Trading Sardines And The Hubris Of Investing Success

What’s that?  Another new all-time high?  Lately, investors have been cheering plenty of new all-time stock market highs. With the S&P 500 rising 22% year-to-date, they would seem to have plenty to cheer about.  It’s been a very good year for stock investors.

In fact, the last decade has seen nothing but new highs every few months.  Regular as clockwork.  It’s hard NOT to feel good about the returns gifted to investors by this wonderful decade.  It’s been a Decade of Prosperity.

When I look at my own portfolio, it certainly feels wonderful to see those numbers creeping ever higher.  I won’t spoil the surprise, but my portfolio is definitely UP for the year and reaching all-time highs as well.  That kind of financial success is enough to get any investor charged-up with enthusiasm.

Instead of enthusiasm, these new all time highs have me thinking about sardines…

The Parable Of  Trading Sardines

Actually, it’s not the sardines themselves, but a story about sardine trading — Seth Klarman’s parable of speculative sardine traders comes from his book Margin of Safety.  (In case you are not aware, Seth Klarman is one of the top value investing wizards of the last 40 years.)  The parable goes something like this:

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”

Clearly the spoiled sardines in this story are worthless, but nobody bothered to look. Or nobody seems to care.  It makes me wonder — Are we all just sardine traders, passing around worthless cans of ‘rotten fish’ at higher and higher prices?  Is anyone actually checking to see if today’s ‘trading sardines’ are any good?

It’s certainly a valid question, and when I see stock prices continuously hitting all-time highs, it makes me wonder if stock prices are becoming unhinged from business value.  In other words, stocks could be worth a lot less than what we think.

Few people bother to “check values” anymore — most just buy their cans of sardines index funds at whatever the prevailing price might be, preferring a “close my eyes and hold my nose, then buy and hold” approach.

On the surface everything seems OK when we look at stock valuations, because corporate earnings have been rising in tandem at a rapid clip.  PE’s are not outlandish.  But earnings isn’t everything — There’s also the wealth effect to consider.

The Wealth Effect

When the markets hit new highs, it’s easy to believe that stock market success is the result of our own personal wealth building actions — working hard, saving, and then investing in all the right places.  The reality is that the rising tide of the stock market will lift all boats.  From the most seaworthy of ships to the leakiest of dinghies.  The rising tide can lift the least seaworthy vessels to a high-water mark…

Prudent investors will carefully ascertain if they’re riding on the seaworthy vessels when the tide is breaking new highs.  Unfortunately this opinion is not shared by all ‘sailors’ on the stock-market sea.  Many investors are simply enjoying their newfound riches instead of checking their ships for “leaks”.  This incredible hubris feeds something called the wealth effect.

What is the wealth effect?  When capital markets rise, increasing stock prices create a feeling of increased wealth.  Feeling wealthy, investors choose to spend more instead of conserving cash.  That excessive spending then drives corporate earnings ever higher, fueling  even greater stock market highs.

This is the wealth effect, a psychological feedback loop that’s fed by ever greater wealth from stock market gains.

Indubitably some of our more recent market highs are at least partially fueled by the wealth effect.  We’ve had 10 years of absolutely wonderful stock market returns to feed it!  We all probably consume a bit more than we should, and (if necessary) could be a little more frugal than we are today.

How much of our extra consumption can be attributed to the wealth effect?  It’s impossible to say, but eventually a froth will form and investment bubbles will grow.  Eventually those bubbles break, causing great crashes and panics.

History is literally littered with stories of once wealthy men and women going bankrupt (or nearly bankrupt) due to excessive hubris.  Many used too much debt.  Those debts eventually get called, causing personal disaster.  It’s a tragic tale, but one that has been repeated over and over again in history.

After 10 years of great investing gains, I think it’s high-time rational investors begin to check their hubris at the door.

Keeping Hubris In Check

How does an investor keep their hubris in check?  It’s not exactly easy to put yourself in a frame of mind where stocks are far lower than they are today.

