All Major Asset Classes Are Crazy Overvalued. It's Time For Risk Management
- How to identify a financial bubble before it costs you money.
- Why Bitcoin is a symptom of the problem, but not the problem itself.
- The one missing ingredient for a historic, final, market top of epic proportions.
- Specific risk management strategies that will protect your portfolio.
It's time to get concerned. (Ed. Note – This article was published Jan 27, 2018 – just one day after the risk-adjusted top in the stock market and before the bitcoin bubble had burst.)
It's not natural for the U.S. stock market to march relentlessly higher into extreme overvaluation with almost no volatility. It's one sided. It's abnormal.
A healthy market rotates up and down within an overall trend because there's a balance of buyers and sellers.
It's not natural for bonds to trade at negative interest rates in many parts of the world with U.S. interest rates approaching zero. It's also not natural for the yield curve to invert (hasn't happened yet, but very close) where the short end has higher interest rates than the long end.
A healthy credit market pays interest for the use of money and charges a premium for the extra risk of lending over longer periods of time.
It's not natural for people to exchange the equivalent of a new car for bits and bytes in the internet ether (otherwise known as cryptocurrency) created out of thin air by some unknown guy in the dark recesses of his computer. Nor is it natural for any sound “currency” to rise by thousands of percent in a year, or for common citizens to “mine” thousands of new “currencies” in a year to cash in on the crypto-mania.
Even worse, I can't show you what a healthy currency looks like because all currency today is “fiat” explaining the unhealthy economic backdrop that gave rise to Bitcoin (and all of these other financial bubbles) in the first place (more on that below…).
I could add real estate to this list of speculative frenzies because it certainly qualifies, but everything else is so crazy-extreme that it makes the real estate bubble pale in comparison. Obviously, that fact isn't healthy either.
Something is wrong today.
As Warren Buffett said, “be fearful when others are greedy, and be greedy when others are fearful”.
Greed is in all the major asset classes.
It's time to be fearful.
Get This Article Sent to Your Inbox as a PDF…
I Didn't Want To Write This But…
This bubble bothers me more than the last three (stock market in 2000, real estate in 2007, bond market from 2013 to current).
This one is bigger, badder, and disturbingly different.
I provided written warnings to subscribers about each of the last three bubbles prior to bursting. In the past, I welcomed them as government manufactured buying opportunities for smart risk managers.
But there's something wrong with today's bubble that makes me more cautious than usual (not that asset bubbles should be “usual”, but that's the reality of the government manipulated markets we live with today).
Until now I've been passively observing the escalating overvaluation in all the major asset classes enjoying the increase in values like other investors. It's been an amazingly profitable ride.
I even ignored the Bitcoin speculative mania as an interesting sideline – a curious, little pet-bubble if you will – until I had a disturbing realization during December as prices pushed the $20,000 per coin level that prompted this article (Yes, I've been sitting on publishing this for two months because it bothers me so much).
Something very important is happening, Bitcoin is a symptom, and the conclusion is not what you would expect. Let me explain…
How To Identify A Financial Bubble As It Peaks
I get interviewed by various media channels a couple times a week. For the past three months, every interviewer asks my opinion about Bitcoin. Also, my coaching clients and course clients are all asking me about Bitcoin.
This has only happened twice before in my career…
- The first time was the two years leading up to the 2000 final valuation top in the U.S. stock market. Every client wanted hot stock tips for the dot-com bubble. Companies with no business model and no clients were being valued in millions. The NASDAQ sold for an insane 200 times earnings. Everybody involved in tech stocks was getting rich, and it was a “new era” because the internet was going to change all valuation rules for business (sounds a lot like the blockchain and cryptocurrency today, doesn't it?). I started getting cautious in 1998 (two years too early), sold my hedge fund investment management business to manage risk exposure, and wrote public warnings (before this site was a blog, it had a newsletter). Typical of all true manias, the emotion was so strong and the beliefs so deeply entrenched that people literally can't see the obvious. In this case, the canary in the coal mine was when one of my early coaching clients, who built his fortune in tech stocks, fired me in frustrated anger when I had the gall to advocate risk management to preserve his fortune in preparation for the bubble bursting. He believed tech stocks were in their infancy and disliked my message, so he killed the messenger. Unfortunately, he suffered life-changing losses when the bubble burst.
- The second time it happened was during the two years leading up to the 2007 top in the U.S. real estate market. Every new coaching client wanted to get rich in real estate. People were so blinded by the consistency and reliability of the gains that the conventional wisdom was that real estate never went down. Seriously! Nobody believes that today, but that was investment truth back then. My wake up call for that bubble was when tenants for my C-class apartment buildings with credit history so bad they didn't even qualify to rent a $600 per month apartment were buying $300,000 houses with no down payment loans (they were called “liar loans” back then). I began the process of liquidating all of my investment real estate in 2005 to manage risk and it took 2 years to unwind the portfolio before the eventual decline. The canary in the coal mine demonstrating the emotion driven blindness of the time was when I was publicly ridiculed for my decision to sell and pay the taxes rather than 1031 the gains to newer, bigger properties. I'll never forget the verbal abuse by certain real estate professionals calling me “stupid” with one in particular so emotional that he was yelling at me with spittle coming out of his mouth. The subsequent decline cost many of his clients their entire life savings.
