INVESTING – SURVIVAL OF THE (MENTALLY) STRONGEST
I recently finished reading the book “The Black Swan” by Nassim Taleb where he relates how we should be considering risk and why the average human doesn’t spot the highly improbable events prior to them happening. It is a fascinating book and stimulated a lot of thinking. Perhaps with a background in investing my thoughts and interpretation may differ to others but there were parts where I agreed and other parts where I disagreed with his arguments from an investing perspective.
In the Black Swan, Taleb writes that when he was young, he came across a newspaper article that analysed the mounting threat of the Russian Mafia in the United States. The article explained that their toughness and brutality was as a result of their being hardened by their Gulag prison experiences. Taleb writes that the concept “hardened by the Gulag” was fundamentally flawed as the survivors of the Gulag camps were still physically weaker than before. Taleb uses an analogy of rats being subject to increasingly higher levels of radiation. He writes that at every level of radiation, those that are naturally stronger will survive; the dead will drop out the sample so one ends with a progressively stronger and stronger collection of rats. However, the central fact is that every single rat, including the strong ones, will be weaker after the radiation than before the radiation. Whilst the analogy of the rat population makes perfect sense, I fear Taleb missed a critical point when dealing with Russian survivors of the Gulag system – whilst the survivors of the Gulag camps may indeed have been physically weaker than before, what his argument misses is that they were in all likelihood mentally stronger than before. When you have faced the worst possible conditions and come through the other side you have the reliance and fortitude to deal with the hard times in the future.
This resilience after having experienced the worst can be also thought about in investing terms. The stock markets tend to move in cycles, generally driven by investment sentiment. Stock markets can be undervalued (in periods of fear) and overvalued (in periods of greed) but over the long-term stock markets tend to move higher, delivering the best long term returns of the different asset classes. This is because companies listed on the stock markets are perfect inflation hedges. They are often able to raise their selling price for their products in response to any inflationary increases in their costs and need to keep up with inflation to remain profitable and in business. Stock markets gains are however not delivered in a straight line as the market moves up in bull markets and sells off in bear markets.
The graphic from Visual Capitalist of 60 years of Stock Market cycles is a great way to explain the typical cycle. The graphic is based on the S&P500 total return which is an index comprising 500 of the largest companies listed in the United States.
The table included in the graphic is the most telling part of the whole graphic. A bull market lasts around 5 times as long as bear market. That means that every 6 years on average we would experience both a bull market and a bear market. The bull market will average a positive return of approximately 150% and the bear market will wipe out roughly 35% of that return. So even with a severe bull market one would still remain up and enjoy a positive return over a six year period.
But have a look at the orange lines in the graphic and you can see that bear markets – or probably better to describe as market crashes are violent. They are a quick loss of capital and can be very painful. Similar to the examples of the Russians in the Gulag system or rats being exposed to radiation everyone is weaker after a market crash. But we also do see an example like the Russian prisoners, where one is mentally stronger having experienced a market crash before.
Taleb also deals with concept of silent evidence in the Black Swan and cites beginner’s luck as an example. Beginner’s luck has actually been proven to be true – gamblers tend to have lucky beginnings. But as Taleb points out this is actually an optical illusion. Those that didn’t have a lucky beginning tend to not continue gambling and just continue what they were doing in their lives. If you have a bad experience at something you are unlikely to continue doing it. This can also be looked at from an investing perspective.
Does the benefit of experiencing good market returns during your first year of investing determine whether you continue to invest or whether you feel that nobody makes money from investing?
The evidence as presented in the Visual Capitalist graphic is that everyone should make money from investing but many people miss out on these returns. We often see people changing their investment strategy or portfolio during or after a crash, requesting to be rather invested in cash. The problem with this is they take a long time to redeploy the cash, as a result missing out on large parts of the bull market meaning that they secure most of the downside but capture very little of the far larger upside. The other habit we see is that the investor may withdraw their full investment as a result of a crash, as opposed to just holding on for the good times.
The graphic on the stock market cycles says that we should accept that market crashes occur on a regular basis and you over your lifetime you will experience a market crash many times, it is part of investing. Given a long enough investment time horizon market crashes just become noise. The graphic from the Visual Capitalist is on a logarithmic scale however if we look at the S&P500 over time one can see how the market moves up, brushing off market crashes. The period circled in red is the market crash due to the Covid pandemic – brutal at the time but just a mere blip over the longer term.
As set out we are all physically weaker after a market crash, but those that can put the market cycle into perspective come out a lot mentally a lot stronger for the experience. The worst thing you can do is to use borrowed money when investing, because in the down cycle you may have to sell at any cost to stop the pain. Secondly, know your personal attitude and tolerance towards risk and don’t take more risk than you can stomach. Finally, you never want to be a forced seller, so make sure you have sufficient reserves to see you through the down cycles.
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