You $ Me

 



                                CHAPTER 16

                    You $ Me

 

Beware taking financial cues from people playing a different game than you are.


The implosion of the dot-com bubble in the early 2000s reduced household wealth by $6.2 trillion.

The end of the housing bubble cut away more than $8 trillion.

It’s hard to overstate how socially devastating financial bubbles can be. They ruin lives.

Why do these things happen?

And why do they keep happening?

Why can’t we learn our lessons?

The common answer here is that people are greedy, and greed is an indelible feature of human nature.

That may be true, and it’s a good enough answer for most. But remember from chapter 1: no one is crazy. People make financial decisions they regret, and they often do so with scarce information and without logic. But the decisions made sense to them when they were made. Blaming bubbles on greed and stopping there misses important lessons about how and why people rationalize what in hindsight look like greedy decisions.

Part of why bubbles are hard to learn from is that they are not like cancer, where a biopsy gives us a clear warning and diagnosis. They are closer to the rise and fall of a political party, where the outcome is known in hindsight but the cause and blame are never agreed upon.

Competition for investment returns is fierce, and someone has to own every asset at every point in time. That means the mere idea of bubbles will always be controversial, because no one wants to think they own an overvalued asset. In hindsight we’re more likely to point cynical fingers than to learn lessons.

I don’t think we’ll ever be able to fully explain why bubbles occur. It’s like asking why wars occur—there are almost always several reasons, many of them conflicting, all of them controversial.

It’s too complicated a subject for simple answers.

But let me propose one reason they happen that both goes overlooked and applies to you personally: Investors often innocently take cues from other investors who are playing a different game than they are.

  

An idea exists in finance that seems innocent but has done incalculable damage.

It’s the notion that assets have one rational price in a world where investors have different goals and time horizons.

Ask yourself: How much should you pay for Google stock today?

The answer depends on who “you” are.

Do you have a 30-year time horizon? Then the smart price to pay involves a sober analysis of Google’s discounted cash flows over the next 30 years.

Are you looking to cash out within 10 years? Then the price to pay can be figured out by an analysis of the tech industry’s potential over the next decade and whether Google management can execute on its vision.

Are you looking to sell within a year? Then pay attention to Google’s current product sales cycles and whether we’ll have a bear market.

Are you a day trader? Then the smart price to pay is “who cares?” because you’re just trying to squeeze a few bucks out of whatever happens between now and lunchtime, which can be accomplished at any price.

When investors have different goals and time horizons—and they do in every asset class—prices that look ridiculous to one person can make sense to another, because the factors those investors pay attention to are different.

Take the dot-com bubble in the 1990s.

People can look at Yahoo! stock in 1999 and say “That was crazy! A zillion times revenue! The valuation made no sense!”

But many investors who owned Yahoo! stock in 1999 had time horizons so short that it made sense for them to pay a ridiculous price. A day trader could accomplish what they need whether Yahoo! was at $5 a share or $500 a share as long as it moved in the right direction that day. And it did, for years.

An iron rule of finance is that money chases returns to the greatest extent that it can. If an asset has momentum—it’s been moving consistently up for a period of time—it’s not crazy for a group of short-term traders to assume it will keep moving up. Not indefinitely; just for the short period of time they need it to. Momentum attracts short-term traders in a reasonable way.

Then it’s off to the races.

Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term.

That process feeds on itself. As traders push up short-term returns, they attract even more traders. Before long—and it often doesn’t take long—the dominant market price-setters with the most authority are those with shorter time horizons.

Bubbles aren’t so much about valuations rising. That’s just a symptom of something else: time horizons shrinking as more short-term traders enter the playing field.

It’s common to say the dot-com bubble was a time of irrational optimism about the future. But one of the most common headlines of that era was announcing record trading volume, which is what happens when investors are buying and selling in a single day. Investors—particularly the ones setting prices—were not thinking about the next 20 years. The average mutual fund had 120% annual turnover in 1999, meaning they were, at most, thinking about the next eight months. So were the individual investors who bought those mutual funds. Maggie Mahar wrote in her book Bull!:

 

By the mid-nineties, the press had replaced annual scorecards with reports that appeared every three months. The change spurred investors to chase performance, rushing to buy the funds at the top of the charts, just when they were most expensive.

 

This was the era of day trading, short-term option contracts, and up-to-the minute market commentary. It’s not the kind of thing you’d associate with long-term views.

The same thing happened during the housing bubble of the mid-2000s.

It’s hard to justify paying $700,000 for a two-bedroom Florida track home to raise your family in for the next 10 years. But it makes perfect sense if you plan on flipping the home in a few months into a market with rising prices to make a quick profit. Which is exactly what many people were doing during the bubble.

