How to Decrease Risk & Increase Return Part 3

There is a truth that the value of things, what they are worth changes.  It might not change as fast as the price, at least not in all cases, but it definitely changes.  What does this mean for us?  It means we can buy something for less than it is worth in today’s market but have it become more than it’s worth in tomorrow’s market.

What does this call our attention to?  Market cycles.

We need to be aware of market cycles

The markets tend to follow relatively predictable patterns over a relatively long period of time, much like the seasons, in fact they are often defined as the financial seasons.  If you take time to think about them the pattern is pretty obvious.

Things start out relatively flat, we sometimes call this a sideways market.  Essentially, during this period industry, etc. is either recovering from challenges, or building up momentum.  In either way we don’t see dramatic changes during this stage of the cycle.  This momentum gradually mounts, people start making more money so they spend more money, which means other people make more money so they have more to spend, which means demand increases and prices rise, as prices rise people make more money, which further increases the cycle.  This is what we call a bull market, a boom, it rises fairly rapidly.

At this point the speculators get in there, they see everything going up, they are excited about it and figure because of the upward momentum they can make money by paying more for something than it’s worth, which drives prices even higher, but it also carries the seeds of the boom’s demise.  At some point we realize things are over-priced, there is no longer a correlation to value, this occurs when people have over-extended themselves, they’ve spent more money than they can afford to spend.  The result is they default on their obligations and they are forced to sell what they bought for less than what they paid for it.  Because they lost money they have less money to spend so they buy less so demand decreases and prices fall somewhat, though they typically don’t fall as much as they rose (for example they might have risen 100% and now they fall 30%).  This is what we call a bust or bear market.  It tends to overcorrect downward as investors panic, recovers slightly, and is followed by another sideways market as the market recovers from the loss and then rebuilds momentum.

Investment Cycles

Visual depiction of the average investment cycles

This cycle repeats itself over and over again on both a grand and local scale.  Oh there are little bumps here and there, real estate for example tends to heat up in spring and cool down around Christmas but in a general sense the big moves occur corresponding to this cycle.  Yes, you still find companies that grow during busts (Apple being a great example in this past recession), but the overall market follows this pattern and the pattern affects the swing of virtually all companies to at least some extent.

The majority of wealth is built by buying when things are flat or have just crashed and selling late in a boom, then repeating the process.  This is part of the reason it takes a fair amount of time to get wealthy, because a person generally needs to ride at least one cycle.  (It’s useful to check out Ray Dalio’s video on How the Economic Machine Works for another side of cycles and predicting them at www.economicprinciples.org )

I hope looking at this cycle you can understand how it could be possible to buy for what seems like a good deal at the peak of a boom and still lose money as it all collapses around you.  This is why Warren Buffet says “try to be greedy when others are fearful and fearful when others are greedy”.  People tend to be greedy when the market is late in a boom and fearful just after a crash.  So how do we decrease risk while increasing returns?

Invest counter cyclically

Investing counter cyclically means you buy when everything goes down and you sell when everything goes up.  When your next door neighbor is deciding to get into real estate development you know it’s time to sell.  The best part about this is not only does your money go further when the market crashes but people are much more susceptible to negotiation as they are in more desperate positions, the inverse is true during a boom you can often ask more than market value for what you’re selling and get it as the speculators show up, thereby setting the new standard.

When you buy for below what something is worth at the bottom of the market it’s hard to lose money.

If you’ve got investing questions you’d like to discuss or like us to cover please click “Ask a Business Question” in the lower right corner of the screen to send it to us, looking forward to hearing from you.

Continued on next post