Thursday, May 28, 2015

Does Your World Look the Same from Your Windshield as Your Rearview Mirror?

Vitaly Katsenelson has some of the most cogent thoughts on investing and financial behavior currently available.  I was reviewing a piece I had saved that he wrote in Institutional Investor in early 2012 about the runup the previous year in cyclical stocks such as heavy equipment makers Caterpiller and John Deere.  He noted that with companies like this, because a large portion of their costs are fixed, profit margins go up disproportionately when sales are up (as they have been recently).  And conversely when sales drop (as they must at some point) profit margins drop disproportionately because those fixed costs once again remain the largely the same.

His comments are specific to cyclical stocks, but the concept applies to most investments: 

Today investing in deeply cyclical stocks is not unlike a game of musical chairs. If you own these stocks, you are coining money while the music is playing. We know what will happen when the music stops: These stocks will plummet.

Of course, it’s difficult to know when the music will stop — tomorrow, six months from now or in two years. Bubbles don’t follow the timetables established by their prognosticators, even when their collapse is being predicted. If you think you possess perfect pitch and will hear the music stop and be able to grab a chair before everyone else, don’t kid yourself. The dot-com investors of the ’90s thought they could, and very few of them got to sit down gracefully.

I think those last two sentences describe one of most important lessons an investor can ever learn:  the siren song of beating the market always looks good through the windshield but rarely looks good in the rearview mirror.

What do you think?


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