All information is correct as at 31 December 2021 unless otherwise stated.
Every investor dreams of getting in on a success story from the beginning. Buying low and selling high is always the goal, but how do you avoid an investment destined for doom?
While it’s easy to get sucked in by the latest craze, it probably won’t benefit us in the long run. To avoid the fads, we have to look at the facts – we’re hard wired to follow the crowd, leading us away from good investing behaviors and following our long-term plan. And we’re wired to do this again and again.
Thankfully, past mistakes make some of the greatest investing lessons. One of the world’s most famous investors Warren Buffett once said “It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes.” And what some of the greatest investors have in common is they’ve been investing for decades. They’ve seen different fads come and go.
We should be investing for the long term. That’s at least five years. The problem is, unless you’ve got a crystal ball, it can be difficult to tell what’s a fad from a genuine trend until it’s too late. And with so much focus on them, it can be hard to fight the FOMO – fear of missing out – to work out if they’re worth our time.
That’s why we’ll take a look at some fads from the past, to see what they can teach us today.
What’s an investment fad?
An investing fad draws in all the excitement, often featuring some periods of sharp price rises, only to ultimately crash and burn. Remember, stock markets can be unpredictable. What was once a chart topper might not be here tomorrow.
They’re usually popular with the crowd and gather lots of attention. But generally, the price rise isn’t built on any solid foundations, like a company’s underlying fundamentals. Just like some fashion trends, what was once hot can become what’s not.
Lessons from the Past
Dot-com bubble – companies that make no money
The internet bubble in the late 90s and early 2000s saw investors from all walks of life flock together to pump billions into small technology-based companies. Everyone wanted a shot at cashing in on the internet boom. Companies vowed to change the world, had the share price valuations to match, but were wildly unprofitable.
Investors loved to buy a stock if its business had even the slightest link to the internet. Ultimately, there were some good ideas in the mix – Amazon was one of them. But at the time, the winning company or technology wasn’t clear – everyone was set up to win.
The internet start-up stocks didn’t live up to their hype and investors lost patience, so the bubble burst.
The tech-heavy US index, the NASDAQ Composite rose and fell by over 200% between 1997 and 2002 – giving up all its gains made during the bubble. It’s important to remember that young companies carry massive amounts of risk, and that doesn’t always pay off.
Dot-com bubble – NASDAQ composite (price index)
Past performance isn’t a guide to future returns. Source: Lipper IM, to 31 December 2002.
The rise of the ‘Go-go’ fund – speculative, high-risk investments don’t always equal high reward
Back in the 60s, the rise of the ‘Go-go’ fund was the latest craze in the investing world. Go-go funds were heavily focused on high-risk companies, usually growth stocks, drawing in investors by attempting to collar above average returns. But managers were shifting portfolio weightings around based on speculative information.
A fund is an investment that pools together money from lots of individuals.
The fund manager then invests the money in a wide range of investments. During this time, investors flocked to markets trying to get a piece of the pie. At this point though, funds had only recently become available to the average investor. So they didn’t have the experience, or past investing lessons, to realize you can have too much of a ‘good’ thing.
This was during a thriving bull market. And being part of a market that only seems to go up can lead to misplaced confidence.
Because a lot of these funds held such speculative investments, not all of them could withstand the test of time. And even though some would’ve benefitted, it didn’t pan out for them all.
It brought to light that growth investments weren’t the only important factor when building a portfolio. After this, people became more aware of the importance of diversifying their investments. Sometimes, the less exciting is equally as important if you want a portfolio to weather the market ups and downs.
The ‘Nifty Fifty’ – good companies that get pushed to crazy valuations
In the 1950s, the Nifty Fifty were all the rage. A group of 50 stocks that were said should be bought and never sold. The companies all had similar characteristics – they were high quality franchises of the time with strong balance sheets, benefitting from a growing economy.
But what had once been an investment trend based on fundamentals, turned into an abounding euphoria. At the peak of the bull market in 1972, the average price-to-earnings (PE) ratio of the Nifty Fifty reached 41.9. Compared to the US stock markets’ PE ratio of 18.9, it had climbed to unimaginable heights. During the bear market of the 70s, large price gains were wiped out.
Although this isn’t unusual during a downturn, the Nifty Fifty is a prime example of how speculation, founded on overstated optimism, can drive prices above their value. Sometimes it’s important to remember “price is what you pay, value is what you get” – the quality of the company is the same, the only thing that’s changed is the amount you need to pay for it.
How to tell a trend from a fad
A trend is the overall direction of a market or share price, and it’s not always easy spotting trends before making a decision on what to invest in. The key difference is staying power.
Trends gain momentum over time. They can be slow burners that can take a while to progress. Fads on the other hand burn out almost as quickly as they came to light.
If you’re looking for individual companies, your first step should be finding a business with solid financials – this means a strong balance sheet with manageable levels of debt. And with interest rates on the rise, being able to manage debt is particularly important.
You’ll need to look for companies with strong free cash flow, revenue, and a growth in profit.
That’s not to say you shouldn’t think about companies with the potential to grow. High growth businesses are typically valued based on their potential, so the underlying figures don’t always warrant their price.
These companies might still have some hurdles to overcome, but if you think they can stand the test of time, they could be worth your attention. Just make sure they only make up a small portion of your portfolio until you can be certain.
Alternatively, investing in funds is a great way to invest in a range of companies within a single investment. They invest in a variety of sectors to offer more diversification to smooth out some of the ups and downs of investing in specific companies.
Some specialist funds focus on niche areas if you’re after something a bit different. Again though, they should usually only make up a small portion of your portfolio.
But like we’ve learned from the ‘Go-go’ era, investing in funds isn’t right for everyone. You should only invest if the fund’s objectives are aligned with yours and you understand the specific risks of a fund before investing. It’s essential it all forms part of a diversified portfolio. Wherever you choose to invest, the value of your investments will go up and down. You could get back less than you put in.
Just remember, by doing what others do, you’ll probably end up deviating from what matters most – your own plan. It’s important for you to see the full picture and stay diversified. Investing your money across a wide range of investment types, sectors and geographies reduces the overall impact to your portfolio if things take a turn in one area.
Fashionable investment approaches will come and go, but you need to remember a long-term, disciplined investment approach based on robust research is what really counts.
Investing behaviors – how to invest for success
Explore our Investment Times January 2022 edition for more articles like this.
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