The Bubble Du Jour
I share those stories so you can see what investment bubbles look like as they occur and how people invested in those bubbles emotionally react to warning signs of problems when the bubble is in late stages. The setup in order of occurrence has been:
- Extreme overvaluation sets up the condition for extreme downside risk.
- Next, a speculative mania causes a final price acceleration phase resulting in an emotional peak as participants get rich. This attracts media attention and crowd psychology results.
- Third, participants who are financially committed to the bubble become emotionally irrational and aggressive to contrary opinion.
- And finally, certain technical indicators break down (specifics depend on the market that has bubbled), signaling the decline has begun.
I have been getting progressively more cautious over the past few years based on cycling overvaluation extremes in different markets (since all the major markets except commodities are overvalued now), but I've continued to dance while the music played because the other three warning signs weren't in place… yet.
My first word of caution came via this post announcing the bond market bubble back in early 2013. I declared in that post there was no positive mathematical expectancy (net of inflation) remaining in the bond market, and that the only sensible decision from an expectancy investing framework was to exit the asset class. While some embraced the idea, others ridiculed it because it violated firmly held tenets of asset allocation/diversification. They were blind to reality, even though the math behind the conclusions was obvious, provable, and has stood the test of time.
Overall, the response to that article was muted. The negative comments were rational indicating no emotional extreme had been reached even though the math was unequivocal. Subsequent market movement have proven the thesis (so far) with interest rates remaining today in the range where they were back on publication date, supporting the best case scenario conclusion in the article (so far) and proving investors would have been better off to reallocate to competing assets and away from bonds.
The longevity and depth of this credit market bubble reaching a 5000 year extreme is the key to understanding why all asset classes are at a price extreme now. The credit boom is what's driving the equity and real estate booms because investors are forced to chase risk assets in search of yield, resulting in risk being mis-priced.
That's why the stock market has continued marching to new all-time highs with the most amazing, record low volatility. As of this writing, the only time the U.S. market has been more overvalued as measured by the CAPE ratio is the narrow window of months preceding the final 2000 top. Other measures of valuation besides CAPE are reaching new all-time highs. Worse yet, valuation levels lower than today's comprise a Who's Who of the worst times to invest in stocks.
Not only that, bonds, as already stated, are in uncharted territory after years of ZIRP (zero percent interest rate policy). This is important because conventional asset allocation relies on bonds moving opposite to stocks during a decline as the Fed lowers interest rates in the face of economic turmoil, but that may be difficult to achieve from the currently low interest rates.
Additionally, real estate has risen to extreme bubble valuations (but remains beneath the 2006-2007 record valuations).
Finally, commodities are hitting record low valuations relative to equities. This is also extreme, and rare, but in the opposite direction of all the other asset classes.
The point is that all major asset classes are at (or near) an extreme in valuation at the same time. That's important.
Three Ways To Value Any Asset
To understand the implications of that statement, let's first establish a common base of understanding by looking at the three ways to value any asset:
- The Greater Fool Theory: In real estate they call it “comparable sales”, and in paper assets like stocks and bonds it's the most recent transaction. The implication is the current market price represents fair market value because it's the price willing buyers and sellers are trading at. The problem is it's absolutely useless for indicating bubbles because it really only tells you what other fools are willing to pay for something.
- Assets: In real estate this would be replacement cost analysis, or how much it would cost to rebuild the structure net of depreciation. In stocks it's book value or Q-ratio as a measure of the underlying assets per share. This is a very important measure of risk because it tells you the premium or discount you're paying relative to what the underlying asset is worth. Extreme premiums are associated with periods of irrational exuberance delivering high risk, and extreme discounts are associated with periods of fear, lower risk, and higher subsequent investment returns.
- Income: In real estate income it's measured as NOI (net operating income), or in retail residential it's often measured as gross rent multiplier. In the stock market it's the P/E or price earnings ratio, commonly measured through CAPE, or cyclically adjusted price earnings ratio. Income is my favorite valuation measure for indicating risk because ultimately the value of any asset is the discounted present value of its cash flows. That's fancy economic jargon for saying an asset is worth what it earns. It measures present worth based on the future benefits of ownership.
Each of these three methods separately provides a different objective measure of valuation for any asset. Interesting conclusions develop when you compare and contrast all three together.
There are two key points to keep in mind with valuation analysis:
- Extremes in valuation provide the most information value. Strong statistical significance occurs that effects mathematical expectancy at valuation extremes (like today).
- The second important point is that price and investment value are two separate and distinct things that should never be confused. Failure to make this distinction will eventually cost you money.
Despite academic rumblings about Efficient Market Hypothesis and other theoretical frameworks supporting buy and hold philosophy, statistically valid investment opportunity occurs when price and investment value diverge in an extreme way. This has occurred at selected times throughout history, and more importantly (and the reason for this article) is occurring again now.
Today's Investment Bubble Revisited
And so that long-winded analysis of valuation methods sets the context for understanding our current asset bubble.
I safely call it an asset bubble because none of the major assets classes (stocks, bonds, real estate) make any investment sense when judged against the only two valuation criteria that matter – assets and income – as described above. They're all priced at or near an extreme risk premium relative to both underlying assets and income, implying several important conclusions:
- Expected returns over 7-15 years will be lower and more volatile than historical averages. That's politically correct language for saying something unthinkable to the buy and hold crowd. We have entered a period where the risk of owning the U.S. stock market over the next 7-15 years does not justify the reward over the same time period.
