Source: Securities Times Network
Author: Qu Hongyan
Without turning to history, it is hard for investors to imagine that within a few short months, the price of a once red-hot commodity could plummet from $30,000 per unit to just a few dozen dollars and eventually hit zero, leaving many participants destitute.
Human nature tends towards admiration of strength, and ordinary investors are easily attracted by prevailing trends. However, if one does not question the source of profits, then skyrocketing prices and enviable gains may become a fatal 'noose.' Investment masters are not conservative by nature but rather consciously collect sufficient counterexamples, understanding the significant risks behind trend-following investments, which lead them to advocate 'don't invest in what you don't understand' and resist being swayed by popular trends, thereby avoiding irreversible harm.
Some may ask, why not take advantage of a bubble? Chasing the wealth brought by a bubble may seem effortless, but in reality, it is the most perilous endeavor. This is because the bursting of a bubble is often swift and merciless, leaving almost no one unscathed. Investors must remember what Buffett said: 'Finance is not like being in a crowded theater where you can simply run straight to the exit. You must find someone willing to take your place, someone who will trade with you.'
While large-scale financial bubbles are rare, localized financial bubbles occur from time to time. However, viewed historically, nearly all negative financial cases reveal that no matter how large a bubble grows, it inevitably collapses to zero. The vast majority of participants not only lose their paper profits but also their principal. Investors who participate in bubbles using borrowed funds often fall into a debt abyss.
In financial investment, liquidity tends to vanish when you need it most. A major loss can alter your life trajectory. Rash investments are easy to make, but the consequences can become an unbearable burden. Investment requires careful consideration, prioritizing the assessment of potential losses over profit-making.
A 'noose' lurks beneath the bubble
Human madness exceeds imagination. By 1636, a tulip bulb, which originally had little value, was priced at the equivalent of $25,000 to $30,000 today, akin to 'a new carriage, two gray steeds, and a complete set of harnesses.'
‘Whether noble or commoner, farmer, artisan, sailor, manservant, maidservant, or even chimney sweep and elderly seamstress, everyone was buying tulips. Every stratum of society liquidated their assets and poured money into the tulip market. Houses and land were sold cheaply for cash, or directly used as payment tools and undervalued in the tulip market. Foreigners quickly became embroiled in this frenzy, causing money to flow into the Netherlands from all directions.’ Charles Mackay described in his book *Extraordinary Popular Delusions and the Madness of Crowds.*
Undoubtedly, each round of price surges attracts more speculators. At the same time, this seemingly validates the rationality of prices, creating room for further increases.
In 1637, as this bubble approached its end, those who had realized the situation and those who were anxious began to exit, with no one knowing the reason: some, seeing others selling, also rushed to sell, triggering panic and causing prices to plummet drastically. It should be noted that a large portion of these speculators had purchased tulips using loans secured by mortgaged property, leaving them facing sudden financial ruin or even bankruptcy.
Mackay said that a great number of merchants were almost reduced to beggars, many nobles lost their estates and fell into irreversible despair. After this disaster, people were in extreme anguish, blaming each other and looking for scapegoats everywhere. However, the real cause of this calamity was public hysteria and ignorance of financial principles.
All financial bubbles inherently carry the risk of total loss.
Disregard for financial history has led to the repeated occurrence of bubbles, with humanity constantly relearning the lessons. Investment masters consistently emphasize the importance of a 'not-to-do list' throughout their investment careers, never participating in investments they do not fully understand.
During the 'South Sea Bubble,' Newton lost £25,000, which is equivalent to approximately $3 million today. This gave rise to his famous remark often quoted to remind people of stock market risks: 'I can calculate the motions of heavenly bodies, but not the madness of people.'
It is difficult for people to get rich in financial bubbles because human nature is hard to change. Everyone wants to seize the last opportunity before exiting the market, but by then it is already too late.
Chasing bubbles is embarking on a point of no return in the pursuit of wealth. Buffett offered a sobering analysis: 'They know full well that the longer they linger at the ball, the higher the probability that the pumpkin carriage and mice will reveal their true forms. Yet, they cannot bear to miss a single minute of this grand ball. These frivolous and reckless participants all plan to leave just one second before midnight. The problem is, there are no hands on the clock at the ball!'
Speculation may seem like the easiest thing in the world, but in reality, it is the most dangerous. There is always a needle waiting for every bubble, and when they meet, a new wave of investors will once again revisit the old lesson.
Every financial bubble carries an inherent risk of total loss. Even if one escapes unscathed this time, the outcome of participating in a future bubble may still be zero. No matter how large the base, multiplying it by zero still results in zero.