Data from Attom, a company that tracks real estate transactions, shows the number of houses in America that sold more than once in a 12-month period—they were flipped—rose fivefold during the bubble, from 20,000 in the first quarter of 2000 to over 100,000 in the first quarter of 2004. Flipping plunged after the bubble to less than 40,000 per quarter, where it’s roughly remained since.

Do you think these flippers cared about long-term price-to-rent ratios? Or whether the prices they paid were backed up by long-term income growth? Of course not. Those numbers weren’t relevant to their game. The only thing that mattered to flippers was that the price of the home would be more next month than it was this month. And for many years, it was.

You can say a lot about these investors. You can call them speculators. You can call them irresponsible. You can shake your head at their willingness to take huge risks.

But I don’t think you can call all of them irrational.

The formation of bubbles isn’t so much about people irrationally participating in long-term investing. They’re about people somewhat rationally moving toward short-term trading to capture momentum that had been feeding on itself.

What do you expect people to do when momentum creates a big short-term return potential? Sit and watch patiently? Never. That’s not how the world works. Profits will always be chased. And short-term traders operate in an area where the rules governing long-term investing—particularly around valuation—are ignored, because they’re irrelevant to the game being played.

That’s where things get interesting, and where the problems begin.

Bubbles do their damage when long-term investors playing one game start taking their cues from those short-term traders playing another.

Cisco stock rose 300% in 1999 to $60 per share. At that price the company was valued at $600 billion, which is insane. Few actually thought it was worth that much; the day-traders were just having their fun. Economist Burton Malkiel once pointed out that Cisco’s implied growth rate at that valuation meant it would become larger than the entire U.S. economy within 20 years.

But if you were a long-term investor in 1999, $60 was the only price available to buy. And many people were buying it at that price. So you may have looked around and said to yourself, “Wow, maybe these other investors know something I don’t.” Maybe you went along with it. You even felt smart about it.

What you don’t realize is that the traders who were setting the marginal price of the stock were playing a different game than you were. Sixty dollars a share was a reasonable price for the traders, because they planned on selling the stock before the end of the day, when its price would probably be higher. But sixty dollars was a disaster in the making for you, because you planned on holding shares for the long run.

These two investors rarely even know that each other exist. But they’re on the same field, running toward each other. When their paths blindly collide, someone gets hurt. Many finance and investment decisions are rooted in watching what other people do and either copying them or betting against them. But when you don’t know why someone behaves like they do you won’t know how long they’ll continue acting that way, what will make them change their mind, or whether they’ll ever learn their lesson.

When a commentator on CNBC says, “You should buy this stock,” keep in mind that they do not know who you are. Are you a teenager trading for fun? An elderly widow on a limited budget? A hedge fund manager trying to shore up your books before the quarter ends? Are we supposed to think those three people have the same priorities, and that whatever level a particular stock is trading at is right for all three of them?

It’s crazy.

It’s hard to grasp that other investors have different goals than we do, because an anchor of psychology is not realizing that rational people can see the world through a different lens than your own. Rising prices persuade all investors in ways the best marketers envy. They are a drug that can turn value-conscious investors into dewy-eyed optimists, detached from their own reality by the actions of someone playing a different game than they are.

Being swayed by people playing a different game can also throw off how you think you’re supposed to spend your money. So much consumer spending, particularly in developed countries, is socially driven: subtly influenced by people you admire, and done because you subtly want people to admire you.

But while we can see how much money other people spend on cars, homes, clothes, and vacations, we don’t get to see their goals, worries, and aspirations. A young lawyer aiming to be a partner at a prestigious law firm might need to maintain an appearance that I, a writer who can work in sweatpants, have no need for. But when his purchases set my own expectations, I’m wandering down a path of potential disappointment because I’m spending the money without the career boost he’s getting. We might not even have different styles. We’re just playing a different game. It took me years to figure this out.

A takeaway here is that few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games than you are.

The main thing I can recommend is going out of your way to identify what game you’re playing.

It’s surprising how few of us do. We call everyone investing money “investors” like they’re basketball players, all playing the same game with the same rules. When you realize how wrong that notion is you see how vital it is to simply identify what game you’re playing. How I invest my own money is detailed in chapter 20, but years ago I wrote out “I am a passive investor optimistic in the world’s ability to generate real economic growth and I’m confident that over the next 30 years that growth will accrue to my investments.”

This might seem quaint, but once you write that mission statement down you realize everything that’s unrelated to it—what the market did this year, or whether we’ll have a recession next year—is part of a game I’m not playing. So I don’t pay attention to it, and am in no danger of being persuaded by it.

Next, let’s talk about pessimism.




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