Cullen recently provided a great ‘food for thought’ post. You can read the complete post at Pragmatic Capitalism.
My mother tells me I predicted the housing bust. My father tells me I predicted the market crash in 2008. Readers believe I predicted the flash crash last year. None of this is true. I don’t predict anything. The intelligent investor does not need to be able to predict the future. He/she merely needs to know when to fold ‘em and know when to hold ‘em. In the investment world, nothing is more important than knowing when to fold ‘em.
When I review the housing bubble I didn’t imagine the crisis that would unfold. I knew a trend in US housing prices was unprecedented, inconsistent with underlying fundamentals and unsustainable. But my conclusion was not of the magnitude of “genius.” No, my conclusion was far simpler. I just stayed away.
Playing with bubbles is a dangerous game. I would argue that the truly intelligent investor simply pulls his chips back and steps away from the table in the midst of such irrationality. Warren Buffett is probably the best case of “don’t mess with what you don’t understand”. And in the case of bubbles, I would argue that no one understands the market’s behavior.
Market bubbles make for a market environment that can be highly rewarding, but astronomically risky. What appears like a perfectly stable system can very quickly devolve into a nightmare.
With that said, are there examples of this in today’s markets? Are there markets that warrant a “do not enter” sign? I believe so. And if I were an investor in the following markets I would merely pull my chips off the table: (details in original post)
2) Municipal bonds.
4) European equities (particularly periphery nations)
I take a similar stance. I don’t know what investment action to take when the market seems irrational, but staying on the sidelines is one reasonable action. Some love to go with the trend and others are born contrarians. If you don’t have a successful track record of following or fighting trends, or do not have patience (good traders must have patience) to sit it out, you can compromise by trading half your regular size.
It’s good advice, but not easy to follow. If you are playing with the bubble and not taking a contrarian position, then you have been making loads of money and it’s very difficult to stop playing that game.
This post is merely one additional reminder that risk management is the single most valuable skill a trader can possess, other than an accurate crystal ball.