Lesson #15: How to Defeat The Paradox of Investing
The paradox of investing is this: even if people know exactly what to do, they usually don’t. Let me explain with a little story.
Joel Greenblatt directed Gotham Capital in the 1990s when it did an incredible (for stocks) 50% compound annual growth rate for each year of the entire decade. In his first book, he explained much of his methodology in trading (mostly) spinoff companies.
While he hoped it would help the average person to retire early, the material proved to be too technical for the general public (various other hedge fund managers found it helpful though). So, in his second book he developed the Greenblatt algorithm and just gave it away.
You can go to magicformulainvesting.com and just by submitting your email address you can get a list of 30 stocks to buy. If you buy all 30, wait a year, sell and rebuy 30 more, then you’re following the plan. Over any 10 year period, this algorithm is very likely to return 18% – 20% compound annual growth rate–which is better than Warren Buffet does by a lot.
There’s no reasoning involved. You don’t need to understand financial evaluation standards. Just buy the list and forget about it for 12 months. Then sell. Then buy the next 30. Repeat for 10 years.
The real drawback is that those returns are very uneven–60% in one year and a 10% loss in the next for example. So, it’s not great for people actively in retirement, but it is good for people looking ahead to retirement in the next 20 or so years.
In his third book, Greenblatt commented that people had a hard time following this new, simplified plan too. In fact, the ones that did the best were the people who bought the 30 stocks and forgot about them completely for 2 years (it was a 2 year evaluation period).
Even with perfectly clear signals, and well established data to support the results, most people couldn’t stick to the plan. They tinkered with it. Trying to improve here and there. Buying and selling on news from other sources, etc.
Almost universally, all that tinkering resulted in worse returns than just stupidly following the algorithm. And with near equal universality, everyone did it anyway.
That’s the paradox of investing.
I was going to make Lesson #15 about the art of the hedge. I think that the topic proves rather advanced and that the greater concern is that people won’t use the basic lessons. Hedging is mostly like insurance. Executing on the strategy is how to get 10x trades in the first place.
I’m going to leave hedging to the masterclass series of lessons on The Art of The Bubble.
In this lesson, then, I want to address the paradox of investing squarely. If you are a paying subscriber, this is especially for you. If you aren’t then, you’ll need to know this about yourself so you can execute on whatever strategy that you have.
There’s a few methods you can employ to deal with it. I’ll explain each and their drawbacks. One of the best, however, is just to set the right level of expectations. And those follow from understanding how things are supposed to work in the first place.
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The Big Idea
To recall the main idea for The Art of The Bubble investment strategy, it works at three different levels and combines the insights from three different schools of investing. The image I’ve been using to explain the strategy is the following pyramid.
At the most fundamental level, the base of the pyramid, the strategy tracks the health of the macroeconomy. I explain in some detail how this is done in Deep Dive #5. The tools used here are fairly standard for the industry and Ray Dalio’s hedge fund Bridgewater is the source of its inspiration.
The notion is simple: nothing goes up in a bad economic environment, so make sure you stay out of bad downturns. That’s the point of my basic economic cycle indicator that Bubble and Crypto riders pay for.
Moving up a level is the Industry Cycle. The source of inspiration for this dimension of analysis is Renaissance Technologies. To get a sense of the problem solved, have a look at the performance of XLE, the energy sector of the S&P in black, relative to the S&P itself (in blue) in the 2014 – 2019 period.
So, the XLE was down 35% while the S&P was up 36% over the same period. That means that while the broader economy was good, energy, especially oil, was terrible.
Rather than replicate the macro-analysis of the basic economic cycle indicator, the Industry Cycle uses momentum analysis to discern whether the industry you are interested in is doing well.
If you’re interested in oil, then both the basic economic cycle indicator and oil price trends need to be ok. If you’re interested in cryptos, then both the basic economic cycle indicator and the price trends of Bitcoin need to be ok.
Finally, the analysis moves to do “old school” value based analysis as inspired by Warren Buffett, whose Berkshire Hathaway needs no introduction. In general, a good value company is better to buy than a bad one. But, when bubble trading, sometimes you want the worst company.
