Image Credit: Christophe Vorlet
By Jason Zweig | 11:05 am ET Dec. 11, 2015
The implosion in energy prices has devastated many investors’ portfolios. If only it would also devastate old ways of thinking.
As oil sank below $37 this past week, the share prices of dozens of energy limited partnerships were down at least 50% for the year.
Many income-craving investors plunged into energy stocks for their high yield. But oil and gas companies have fallen so far, so fast, that more than four years’ worth of income have been wiped out by the recent capital losses.
But chasing yield beyond the safety of government bonds is a sure way to lose a chunk of your principal. You might never learn that until you can let go of the delusion that the future will repeat the past.
Just look at the torrent of money that poured into energy stocks.
Between year-end 2007 and the end of 2014, oil and gas companies raised $255.7 billion in initial public offerings, subsequent share offerings and convertible-bond issues, according to Ipreo, a financial-research firm.
Over the same period, asset managers launched almost 100 mutual funds, exchange-traded funds and closed-end funds specializing in energy stocks. The investing public pumped $64 billion into these funds.
But almost no one foresaw oil below $40 (including me) — just as almost no one imagined that real-estate prices could drop before the 2008-2009 financial crisis.
As oil approached its peak above $140 in mid-2008, Goldman Sachs predicted that black gold would hit $150 to $200 a barrel, and other Wall Street firms weren’t far behind.
The analysts’ view of the future was consistently anchored on the present.
After oil shot up to $140 in June 2008, analysts cranked their estimates of its year-end price up 5% to nearly $113. Then, when the oil price fell by more than half between September 2008 and January 2009, the analysts halved their predictions for the year-end 2009 price. Future expectations have moved almost in lockstep with current price ever since.
By extrapolating the recent past, oil analysts were only human.
Looking at nearly 38,000 forecasts of stock prices and other assets, behavioral economist Werner De Bondt found that investors incorrigibly project the recent past into the future. In one of his surveys, every 1% rise in the Dow over the previous week made people 1.3% more likely to be bullish on stocks over the coming six months.
Other researchers have found similar effects among investment-newsletter editors and stock analysts. The investing mind not only sees what it wants to see; it bases that on what it is already seeing.
If oil stocks have burned you, use that as motivation to rethink how you form your expectations of the future. That requires breaking from the past and your peers.
Charlie Munger, vice chairman at Warren Buffett’s Berkshire Hathaway, has long urged investors to “invert, always invert.” By considering the opposite of the conventional expectation, you can break the habit of chasing past performance. Mr. Munger did that in March 2009, when he sank millions of dollars into Wells Fargo & Co. With many other investors fearing that the financial system would collapse, he asked: How will this bank do if it survives?
Virtually everyone expects the Federal Reserve to raise short-term interest rates next week. That doesn’t guarantee that all the experts are wrong. But it does mean you should ask yourself whether you are prepared for the Fed to do the unexpected and leave rates unchanged. (Hint: Stocks would probably stumble, and bonds would likely get a lift.)
Likewise, almost no one expects inflation to flare up again. And it probably won’t — but that doesn’t mean it can’t.
So ask yourself or your financial adviser: What is the probability that inflation will exceed an annual rate of 2% in the next 12 months? What events could lead to that scenario?
Unless you think the odds of 2% inflation are zero, you should own some Treasury Inflation-Protected Securities or a TIPS fund that can benefit when their prices are adjusted upward when inflation takes an unexpected jump.
In short, you can’t get higher income just because you want or need to. There’s no safe way to make, say, 6% in a world of 2% bonds.
The best way to raise your yield is not to buy what’s popular, but to wait until other investors are extrapolating misery — and then buy.
Mr. Munger likes to point out that successful investing requires “this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself.” Energy stocks, high-yield bonds and emerging markets might be nearing those levels soon.
Source: The Wall Street Journal