Tips for Non-Professional Investors

2/6/21

Lately I feel besieged by articles and advertisements relating to non-traditional assets like cryptocurrencies and gold. A good portion of what I’m reading/seeing, however, is suspect. I’m particularly concerned about content produced by marketers of financial investments and by people who have asset holdings already and are seeking to encourage others to act to bid up the prices on those holdings. Often, these ads and articles pique the public’s interest in a particular assets by referencing some dramatic price appreciation; but that price history, itself, should be a warning sign. As odd as it might sound, the greater the past appreciation, the more cautious one should be about the investment’s prospects.

This phenomenon often plays out in connection with commodities and commodity funds. While these vehicles are typically hyped as a means of diversifying portfolios, promotions generally get more oxygen during periods of sharply rising prices. This attention might seem understandable, as performance of these investments depends on the prices of the component commodities. However, commodity prices are determined by supply and demand — neither of which can be easily predicted with accuracy or precision. The presumption that these assets should be expected to yield a positive rate of return simply on the basis of past performance is problematic.

Despite the standard warning that past performance may not be indicative of future performance, naïve or inexperienced investors have a tendency to disregard this advice. All too often, they base their return expectations on recent history and jump on the momentum train after it’s too late. Predictably, those late to the game often turn out to be the suckers. At a minimum, a reasonable rule of thumb is to stay away from any asset class that has the smell of a bubble. No one can credibly predict how high prices will rise or when sentiment will change and the bubble bursts; but burst it will.

The GameStop history serves as an abject lesson. After skyrocketing to a high of $483 the last week, GameStop closed on 2/5/21 below $64. We’re dealing with a stock that has been losing money! For Bitcoin, the shoe could drop any time. As of the time I’m writing this essay, Bitcoin had appreciated by about 380% over the last twelve months. If that’s not representative of a bubble, I don’t know what would qualify.

Perhaps it goes without saying that no investment should be made unless it has a positive expected return; but the catch is that “expected return” should be more than a hope and a dream. Some rational feature other than past appreciation should back up that expectation. Just because a market had been rising in some recent history doesn’t mean that the trend will necessarily continue.

Critically, the same admonitions may not necessarily apply to trend-following, professional traders. They look for a signal that a trend has taken hold and initiate a position, accordingly; but they impose a discipline to limit losses to assure having the wherewithal to trade another day. They fully appreciate that they won’t win on all of their trades, but the hope and expectation is that the discipline they impose will allow the gains on the winners to outpace the losses on the losers. This kind of trading, however, requires a level of diligence that non-professionals rarely can muster. And without that discipline, the prospects for ongoing success are limited, at best.

For non-professionals, the advice stands: Watch out for hype that promotes investments based on extraordinary (and unsustainable) past price appreciation; and look skeptically at any prospective asset class that fails to involve some productive, income-generating activity. That advice won’t necessarily guarantee success, but it should go a long way toward limiting the prospect of failures.

Kawaller holds a Ph.D. in economics from Purdue University.