Compare, for example, the responses of Canopy Growth Corporation (CGC) with Sundial (SNDL). The former is a solid cannabis company in Canada, while the latter is (and was) barely paying its bills. This is how they performed after Biden won the US election in 2020.
While CGC made a respectable climb above a 40% return in the months after the November election (black line), SNDL popped more than 1500% at one point (blue line).
Why? Because the market thought that SNDL would go out of business, but after Biden’s win, they had to reprice the possibility that it would survive. That’s why the worst sometimes do the best. A value analysis helps you identify those possibilities (explained in more detail here).
Finally, using all this information, you can look at trading leveraged products, if that is your interest. Often, it proves unnecessary … and especially risky given the level of noise bubble trades usually have.
Momentum and Noise
Now we’re at the heart of the lesson. The following charts of Tesla’s stock price explain the point at issue. Here’s the first, Tesla during the latter part of 2017. The black line is the simple moving average of the past 200 days (abbreviated SMA 200).
Suppose that, after seeing that run, you thought to yourself that Tesla is a bubbly stock and you’d like to make money trading it.
Following the process of bubble trading outlined here, you decide to buy when the price is above the SMA 200, sell when below that. Well, here’s how things would have looked for the next 12 months.
That’s right, you would have had 8 false signals for a run in 12 months. It would have been difficult to persist in the strategy at a psychological level.
Actually, after that, you would have had 1 more false signal followed by 12 months of downward trending for Tesla where most people would have lost interest. Notably, you wouldn’t have experienced those losses because you would have sold out following the strategy.
If you had kept with it through all those false signals and the 24 month stagnation and decline, you would then have found this.
Yes, following this simple strategy you would have caught the ride of a lifetime, buying TSLA stock right around $50 a share.
The rest of the story looks like this (if you don’t know already).
Yes, you would have held on until you got to about $600 and sold for about a 12x return in a little more than a year. With the strategies of The Art of The Bubble, you probably would have increased those returns to about 15x.
The lesson from Tesla really does generalize to other cases. Bitcoin’s crypto-winter, for example, is similar in character. Here’s the 2019 to early 2020 run.
Notably, you would have sold out before the worst of the March 2020 crash. So that’s nice, and you would have made some gains on the 2019 run. But there were a lot of false starts too.
The moral of these charts is simple: momentum trading runs into a lot of noise. This makes it psychologically difficult to execute.
That’s one of the key reasons why most people don’t do it successfully. It also explains why many hedge funds don’t follow some of these methods–they couldn’t always keep their clients happy.
I mentioned these points in the very first lesson of the Absolute Beginner’s guide, but they’re worth repeating here at the end of The Art of The Bubble guide.
This is the same reason Greenblatt gave away his “magic formula.” Both strategies are psychologically difficult to execute, which is why they never become crowded trades.
You might compare the problem to achieving six pack abs (or perfect thighs).
We all know how to do it. Really. Just have a basic exercise routine that includes strengthening practices and (for most of us) eat less. Also, eat boring. Mostly, you’ll have chicken, fish, and broccoli … and maybe some savory carrots. Never eat bread. Ditch the alcohol too. Do that every meal, with small portions, get your vitamins, and with a consistent workout plan, you’ll get there in 1 or 2 years.
There are some minor adjustments for specific cases, but the basics are common knowledge. Still, not everyone has six pack abs and perfect thighs, just like most people don’t have millions of dollars from investing and trading.
So, with that in mind, let’s look at three solutions.
Three Psychological Solutions
In my experience, the best way to beat your own psychology is to admit that you’ll fail. Just as I made much better progress with my health goals when I admitted I hated working out and that I love IPA beers, so too have I made far better trades when I admitted that I find it hard to buy more when the market is down, and that I get discouraged psychologically when I have a lot of dumb, noisy trades.
One way I developed to get around this was to write algorithms and then connect platforms to them so that trades could happen automatically.
But you always have the ability to override your algorithm. And with cryptocurrencies, you’ll often find that you are forced to “trade by hand” anyway. So, here are three techniques I use to act on what I already know I should be doing.
1. Pessimistic Anchoring
A few weeks back, I traded out of most of my cryptos based on news that the US regulatory framework was shifting. A day later, everything was resolved so I jumped back in. Noisy trades for sure.