- The only thing supporting the current bull market in the major asset classes is momentum and “Greater Fool Theory” valuation metrics as described above. As long as momentum prevails the market can still rise dramatically over the short term. Momentum is a powerful force. However, mean reversion assures that all short term gains between now and the final top will be given back abruptly… and then some.
- A smart investor should be on the lookout for the remaining bubble conditions (as described above) to be satisfied, thus indicating the final turning point because valuation and anecdotal evidence are very blunt-edged tools that can be wrong by years. Overvaluation is a necessary precursor for a bubble, but it's not sufficient. Notice how each of the previous bubble top descriptions in 2000 and 2007 discussed a 2 year window. The same is true with this analysis.
So while item 1 states unequivocally that we've already entered an unfavorable intermediate term investment horizon of 7-15 years, items 2 and 3 tells us the short term remains indeterminate until the remaining factors narrow the time window.
Stated another way, we are close to the end of this historic bull run resulting in an asset bubble of epic proportions that will ultimately result in life-changing losses to investors, but certain puzzle pieces have been missing… until recently.
The window is getting much closer to closing…
There Was No Mania… Until Now
The most disconcerting aspect of this entire bubble has been how calm it is. That's not how bubbles blow up.
Most bubbles finish off the overvaluation phase with a rapid price acceleration phase that causes sudden riches for investors, resulting in mass media attention and a polarization of public opinion. However, this final acceleration phase usually begins from lower valuation levels than we have today and usually occurs in a single market, not all major markets simultaneously. It's where all the symptoms of excess appear.
In other words, even though all three major markets have relentlessly marched to record price highs (and record low yields) creating historic overvaluation, there's been no clear indication of a speculative fever to create a vacuum underneath prices resulting in a collapse. Instead, there's record low volatility, no animal spirits, no asymptotic growth curves, no crazy stories of sudden riches. In short, until recently we've seen none of the circumstantial evidence supporting insane animal spirits taking over the market in a fit of speculative greed.
Every bull market top has its poster child of irrational exuberance where proven economic common sense was tossed out the window because “this time is different”.
- The 73-74 bull market had the “Nifty Fifty”
- The 2000 top was marked by the dotcom bubble and the internet revolution
- The 2007 top had insane real estate valuations supported by a belief that real estate never went down.
Which brings us full circle to today – Bitcoin – and the reason for this article warning you that we've finally entered the window of time to take risk management seriously.
BitCoin Fulfills The Speculative Mania Criteria
There is a long history of bubbles being marked by the issuance of a new “type of currency” that catches public imagination resulting in feverish trading.
- John Law issued shares of the Mississippi company (see Wikipedia article for “new currency” parallels)
- Dutch Tulip-Mania (see Wikipedia for parallels including futures trading to capitalize on speculative fever when underlying transactions were difficult similar to Bitcoin today).
Bitcoin has delivered one of the key indicators of important market tops – an irrational, speculative fever based on “this time is different”.
- Bitcoin has an asymptotic price climb.
- Stories abound of ordinary people getting instant riches from Bitcoin.
- Bitcoin is everywhere in the financial press. I can't be interviewed without being asked my opinion about it. My friends and clients are all asking about it.
- Bitcoin completely fails the two primary valuation criteria listed above for analyzing an investment – it has no intrinsic value, and it yields no income.
- Therefore Bitcoin is purely a speculation and not an investment, just as Tulip Bulbs and Mississippi shares were in years gone by. It could go to a million per coin, or it could go to zero. There is no intrinsic value except what human minds decide to give it.
- Bitcoin is rallying under the “this time is different” moniker. It's a new currency, free from government manipulation, limited in supply, and part of the digital revolution. It's different this time, because every bubble is always different every time.
But there's one problem with this analysis…
The important overvaluation we need to worry about is in stocks, bonds, and real estate; however, the bubble has occurred in a totally unrelated market – cryptocurrency.
That difference bothers me.
If the collapse were to occur in stocks, then the normal order of events should be to inflate the bubble in stocks to set up the vacuum under prices for the ensuing decline. That hasn't occurred yet, which makes this particular bubble so disconcerting.
In other words, you have bubble valuations in stocks, bonds, and real estate right now (February 2018), but no final price acceleration phase that polarizes public emotion. The extreme overvaluation level sets up the necessary condition for the subsequent price collapse, but historically that hasn't been sufficient alone. Also, the fact that all three markets are extremely overvalued at the same time is unusual and risky.
The point is there's usually an acceleration phase and public mania in the market that collapses. We've seen it in Bitcoin, but not in the other major markets.
What Scares Me About Bitcoin
I believe Bitcoin is a symptom of the real problem. It won't be the cause.
Let me be clear. I believe the blockchain is 100% the revolution that proponents claim it will be. It's going to change life in ways we can hardly imagine, just as the internet was 100% the revolution it was claimed to be back in the 1990's. That part of this story is likely real.
But just as investors in the dotcom bubble got wiped out despite the internet fulfilling its destiny, investors in the cryptocurrency bubble will face a similar fate despite blockchain fulfilling its destiny.