So, I’ve put together a handy set of tips that I try to use in order to keep my own hubris in check:

* Don’t Look At That Balance — This first one is pretty easy to do.  If you don’t want to feel wealthy and be effected by the feeling of ever greater wealth, then just don’t look at your portfolio balance!  Imagine you only have the money in your checking account.  Ignore any retirement accounts or investment accounts.  Then, keep on earning, being frugal, and saving as if those growing investment accounts don’t exist.

* Give Yourself A Mental Haircut — Since I do happen to check my account balances occasionally, I do what’s called “The 50% Mental Haircut”, I mentally “chop-off” 50% off my net-worth when looking at the balance.  If my portfolio balance says $3 million, then I automatically think “This is actually about $1.5 million”.  Why 50%?  Some of the biggest stock market crashes in history have seen declines approaching 50%.  That, and 50% makes a nice round number for easy “mental math”.

* Don’t Retire Early At The Height Of A Bull Market.  Many an investor has called it quits at the height of a bull market only to find that his (or her) dreams of sun-drenched beaches are simply fantasy when the market declines.  Sequence of returns matter when it comes to retirement withdrawals.  Instead of going out at the top, wait for the bottom of a bear market and then pull the trigger on any retirement plans.

* Remind Yourself Of Who Really ‘Made’ Those Returns — While we might like to believe we can take credit for investing returns, the reality is that most people extend no special effort that might merit such credit.  In most cases, Mr. Market is the real person to blame for our investing returns, and you (the investor) was merely in the right place at the right time to capture Mr. Market’s incredible enthusiasm.

* Avoid Personal Debt.  Whenever I see headlines like “Stocks hit all time highs” I mentally replace those headlines with “Pay down your debts right now!”.  If history has taught us anything, it is that it’s very hard to go bankrupt without debt!  So why not pay off the debt when times are good?

* Avoid Investments With High Debt Loads.  Just like personal debts, it only makes sense that a prudent investor should also avoid investments that are putting on large amounts of debt near the height of a bull market.  They might be able to afford that debt now, but what about a nasty 50% decline in business?  It’s gonna hurt.

* Cash Isn’t For Losers.  A lot of investing and FIRE blogs recommend being 100% invested in stocks.  That’s fine if you don’t mind selling in the middle of a stock panic, but I think it might be prudent to hold a bit of cash to “ride out the rough spots”, so to speak.  There’s absolutely nothing wrong with having cash in a money market account (which roughly provides returns matching inflation).  In fact, even famous investor Warren Buffett has been putting on a little extra cash lately — Berkshire Hathaway has a cash position over $122 billion dollars.

* Look For Ways To Cut Expenses, Now.  Yes, before a recession happens!  Ask yourself if there’s a way you could cut your expenses right now.  Try to find ways to reduce expenses *before* it becomes painful and necessary.  Maybe you really don’t need that vacation home or a full-time maid to clean your house.  I guarantee you it’s going to be much easier to make a habit of cutting expenses earlier than doing so under the threat of bankruptcy.

* Trim The Losers.  At this point in the economic expansion, if a stock isn’t doing well, then there’s something clearly wrong with it.  Maybe it’s a business already on the decline.  I can almost guarantee that when a recession comes its going to hurt for these ‘Loser’ stocks.  They’re clearly the leaky ships in your portfolio.  It’s best to trim them now.

A Humble Ending

After 10 years of pretty incredible returns, keeping hubris in check is definitely getting harder.  My own personal mantra is to ‘stay humble’, and I need to keep reminding myself to spend like a broke college student…. because some day, (maybe even relatively soon) my net worth will come crashing down when Mr. Market finally opens up a sardines cans to find out what’s inside.

It’s getting harder and harder to stay humble at each new high, but I prefer to be prepared instead of crushed by the eventual fall.

Beware my friends… it’s starting to get fishy.

[Image Credit: Flickr1, Flickr2]