that’s crushed by whatever company does become the Amazon of Blockchain.
Start-ups go to the wall all the time. The Facebooks and Googles of the world are very rare. The ratio of new companies touted as The Next Facebook or The Greatest Opportunity Since Google to, well, Facebook and Google would be similar to the ratio of many thousands of stars you can see on a clear night sky – with binoculars – to the lonely sole moon.
Single investments in individual companies are extremely dangerous to your wealth for this very reason. If it goes bust you lose all the money you put in.
If you must do something, think of it as like having a punt down at the dog-track rather than an investment. Bet a fiver, not your pension.
Take it steady,
The Accumulator