So the scary part is not the cryptocurrency bubble. That's too small, too obvious, and too disconnected from important economic fundamentals to be anything more than an interesting distraction.
What worries me is the premise that's driving the cryptocurrency bubble. It's anti-government. The speculative fever is driven by the masses distrusting all government economic manipulation and fiat currency. If you aren't clear about this premise then just try to imagine Bitcoin gaining speculative interest in a hard currency world backed by gold where no inflation existed, a dollar would have the same buying power 3 generations from now as it has today, governments balanced their budgets, and there was no looming debt crisis. When you wrap your head around this strange world order you realize there'd be no crypto-mania because there would be no problem for cyptocurrency to solve.
Stated another way, the string of financial asset bubbles over the past 20 years all owe their underpinnings to fiat currency and government policy manipulation in the economy. The current cryptocurrency bubble is the most overt example.
The fact that the current bubble-du-jour is a new age currency outside of government policy delivers a disturbingly poetic reference to all that is economically wrong today with government policy and the resulting mass psychology driving the animal spirits.
In a perverse way, Bitcoin has become a positive bet against continued government success at fabricating stable economic growth through financial manipulation.
I say perverse because the normal loss-of-faith bet would be to sell risk assets and/or the domestic currency itself (the dollar).
But today's speculative bubble is so persistent and pervasive across all asset classes that it managed to create a new “long” speculative bubble that's essentially a “short” position against all the other speculative bubbles happening at the same time.
Worse yet, the public “gets it”. Disbelief in our fiat financial system is now so widespread that it resulted in an anti-government speculative fever among the masses.
Meanwhile, risk assets relentlessly march to new highs like lemmings to the sea.
I've never seen anything like it. This time really is different (sort of). But in all the wrong ways.
And now the dollar is finally breaking down, which is what you would normally expect for this emotional back-drop.
The Other Missing Ingredient
Another aspect of bubbles that I've learned to expect is being personally attacked near the top for advocating contrary opinions that include prudent risk management. It has happened every time and marks the emotional peak where public opinion is so one-sided that the idea of managing risk invokes an emotional, irrational response. Until a few weeks ago it was missing from this bubble, but that changed as well…
I was recently interviewed for a podcast (not listing the name because nothing is gained from pointing fingers) targeted at the FIRE (financial independence retire early) community. In that episode I pointed out how the conventional investment approach to FI (low cost passive index asset allocation in paper assets) lacked adequate investment risk management for the current market environment.
Surprisingly, it was the most controversial and polarizing interview in the show's history, garnering more comments in the Facebook discussion group than any other show. Listeners either loved it, declaring it the best episode yet, or they hated it. I was called a “scum bag”, my professional reputation was questioned, and I was personally attacked. People were so emotional that several said they had a hard time listening and others commented how it was “a sucker punch to the gut”.
Seriously? It's an audio interview where I discussed financial topics including risk management. What gives?
I've been on 200 podcasts and never got a reaction like that. The normal response is listeners appreciate an interesting conversation where different ideas are shared. It's just a conversation.
However, this interview was different because I made a crucial mistake. I failed to reconcile the fact that the market had reached an extreme overvaluation, thus polarizing sentiment with the fact that this community was fully invested in this bull market with no serious risk management discipline. Their own survey shows the vast majority hold 90% (or more) of their assets in stocks. Many have recently gained early financial independence, or expect to retire soon, based on their stock portfolios.
In hindsight it's obvious they'd respond emotionally and aggressively to alternative viewpoints! Dohh! Their financial security and future life plans depend on buy and hold working in the future like it has in the past.
As it turned out, this polarized emotional response was identical to other market tops where in 1999, my coaching client that made his fortune in tech stocks got aggressive and fired me because I advocated risk management to protect his fortune. And the real estate pros in 2006 cussed me out and called me “stupid” for cashing out all of my investment real estate and paying taxes to manage the downside risk. In each situation these people were invested. Their financial security is dependent on the bubble du jour continuing.
That makes their emotional response a key contrary indicator.
Get This Article Sent to Your Inbox as a PDF…
The Final Missing Ingredient
And so that leaves us with everything in place (almost) for a historic, final market top of epic proportions (measured in terms of a decade, or longer), except for two things…
- We have extreme overvaluation. (Worse yet, the overvaluation is in all major asset classes at the same time, except commodities, which are the polar opposite.)
- We have a speculative mania that has captured mass psychology. (Worse yet, this speculative mania is anti-currency and anti-government, implying loss of confidence in the system that supports the bubbles in all the other asset classes.)
- We have an emotional peak demonstrated by aggressive behavior to contrary opinion advocating risk management.
But there are still two things missing to make this analysis rock solid.
The first factor missing is for the major markets to actually break down.
Analyzing the “break down” is beyond the scope of this already-too-long article because it encompasses market internal indicators like credit spreads, divergences between equity indices, yield curves, investor sentiment, price momentum, quality indicators, economic indicators, M&A/IPO indicators, and more. However, it's worth noting that this article is being published at the beginning of February, 2018 rather than months or years ago when valuations were already high, implying the market internal indicators are getting “warmer”.
But “warm” is not “rolled over” yet, so until various internal indicators fail, we still lack clear evidence of momentum failure. That means the animal spirits remain in control. The clock is ticking, but it hasn't struck midnight quite yet.
