Patience is passé

Amazon, Apple, Alphabet, Microsoft and Facebook did not grow into the tech behemoths they are today overnight. It took years before people saw their early investments, in a seed of an idea, pay off in a big way.

The belief of investors was tested in the early years, when income statements were covered in red ink, as these companies focused resolutely on growing the business. For those who were forward-thinking, trusted the fundamentals and invested for the long-term, they were handsomely rewarded years later.

Yet, such patience has become increasingly rare in a year rife with plenty of “get-rich-quick” trades that have taken the form of a struggling games retailer (GameStop), a cryptocurrency that started as a joke (Dogecoin), virtual tokens linked to jpegs (Non-fungible tokens or NFTs) and vacuous shell companies, some with celebrity names plastered to them for good measure (Special Purposed Acquisition Companies or SPACs).

Indeed, when investors buy an asset believing they can quickly sell it to the next person who is willing to pay a much higher price, we are essentially looking at a speculative market. It is difficult to chalk up the parabolic rise in the prices of these assets to changes in company-related or economic fundamentals, particularly because, in some cases, there are none.

Follow the herd

In the case of GameStop, we saw the Reddit herd push up the stock prices of beleaguered companies like GameStop, Nokia, AMC and Blackberry with unyielding focus, primarily because they wanted to stick it to the financial elites on Wall Street. Of course, as the dust settled, it was unsurprising to find out that other big money hedge fund players had joined the mania. After all, how can they pass up such a lucrative opportunity to ride the wave of speculation?

But for all the success stories reported in the media, there are plenty more that have ended with nasty losses instead of resounding riches. The inconvenient truth is, there is a higher probability of being burned in speculative trades than many may care to admit.

The success of such trades hinge on flows and momentum moving prices in your favour and timing your exit perfectly. As the herd pushes prices ever higher, greed tends to lull speculators into a false sense of complacency and confidence. They believe the gravy train will continue chugging forward and that they will be astute enough to sell at the peak.

Many a times, they are wrong. Meanwhile, the result may be much worse for those who join the herd when prices are close to the peak. Taking on leverage to amplify such bets worsens the outcome if the trade unravels. In the end, such frothy markets are extremely vulnerable to significant corrections, the timing of which is hard to predict. But when it happens – as it surely will – it is often sudden, quick and sharp.

A speculator’s market

There are many reasons for the rise of speculative manias seen over the past year. For one, investors may fear missing out on a potentially lucrative trend, even though they may not necessarily understand or appreciate its full nature and risks. We saw this during the dot.com bubble in the late 90s and early 2000s, where just slapping a dot.com moniker on a stock name elicits an inordinate amount of investor interest. One could certainly argue that crypto technology and its assortment of digital instruments have replaced the dot.com craze of yesteryears.

Second, irrational exuberance in certain pockets of the market is often the unintended consequence of the financial repression policies of central banks. The Federal Reserve has slashed interest rates to close to zero and the money printing presses have been kept on overdrive to buy financial assets to keep markets flushed with liquidity.

As a result, the average investor is not earning very much in the way of interest paid out in savings accounts, which leads them to hunt for returns elsewhere, often taking on higher risks – some taking on more risks than they can handle. Ultimately, when the opportunity cost of capital is low, the willingness to take risks tends to increase.

Third, speculative behaviour may be amplified by almost frictionless trading in the markets, with plenty of brokers offering a plethora of investment products to trade using very intuitive platforms at very little or even negligible costs. Since the pandemic began, the availability of fresh funds through direct government transfers, coupled with plenty of time to spare yet constrained at how to spend it due to partial lockdown measures, and frictionless channels that minimise transaction costs have stoked massive retail participation as day traders hunt for returns, some of which are clearly speculative gambles.

Put together, these factors could explain the rise of speculative waves in the market. The GameStop saga also showed that the proliferation of social media has made it easier to rally the base and galvanise public support for a singular objective, even for something as simple as buying a stock. A herd forms as a result, stoking a sharp surge in the stock price. Yet keeping the herd together over a sustained period of time is virtually impossible as commitment to a cause is fleeting without a mechanism to enforce cooperation. Therefore, it follows that such speculative gains are often transient and fully dependent on market timing.

Shoulda, coulda, woulda, but didn’t, so don’t

We wouldn’t be so bold as to deny that perfect market timing can be extremely profitable, especially in the eye of the storm. But few can credibly claim to do this well, over a sustained period of time. In the end, the risk-reward may not be worthwhile given the narrow margin for error.

Whether one should do it at all is a matter of risk preference. It depends on the risks you are willing and can afford to take. Importantly, investors must recognise such trades for what they are – speculative gambles. Investors must think carefully how losing the capital on a single speculative bet will affect their financial standing, as opposed to getting caught up with the potential upside. Rational minds should win the day, not greed.

For long-term investors, they should always be able to distinguish between speculation and underlying fundamentals. Our view has always been to invest in assets with good fundamentals at a reasonable price, with a long-term outlook. We stay away from chasing speculative and dangerous fads, and remain focused on sound asset allocation principles and long-term fundamentals in our portfolio management.