E Most Important ing Is . . . Awareness of the Pendulum

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The Most Important Thing Is . . . Awareness of the Pendulum

When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there's chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.

The second investor memo I ever wrote, back in 1991, was devoted almost entirely to a subject that I have come to think about more and more over the years: the pendulum-like oscillation of investor attitudes and behavior.

The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum "on average," it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.

Investment markets follow a pendulum-like swing:

? between euphoria and depression, ? between celebrating positive developments and obsessing over

negatives, and thus ? between overpriced and underpriced.

74 A W A R E N E S S O F T H E P E N D U L U M

This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a "happy medium."

"First Quarter Performance," April 11, 1991

Thirteen years later I revisited the subject of the pendulum at length in another memo. In it I observed that in addition to the elements mentioned earlier, the pendulum also swings with regard to greed versus fear; willingness to view things through an optimistic or a pessimistic lens; faith in developments that are on-the-come; credulousness versus skepticism; and risk tolerance versus risk aversion.

The swing in the last of these--attitudes toward risk--is a common thread that runs through many of the market's fluctuations.

Risk aversion is the essential ingredient in a rational market, as I said before, and the position of the pendulum with regard to it is particularly important. Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash. It's an oversimplification--but not a grievous one--to say the inevitable hallmark of bubbles is a dearth of risk aversion. In crashes, on the other hand, investors fear too much. Excessive risk aversion keeps them from buying even when no optimism--only pessimism--is embodied in prices and valuations are absurdly low.

In my opinion, the greed/fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk. The academics consider investors' attitude toward risk a constant, but certainly it fluctuates greatly.

Finance theory is heavily dependent on the assumption that investors are risk-averse. That is, they "disprefer" risk and must be induced--bribed--to bear it, with higher expected returns.

Reaping dependably high returns from risky investments is an oxymoron. But there are times when this caveat is ignored-- when people get too comfortable with risk and thus when prices of securities incorporate a premium for bearing risk that is inadequate to compensate for the risk that's present. . . .

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When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-averse, prices can offer more return than risk.

"The Happy Medium," July 21, 2004

The pendulum swing regarding attitudes toward risk is one of the most powerful of all. In fact, I've recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It's possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns. But from time to time, at the extremes of the pendulum's swing, one or the other predominates. For example:

? In 2005, 2006 and early 2007, with things going so swimmingly and the capital markets wide open, few people imagined that losses could lie ahead. Many believed risk had been banished. Their only worry was that they might miss an opportunity; if Wall Street came out with a new financial miracle and other investors bought and they didn't--and if the miracle worked--they might look unprogressive and lose ground. Since they weren't concerned about losing money, they didn't insist on low purchase prices, adequate risk premiums or investor protection. In short, they behaved too aggressively.

? Then in late 2007 and 2008, with the credit crisis in full flower, people began to fear a complete meltdown of the world financial system. No one worried about missing opportunity; the pendulum had swung to the point where people worried only about losing money. Thus, they ran from anything with a scintilla of risk--regardless of the potential return--and to the safety of government securities with yields near zero. At this point, then, investors feared too much, sold too eagerly and positioned their portfolios too defensively.

Thus, the last several years have provided an unusually clear opportunity to witness the swing of the pendulum . . . and how consistently most people do the wrong thing at the wrong time. When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there's chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.

76 AWA R E N E S S O F T H E P E N D U L U M

Very early in my career, a veteran investor told me about the three stages of a bull market. Now I'll share them with you.

? The first, when a few forward-looking people begin to believe things will get better

? The second, when most investors realize improvement is actually taking place

? The third, when everyone concludes things will get better forever

Why would anyone waste time trying for a better description? This one says it all. It's essential that we grasp its significance.

The market has a mind of its own, and it's changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves like a pendulum.

Stocks are cheapest when everything looks grim. The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions. Maybe their buying attracts some attention, or maybe the outlook turns a little less depressing, but for one reason or another, the market starts moving up.

After a while, the outlook seems a little less poor. People begin to appreciate that improvement is taking place, and it requires less imagination to be a buyer. Of course, with the economy and market off the critical list, they pay prices that are more reflective of stocks' fair values.

And eventually, giddiness sets in. Cheered by the improvement in economic and corporate results, people become willing to extrapolate it. The masses become excited (and envious) about the profits made by investors who were early, and they want in. And they ignore the cyclical nature of things and conclude that the gains will go on forever. That's why I love the old adage "What the wise man does in the beginning, the fool does in the end." Most important, in the late stages of the great bull markets, people

AWA R E N E S S O F T H E P E N D U L U M 77

become willing to pay prices for stocks that assume the good times will go on ad infinitum.

"You Can't Predict. You Can Prepare," November 20, 2001

Thirty-five years after I first learned about the stages of a bull market, after the weaknesses of subprime mortgages (and their holders) had been exposed and as people were worrying about contagion to a global crisis, I came up with the flip side, the three stages of a bear market:

? The first, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won't always be rosy

? The second, when most investors recognize things are deteriorating

? The third, when everyone's convinced things can only get worse

Certainly we're well into the second of these three stages. There's been lots of bad news and write-offs. More and more people recognize the dangers inherent in things like innovation, leverage, derivatives, counterparty risk and mark-to-market accounting. And increasingly the problems seem insolvable.

One of these days, though, we'll reach the third stage, and the herd will give up on there being a solution. And unless the financial world really does end, we're likely to encounter the investment opportunities of a lifetime. Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.

"The Tide Goes Out," March 18, 2008

Just six months after those words were written, the progression had gone all the way to the third stage. A full meltdown of the world financial system was considered possible; in fact, the first steps--the bankruptcy of Lehman Brothers and the absorption or rescue of Bear Stearns, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, Wachovia and WaMu--had taken place. Since this was the biggest crisis ever, investors bought into the third stage, during which "everyone's convinced things can only get worse," more than ever before. Thus, in many asset classes, the things determined by the pendulum's swing--the price declines in 2008, the resultant investment

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