The second thing that's missing is how the acceleration phase causing sudden riches resulting in mass media attention occurred in an unrelated market – cryptocurrency. None of the major markets (stocks, bonds, real estate) have gone through the sudden price acceleration phase that typifies a final top… yet. That leaves open the possibility for that sudden acceleration phase to still occur.
However, your key takeaway should be how all the other evidence makes it clear how this party can only continue for the short term (from now to less than 2 years on the extreme high side, probably less). We're now at the point where this is a bubble looking for a pin. Any continued rise just gives further to fall, and any new gains should be rapidly reversed once the downturn begins. This party is on borrowed time, which is why I wanted to give this warning.
Yes, it's still possible for one (or more) of the major markets to run through a final price acceleration phase to cap things off, which is what would cause the longer time horizon pushing 2 years. But overvaluations are already high enough and there's enough anecdotal evidence in place that it's prudent to ring the warning bell and call in the defensive team (risk management) to protect against excessive loss.
How Risk Management Works
Risk management acts like insurance. It's a complete waste of money when there's no problem, but when disaster strikes it'll save you from suffering a life-changing loss.
You intuitively understand how this works with homeowners insurance where you hope that every renewal is a small waste of money, but when that rare fire strikes, insurance will be the only thing that saves you from financial disaster.
Smart investors who practice risk management have been renewing their policies without so much as a spark (market volatility), not to mention a fire (bear market), for years. It's been a complete waste.
That's about to change.
Nobody has a crystal ball so I can't tell you exactly when mass psychology will sober up, or if we'll go through a final acceleration phase in the major markets before they collapse, but mean reversion assures it's far closer and will be far uglier than any investor wants to endure on a buy and hold basis.
There's enough evidence in place that it's prudent to get cautious. Yes, it would be normal to experience price acceleration from here first before collapsing which could extend the time frame up to a maximum of 2 years, but the breadth and depth of the overvaluation is already abnormal. This isn't just one market that's overvalued. It's all the major markets (except commodities).
And the cryptocurrency mania reaching mass consciousness is a warning of possible loss of faith in government economic policy solutions (“The Fed Put”), which is particularly worrisome because belief in omnipotent Fed policy is the only thing that's shortened each of the prior collapses resulting in ever increasing bubbles.
For these reasons, it now makes sense to err on the side of caution by getting your risk management strategies in place. Proper risk management will allow you to still participate if the party continues, but give your portfolio downside protection when the bubble bursts.
To help you I have a 100% free mini-course on investment risk management coming out in a few months. I'm working on it right now and it's my top priority. I'll announce it in this newsletter when it's ready. However, if you don't want to wait that long you can get all of that instruction (and a lot more) in my advanced wealth building course here. It will show you how to structure your portfolio to better manage risk, including extreme event risk.
While I can't explain all the risk management strategies that are possible, a few actionable ideas include:
- “Deep diversification” (where you diversify by strategy and source of return, not just asset class, by identifying sources of return that inversely correlate with the stock market)
- Diversify into certain business and real estate assets where the outcome is driven by a micro-economy
- Diversify into alternative assets
- Switch to an investment process that includes an exit discipline
- Increase allocation to cash
- Switch from high volatility, high beta assets to low volatility assets
- Diversify into favorably valued assets that might include domestic value plays, certain emerging markets, commodities, and commodity producers
- And much, much more
There are many risk management strategies to consider that can help you protect your wealth, but you can't wait until everything rolls over before you put them in place. Once the tide goes out, everyone can see who's standing naked.
The current extreme in valuation (and other anecdotal evidence) makes it clear that an equally extreme mean reversion is a fait accompli. It's only a question of “when”, not “if”. You don't have to predict the final outcome to benefit; you just have to prepare in advance.
I hope this warning (and this course) help you think through the issues so you aren't caught by surprise.
Here’s how to make more by losing less…
If you're looking for an investment strategy that goes beyond "buy and hold" while controlling risk and requiring as little as 30 minutes a month to manage, this is the answer. It’s so good I wish I had built it myself. Take back control of your portfolio and start getting results today.
Thanks for your level-headed advice. I love your book about how much we need to retire. I also enjoyed meeting you at FinCon.
I agree with all you are saying here. I lived through 1987, 2000, and 2008. You really have to experience it to fully grasp the magnitude of the emotional turmoil that hits you.
I’m at 40:40:20 or so (bonds:stocks:other) but am buying into more businesses and real estate. After reading this, I may boost my emerging markets and commodities.
Glad it was helpful. Yeah, it’s hard to understand until you’ve lived through a few of them. This one is shaping up to be “special”.
Love the article. As always very nice advice. Thanks. Your training has helped me.
Great to hear from you, Dom!
I know which podcast you we referring to, but you can count me as one of your fans and not one in the angry crowd! I think what you have to say can be hard for some to hear, but it’s valuable nonetheless. Thanks for putting yourself out there to share your knowledge and insights.
Thank you for your support, Chrissy!
Love your website and podcast Todd, thanks for all of the FREE knowledge you share, and more importantly, the time you spend doing it. I’ve learned a lot from you, and will continue to follow your blog. It’s disappointing that some people get so easily offended when you promote your business (courses, books, coaching, etc.). Not sure why people think you’re obligated to give away your life’s work and knowledge completely for free. I for one, appreciate everything you share, so please don’t get discouraged. Keep up the great work!