This is what Qiu Guogen, founder of CICC Investment, once referred to when applying the concept to investment. If a strategy lacks 'ergodicity,' it implies the possibility of ruin or being forced out, turning investing into a perilous game of 'Russian roulette.'
In any investment, as long as there is a possibility of total loss, no matter how small the probability of it occurring may be, if this possibility is ignored and investment continues, the likelihood of capital depletion will keep increasing. Sooner or later, risks will expand infinitely, and even substantial funds may vanish. No one can escape this outcome.
More important than making money is avoiding significant irreversible losses, which is also why investment masters over the past few decades have never been tempted by hot trends or deviated from their investment principles. It is not that they are slow to react to new things; rather, they deeply understand financial history and do not wish to repeat the tragic fates of those caught in bubble bursts.
The capital markets are crowded with intelligent individuals, but the winners in investing are often not the smartest people, but those who remain disciplined.
Charlie Munger once said that it is easy for a smart person to deceive you. Investment should avoid games of wits with clever individuals, as competing to be smarter is an endless game. Moreover, retail investors occupy the most vulnerable position in the capital market ecosystem.
Value investing is a win-win strategy, avoiding games with most clever individuals. It does not require much timing or high-difficulty maneuvers; instead, adhering to simplicity and staying within one’s circle of competence while following a few fundamental principles of value investing is sufficient.
Long-term bullish stocks in the A-share market also indicate that such stocks generate returns based on fundamental growth rather than valuation increases. If the company's fundamentals fall within the investor's circle of competence, through long-term tracking and careful research, the investor can, with high probability, foresee changes over the next three to five years, or even a decade.
It is easy for a smart person to deceive you.
While studying at Columbia University, Graham ranked at the top in every subject, whether physics, mathematics, music, or literature. He could speak Greek and Latin fluently and compose poetry in Latin. Graham was erudite and highly gifted.
Among Graham's students, some were very close friends. They regularly organized gatherings to bring everyone together. On one occasion, they invited Graham as well. At this gathering, Graham brought out a prepared quiz to test everyone. The average IQ of those attending the gathering was certainly above 150.
Graham's quiz was simple—just true or false questions requiring checkmarks. Despite its simplicity, among all attendees at the gathering, including Munger and Buffett, only one person answered more than half of the questions correctly.
How did this happen? Because Graham was an extremely intelligent person who deliberately set traps in the questions to mislead the respondents. The person who answered the most questions correctly genuinely knew only three, and guessed the rest. By a mix of partial knowledge and guesswork, they barely managed to get slightly more than half correct.
Graham never revealed to them the lesson he wanted them to learn. Munger believed that Graham wanted everyone to understand that if someone much smarter than you intends to deceive you, no matter how carefully you analyze and judge, it is still very difficult to avoid being deceived.
Munger said, fortunately, Graham is a genius, and few people are as smart as he is. Moreover, we are fully aware of our limitations and know there are many things we cannot achieve. Thus, we cautiously stay within our 'circle of competence.' The concept of the 'circle of competence' was introduced by Buffett, and both Buffett and Munger believe that their 'circle of competence' is a very small circle.
A friend once remarked, 'Munger only concerns himself with matters directly related to his business, and anything outside of that, he knows nothing about.' Munger clearly delineates the boundary between what he knows and what he doesn’t, operating solely within the realm of his known circle.
Avoiding the Games of Smart People
Wang Guobin, founder of Quanguo Fund, once said that value investing is not about competing against others; rather, it is a win-win strategy.
The first advantage of value investing is that since speculative investment is a zero-sum game, most people are preoccupied with daily price fluctuations. When you adopt a value investing strategy, your competition becomes relatively minimal, allowing you to avoid competing with the majority of smart individuals. I prefer value investing because it helps me avoid direct competition with others and spares me from engaging in speculative contests with other investors.
The second advantage is that predicting the future is extremely difficult, so we must find a method that does not heavily rely on timing. Value investing precisely fits this criterion, allowing us to minimize forecasting.
The third advantage is that the long-term approach of value investing can help reduce dividend taxes and commissions paid to brokers. In the U.S., value investing is particularly effective due to capital gains tax considerations—holding assets for longer periods results in lower capital gains tax rates. When we excessively engage in short-term trading strategies, after selling and recovering cash, we inevitably choose to buy something new. Each additional decision increases the likelihood of making a mistake. With value investing, you invest significant time and effort into thoroughly researching each trade, which helps reduce the probability of errors.
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Editor /rice