More Investing Truisms

Since posting Investing Truisms: Are They True? a month ago, I’ve remembered or been reminded of a few more. As I noted last time, these sayings are passed down through the Wall Street generations without, to my knowledge, ever being statistically analyzed, much less proven. In fact, it’s unlikely that many traders or fund managers follow these rules, but rather cite them when they confirm a course of action already decided upon. If I’m afraid to buy a stock that is going down, I will say to my team, “Let’s not catch a falling knife.” If on the other hand I feel confident that the stock has bottomed, I’ll conveniently forget about the knife.

With that caveat, here are some more truisms and my view of their accuracy.

Nobody Ever Went Broke Taking a Profit – I rate this “not as true as it seems on the surface.”

Famed investors from Peter Lynch to John Templeton have agreed that even the best analysts will only be right 60-66-2/3% of the time. Because we’re all going to take losses, we need the winners to offset them. If you sell the latter the first minute you are up, you will often be forgoing the gains that get you into an overall profit. It’s better to stay focused on the winning company’s earnings growth and valuation, while resisting the urge to sell just “because it went up” – subject to portfolio weighting considerations, as I discussed in Position Sizing for Value Managers.

Picture a fund manager who invested five years ago in a portfolio of dogs like AT&T, Walgreens, and Paramount, but in a stroke of luck or genius also bought Nvidia. Unfortunately, when he had a 30% gain on NVDA the poor shlub sold it, bleating, “Nobody ever went broke taking a profit.” He missed out on 10x earnings growth and a $3.5T market cap. Anyway, he’s broke now.

You’ll Never Get Rich Playing Another Man’s Game – To the extent that I have any investment ability, it has only been in analyzing emerging markets and their stocks, buying them and holding. In my funds I don’t do bonds, I don’t sell short, and I don’t use derivatives. For decades brokers have approached me with option ideas that are “guaranteed” to enhance returns, and I have always turned them down, noting that the person on the other side of the trade is usually a math genius from M.I.T. or Stanford, whereas I was an English major who to this day can only do basic arithmetic.

The first derivative I was offered and rejected came from ING in the middle of the 1998 emerging markets crisis. It was some sleight-of-hand called a “knockout swaption” on Norilsk Nickel, which would protect our fund against further losses (after the stock was already down by half). The broker assured me it would leave us all the upside, unless certain very unlikely events occurred. All I remember is that the unlikely events did occur, we would have been “knocked out” of Norilsk, and we’d have missed a 1000% gain over the following decade.

I wrote in Shame, Guilt, and Fund Management that style drift has doomed many a hedge fund. The most common scenario is that a manager who is mainly a stock picker makes one successful macro call and now believes himself a top-down savant. Not only does it turn out that his next few big macro trades – long gold, short the Hong Kong dollar, S&P puts, etc. – fail, but his investors angrily start redeeming, because this wasn’t what they signed up for.

Sell in May and Go Away – This is heard mostly among emerging markets investors, possibly because we carry scars from previous summer meltdowns, as in 1998 and 2008. Even managers who weren’t in the markets in 1998, maybe were still in diapers, have inherited trauma about the dangers of July and August. It isn’t so, however, and a look at the last ten summers shows that the EEM emerging markets ETF was equally likely to be up, down, or flat. In fact, selling in May overall would have cost money, as the manager would’ve missed a 25% rally in Summer 2020.

There are a couple of seasonal observations that have borne out over time, notably that since 1928 the S&P has declined an average of 1.1% in September, the only month with a negative return. People have tried to come up with explanations, but none are convincing. I am fairly sure that I could personally stop this trend by choosing some year to sell all my stocks at the end of August, with a plan to buy them back a month later. I guarantee that the market will rip.

The Trend is Your Friend – No it isn’t. If you want a friend, buy a dog.

If You’re Going to Panic, Panic Early – Good advice. 95% of the time it’s better to keep your cool, but in some cases there’s no choice. If a market event threatens your solvency and you know that you will ultimately panic if it continues for long, it’s better to take your medicine early. This adage assumes enough self-awareness to assess the pain you can stand before you crack – and to know that you will crack.

In severe turbulence, late panickers will be dumping positions near the bottom of the move (technically known in the business as “puking”). They’re unwittingly creating the “capitulation” phase, when smart buyers step in to benefit from their distress. Savvy and well-funded traders like George Soros and Warren Buffett have made untold fortunes from others’ capitulation.

Soros himself provides an example of a good “early panic,” having hastily sold out of the stock market in Spring 2008, reportedly after some rich friends playing tennis at his house all seemed too complacent about what was coming.

The Market Can Stay Irrational Longer Than You Can Stay Solvent – This adage, attributed to John Maynard Keynes, is a companion to the previous one. Investors who are leveraged or overextended may ultimately have to sell in distress or go bust. Long-Term Capital Management, the hedge fund whose Board included two Nobel Prize winners, is perfect proof of Keynes’ wisdom. LTCM believed its trading models were so robust that they could safely be leveraged 30-40x. As the emerging markets crisis of 1998 unfolded, with spreads blowing out to “thousand-year flood” levels, instead of reducing risk, LTCM allowed the leverage to grow to 50x, then up to 130x. They just knew that if they held on, sanity would return.

The problem is that counterparties’ patience is not unlimited, and when the whole Street knows you have a problem that you can’t or won’t fix, it will take the form of a giant predator and rise up from the ooze to finish you off. LTCM finally needed a bailout organized by the N.Y. Fed, lest the size of their exposure collapse the market.¹ Incidentally, my Russia fund was caught in August 1998 with just some leverage, for the first time, and we received a surprise margin call. I remember I sounded rattled on the phone with the broker and word must have gone around, because I soon got a call from Ron Insana at CNBC, asking if we were “blowing up.” Survival mode kicked in and by the end of the day we’d done whatever we had to, to remove all leverage. Since that near-death experience, we have never touched another drop of it.

So the #1 way to stay solvent is to avoid significant leverage. There’s a second, less obvious way: don’t drink your own or anyone else’s Kool-Aid. I’ve always had complete faith in my own funds, but am aware of their risks and never had my whole net worth exposed to them. As a result, during the numerous crises over three decades I didn’t face the prospect of personal ruin and could stay calm. I’ve also always lived well within my means, which is an especially good idea for anyone who depends on the markets.

The biggest Kool-Aid risk I see today is crypto (with A.I. coming along strongly in second place). Say you’ve been converted to believing that crypto is wonderful, you tell everyone so, you put most of your assets into it, then it starts going down. “Why?” you ask. “It’s irrational that it’s going down when we know how good it is,” you say, and buy more, maybe even go all-in. But it keeps falling, now it feels too late to sell, and to add to the stress, your spouse starts yelling that you’re going to lose everything. It’s inconvenient for you that this is happening – but the market doesn’t care about your convenience.

To avoid this or similar nightmares, avoid any Kool-Aid and stay diversified.²

Diversification is the Only Free Lunch in Investing – Attributed to Harry Markowitz, a more sensible Nobel Laureate than the LTCM ones, this adage is often repeated by Jim Cramer on Mad Money. I rate it 100% true.

1. The definitive book on LTCM is Lowenstein, When Genius Failed (2001).

2. The new bullish story I’ve heard on crypto is, “People coming into the White House own it personally, so they’ll make it go up.” Welcome to Russia.