Thank you Scott. I soooo appreciate your comment. I think it’s four things: (1) there are a lot of scammers and hard-core marketers giving marginal value so healthy skepticism is legitimate (but baseless attacks are uncool) (2) the easiest thing in the world is to be a critic. (3) it’s far easier to tear down than it is to create something valuable (4) there’s an entitlement mentality that goes with the quality and level of free stuff on the internet. Many people lose sight of what it costs to provide all this for free and the value of someone having a valid business model so they can give even more value.
Geeze. That was intense Todd! Thanks for the advice. I have an extremely small investment portfolio right now, so I haven’t been worried too much about a bubble (and almost welcome it, this early in my life). But I’m excited to go through your course on risk management. It’ll definitely help me as I move forward and grow my wealth.
As always, thanks Todd.
Yes, if you’re in the early stages of building wealth then a return to reasonable valuations and (hopefully) sound economic policy would work in your favor over the long term. The people that get hurt are those with assets that are in the advanced stages of their lifecycle of wealth.
As always, great analysis with great clarity. Thanks for being an advocate of professional investing. Fed interest rate could play a crucial role in how the next few months unfold as well.
I know which podcast you’re referring to. I’m an active member of that community and heard the podcast the day it came out.
I’m in my 60s. I’ve lived through the meltdowns of 1987, 2000, and 2007. I recognize the signs of a peak. I agree that we’re very close to a major downdraft.
I tried a couple of times to share graphs of the Buffett Indicator and the CAPE Index on that FB page, but you’d swear that I was taking a swipe at the Virgin Mary or something by the blowback I received. It’s like religious dogma: VTSAX, VTSAX, VTSAX, etc….
I’m VERY, VERY close to putting everything into a money market fund, waiting for the dust to settle in a few years, and start buying assets Buffett-style. I’m not rich by any means (net worth: just south of $300,000), but I ain’t got the time to endure another 1930s sideways slide into my 70s.
I’d like to THANK YOU for agreeing to that podcast. You offered a POV that the community definitely needs to hear. There’s a groupthink that is most frustrating. All they want to hear are POVs that confirm their biases. Anything else is heresy and the speaker must be repent and shown the error of their ways.
I’d like to remind everyone of Warren Buffett’s Two Rules of Investing:
1. Never lose money
2. Never forget Rule #1.
Yeah, I purposely avoided references to religious dogmatism but that would not be incongruent with my experience. In fact, it’s completely consistent with the emotional polarity point made in the article. It’s interesting to know that you had a similar experience. Thanks for sharing.
Todd, I’m here due to the mentioned FIRE podcast. Your words rang true and different because they spoke of the other side of the equation, “risk management,” rather than just tracking historical upside potential. While I’ve always known risk management to be important, this was the first time I heard someone speak of it with such intentionality. So… I’m now here on your site to learn more. Thanks for the enlightenment! Thankfully I wasn’t aware of the facebook reactions!
…and regarding the intent of this specific article: wow, spot on. You’ve articulated this in a very clear way and given me much to ponder and distill into actionable items. Thanks!
You’re welcome,David. I’m glad it was helpful.
I found your podcast episode interesting… I’m on the shady side of 50 so I found the points you made on risk management were good food for thought. Real estate prices here in Australia are some of the highest in the world… we’ve all been saying it’s a bubble for years but the prices keep marching higher!
thank you for such a detailed article . i have seen through the bubble in crypto and read about the underlying reasons ( about the distrust in government ) but i never really think it the way u have mentioned . thank you very much !
I have also listen to that particular podcast and u made perfect sense in it and impressed many people with your knowledge . especially about one thing obvious that no one else is looking at ( inflation)
Please continue to wow us with your insights , looking forward to more articles from you .
Thank you for publishing this. I’ve read the article a couple of times to digest all the information. It will be interesting to see how this market cycle ends. It’s strange how many in the FIRE community are so mindful of value in all other aspects of their lives but completely disregard the argument when it comes to paper assets.
Amen! Fully agreed. An equally amazing logical contradiction to add to your list is how they view a major market declines as a “risk on” buying opportunity but they don’t view a major market run-up as an equally valid risk management opportunity. They’re both mean reversion. It’s the exact same thing. Strange….
Thank you Todd for your continued service work, your articles are insightful and thoughtful. I’ve been reading for several years now and appreciate your level headed, and sometimes contrarian approach. You’ve always served as a great measuring stick against the herd mentality, which has been a constructive way for me to self reflect and question any “emotional” attachment I may have towards any given strategy. Best
Thank you for your support! I’m glad my writings have been helpful.
I wonder if indexing is contributing to the low volatility? With this potential risk:
Thanks for the great article Todd!
I found you back in 2014 and have really learned a lot from your newsletter. That being said, I read this article yesterday and realized that I’m pretty far off track from having a financial plan that has a viable risk management strategy (due to my decision to simplify my ‘strategy’). I found the FIRE community a year or so after I found you, and always felt the investment advice there is very simplistic and too one-size-fits-all. However, the simplicity of it appealed to me and some aspects of it helped me feel better (for a time) about certain investment approaches. But I’ve been quite uneasy about the path I’m on for awhile (95% stocks) and have genuine concerns about how to shift it to go into risk management mode.