But when you are momentum trading–and that’s a key part of The Art of The Bubble–then you are going to act on noise because you can’t tell beforehand (remember TSLA in 2018!).
You can prepare for that if you expect frustration. Just remember: TSLA has 9 noisy trades over 13 months, and then 11 months of decline, before shooting off. If you do better than that, it’s amazing.
In short, anchor your expectations to a pessimistic outcome like TSLA. Expect that to be the norm, so that when it happens, you won’t be terribly upset. Also, if it doesn’t happen, you’ll be surprised in a good way.
2. Layers of Defense
Way back when I began trading and investing, I found that I often sold at exactly the wrong time. I used to awake at night with an anxious gut feel and sell as soon as possible on a trade that had gone bad in the morning. Inevitably, the stock would rebound and I would have sold at a loss for nothing.
Or else, I would act as an “ostrich,” deliberately ignoring all news about my trade. Of course, when I did eventually check, things were worse rather than better.
What to do?
I wrote a lesson on scaling out of your trades as part of this series. An additional advantage of this approach is that it allows you to more successfully execute on your strategy.
By selling out a little at a time, or by buying in at 5 different stages, you will add layers of defense against your own worst impulses. So, the strategy not only helps identify better entry and exit points, it also helps to make each of those activities more psychologically bearable.
3. The Always Winning Approach
Finally, especially when you need to cut your losses, as is inevitable with trading and investing, it helps to have some area in the green among your sea of red.
I trade lots of bubbles primarily because that approach ensures that my portfolio can grow continuously. But the idea also makes it easier to act as you know you should be acting.
Yield farming, which can help you retire on $250,000 and live on $100,000 annually, is not only useful for high annual percentage returns. It gives continuous wins too.
If you’re really deliberate about it, allocating a large enough portion of your funds to yield farming, you may avoid losing money altogether. Your yield farming might pay for dips in your other investments so that your net position is always positive.
I don’t actually do that, since it would slow my gains too much, but it’s something to consider if you really don’t like having negative returns in your portfolio ever.
The always winning approach, then, not only evens out your portfolio returns, it also makes it psychologically easier to stay in the game and cut your losses when you should.
At this point, I’ve concluded the basic series of lessons that make up The Art of The Bubble. I was thinking I’d develop a final master class course beyond this to cover what I didn’t think made sense in this series.
But for right now, if you’ve gone through these 15 lessons you’ve learned quite a bit. The lessons range from:
- Why you should never try to guess the top of a bubble (Lesson #1), to
- How to distinguish the three kinds of bubbles (Lesson #10), to
- How beauty pageants explain the best approach to investing (Lesson #7), to
- Why being late to a trend pays more money (Lesson #4), to
- The art of the crash (Lesson #11).
The whole process is highly counter intuitive, and, as you know now, difficult at a psychological level.
My aim is to make 10x trades regularly and I have been able to do so following this approach. I even wager that it can fairly consistently do 100% compound annual growth rate each year. Coupled with yield farming, most people should be able to retire well rather quickly as a result–much faster than following Greenblatt’s method.
This is an art, though, so knowing the principles is only the beginning. Initially, I imagined the subscription services offered as a kind of “hands on education.” You can’t learn to do this for yourself without trying your hand at real trades. The best lessons come from at least a year’s worth of following along and learning with others.
The crypto and bubble rider subscribers get so see what I do and how I decide. The DIY-ers get to learn about how I pick moonshots and how I monitor my yield farming positions. All paid subscribers get to ask specific questions about my positions or my thoughts on certain investments. That’s the kind of education anyone needs to do this kind of activity.
But for right now, if you’ve made it through the 15 lessons, then you’ve got reason to feel accomplishment. As the indigenous people of Mesoamerica used to say, life gives few pleasures, so enjoy them when they appear.
That’s it for this week, then. Happy Trading!
General financial disclaimer: This post is provided for entertainment purposes only. I am not giving you financial advice and I am not a financial advisor. You should expect no financial returns one way or another based on my statements. These points hold equally for any statements that could be attributed to The Art of The Bubble or any related business entities. If you decide to buy or invest in anything, then your returns and potential losses are your own. No statements about taxation are taxable advice and you are encouraged to consult your own tax professional. You are also encouraged to do your own due diligence before investing in anything