My biggest question is:
Since Bonds seem to be in a precarious situation right now AND
I don’t believe have the bandwidth/skills to start an income producing business outside of my W-2 job AND
It would cause heavy marital distress if I proceed into another Real Estate venture (I lost a significant chunk of money a few years ago in a RE venture gone wrong)…
…What would be an appropriate risk management maneuver to shift my Stock assets into?
Please look carefully at the list of strategies provided at the end of the article. There is a wide variety to pick from so you can choose what fits your needs. I included adopting an investment process that includes a sell discipline (ie – trailing stops or trend following) which would allow you to participate in the acceleration phase if it occurs while limiting downside risk exposure should the final top prove closer than any of us would like. I also included diversification to value based assets since they tend to outperform growth during declines. Again, just look carefully at the list and decide what fits your personal situation and demeanor. As you correctly stated in your comments here, one size does not fit all. That’s why there are a variety of valid choices to pick from. I hope that helps!
Steve – You are correct. It’s not everyone in that FIRE FB community, but it’s a very high percentage. I don’t mentally buy into the dogma there, but I did essentially buy into a lot of it with my actual money. The incompatibility of the investing knowledge I have from reading Todd and the siren call of the simplicity of the FIRE approach has left me in a very uneasy spot. As a member of that community you WANT to believe its as simple as they teach, but it JUST NOT! Individual circumstances and where you are in the journey make a HUGE difference and many in the group seem to think that acknowledging the fact that one-size does not fit all somehow means that it invalidates THEIR own individual decision to follow the simple path plan. Well, I’m someone deep in it and it is not a good strategy for me at my stage of wealth building with my near term goals.
Great stuff, very interesting and great depth! Most of it resonated although some a little over my head. I’ve seen a lot of stuff about overheated markets but nothing about how to protect against it if everything is overvalued. I guess there’s no simple answer and it does require a full course. I considered the simple solution of just being mostly in cash and entering the market again after the crash but that’s timing the market and tricky plus there’s the fact that the dollar could well be devalued.
Just to be clear, I did provide actionable solutions at the end of the article that don’t require you to take the course to implement.
Guy R Wilson
Thank you for this advice. I also found your book very good and am moving money into commodities, government bonds and cash to be at 40% as I type this. I have always been very aggressive for building wealth but now am within 3 years of retiring and need to provide RISK MANAGEMENT. Don;t let their name calling get to you…..you get IT.
Todd – this is a timely and much-needed article. Thank you!!
I heard the podcast that you refer to. I, too, agree that while many kudos are due to the FIRE community, there is often significant oversimplification (particularly as it concerns risk management).
I am a big fan of your work, and in particular, two of your excellent books: “How Much Money Do I Need to Retire?” and “The 4% Rule.”
We are very fortunate to be able to be able to adopt your “simple three rule system for income-based retirement planning” from the Model 3 in “How Much Money Do I Need to Retire?”
That is, we are able to live entirely off net positive cash flow from multiple real estate properties, plus a small pension and social security. We, therefore, will never need to touch our significant 60/40 mix of stocks and bonds – not even the dividends. The only exception is that we will need to pay some of our RMD taxes out of dividends, but we have way more dividends than the RMD taxes.
In short, with the exception of paying taxes on RMDs, we will never touch our portfolio of stocks and bonds at all.
With our circumstances of never selling any shares of bonds or stocks, and only using a small portion of the dividends for RMD taxes, would you let our 60/40 portfolio “ride” as-is, or would you still consider employing some of the list of risk management strategies at the end of the article? (We are in our mid-60s and retiring very soon.)
Thank you again for all of your service and work!
Thank you for purchasing my books. I’m glad they were helpful. Regarding your question, unfortunately I can’t give personalized financial advice by law. Nor should I try since I don’t know enough about your personal situation to do it justice in a comment thread. There is so much more to understand than what you shared because every decision is both financial science and art. The science answer is “whatever gives the highest after tax return”, but the art answer involves your personal goals, risk tolerances, and implications of the investment alternatives you would allocate to and how that affects all the above. There is no way to assess those issues properly in a comment thread and do them justice, nor do I want to start a pattern of giving personalized financial advice in response to articles. Sorry, but your final financial decisions are between you and your advisor. I’m just an educator, which is actually a good thing because that means my writings aren’t biased by investment product sales incentives. My primary motivation is to provide the best education that I can. I hope that’s helpful.
Great, great stuff Todd! I read everything you put out and appreciate that your primary motivation is to simply educate. We have been deeply influenced by reading your website, newsletter, and listening to your podcasts and haven’t paid more than maybe $5 for an eBook for any of it. Maybe I shouldn’t make that confession, but there’s part of me that thinks helping others like myself has brought a satisfaction to you that exceeds what a fee for the same service would bring, so thank you!
I did have a question in response to this article… I work for the federal government and my retirement savings are tied up in the government’s TSP (thrift savings plan) which I’m sure you’re familiar with. In the TSP, we only have a handful of index funds to choose from which doesn’t give us the option to redistribute to other asset classes as you suggest.
A significant portion of our retirement plan is in anticipation of a government pension, so we’re not completely dependent on my TSP savings. Currently, 100% of my savings are in the TSP’s small cap fund, which we have of course done well with the last few years. As you say though, the bubble seems to be getting bigger and bigger and has us worried about how we should respond. Conventional wisdom would be to “diversify” but with an impending collapse, does it make sense to be invested in equities at all? Wondering if throwing it in the G fund (government bonds) and waiting the storm out would be our best option. The 5% match is too good for us to pass up so continuing to invest in the TSP seems to still make the most sense to us.
Any thoughts you have about our situation you’d be willing to share would be greatly appreciated. Thanks again for everything you do.
I’m glad my writings have been helpful. Yes, you are right. My primary motivator is hearing from people like yourself how your life has been positively impacted by this work. And I also run a business where my course students get personal attention. Regarding your question, I can’t give personalized financial advice by law. Nor should I since I don’t know enough about your personal situation to do it justice in a comment thread. Sorry, but your final financial decisions are between you and your advisor. I’m just an educator, which is actually a good thing because that means my writings aren’t biased by investment product sales incentives. My primary motivation is to provide the best education that I can. I’m glad you’ve benefited from it!
I too listened to the podcast and was very surprised by the negativity many of the FIRE fans. You made it quite clear that you had respect for the prominent figures in that community. Guess its like you said, its easier to tear something down.
I have subscribed to the course and have had an incredible learning experience. The principles you teach have never even been mentioned by my “Financial Advisor” Looking forward to more.
Are the risk management strategies you put forth at the end of this article applicable to managed 401K plans? Im not a fan of these, but it is what is offered via employment and I receive matching contributions. I dont have the option via the fund management to self select how that money is invested. I would love to figure out how I can try to manage downside risk within the plan.
Thanks again for all of the wonderful insight.
I’m glad your getting good value from the Step 3 Expectancy Wealth Planning course. Yes, traditional advice doesn’t teach most of what’s in that course because their focus is on managing the wealth you’ve already created; whereas, the course is focused on helping you create the wealth in the first place. They’re very different objectives.
Regarding your 401k question, it’s a problem I run into frequently with clients. The investment selection limitations can make certain objectives prohibitive. One solution I’ve seen work on rare occasion is the client saves through the 401k to get the employer match but then moves the money in periodic chunks out to a rollover IRA. I say “rare occasions” because most plans will only allow you to roll the funds over after you terminate employment, but it’s something worth exploring in case your plan is one of those rare exceptions. I hope that helps!
I guess this begs the question whether Bitcoin has merit as a FED:PUT? I’m not sure that BTC has “no intrinsic value”, it’s obviously not functioning as a currency; but it may still have value. We associate gold with money but it’s not a particularly useful element; copper is much more important to the functioning of modern life (electronic circuits) but we don’t psychologically link Cu with money.
If the economy blows up it will BTC be used as a store of value?
I think Warren Buffett said it best regarding Bitcoin. Paraphrasing, he said he doesn’t know where the final high will be or what the path will be to get there, but if he could get a five year put on Bitcoin then he would take it. I agree. That should answer your question asking my opinion of using it as a store of value. It has no inherent value, except that which humans ascribe to it. I believe there are high enough odds that enough will change between now and five years from now affecting the perceived “value” of Bitcoin that the risk/reward is unfavorable. Obviously, this has nothing to do with short term speculative profit potential. It’s just referring to long term value analysis.
I’m sure Buffet is correct going forward but he could have admitted to being wrong with his warnings on BTC back in 2014; instead of the scoffing tone from him, Munger, Dimon (at least Dimon acknowledged the blockchain but I doubt he’s really studied it).
Surely there’s room for asymmetric payoff speculating with money you can afford to lose: Taleb’s positive Black Swan? It seems the world is becoming more asymmetric.
There’s no such thing as “money you can afford to lose”. All money is part of your asset picture and represents some percent of those assets. No matter how small, all assets are managed according to expectancy principles with discipline. The expectancy of Bitcoin is unknowable therefore it’s a gamble or speculation, not an investment. This is business, and it requires discipline. You don’t ever want to get sloppy in your thinking, even on small dollar amounts, because then it opens the door to making the same mistakes with bigger dollar amounts. My two cents worth.
I am an unapologetic Todd fan and past Financial Mentee. I have also become an active FIRE observer, consuming content. Heard the podcast and it was so full of truth and uncomfortable observations that rejection and backlash was (sigh) predictable. I fervently want the FIRE community to succeed because America needs a shot of anti-consumerism and some real perspective. Parts of the rest of the world do too, but American needs to Super-Size it. Since the FIRE community is in general (there are notable exceptions) in its adolescence and has only seen the recent go-go market there is a severe lack of understanding of risk and probably too much optimism. I’m reminded of my favorite Mark Twain quote, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” It turns out that Twain borrowed it from Josh Billings, but the quote is great. Folks have been handed the gift of a light in the darkness, helping to see what ain’t so. If the light makes visible something uncomfortable, does quenching the light make it go away? Nope. Darkness only conceals. Thank you Todd for trying to elevate the conversation. It appears that you have reached some, and when your words are revisited during the bear, or after the bear into the next bull, you will reach some more who will be able to hear the truth that they cannot hear today. One more quote: “It is difficult to free fools from the chains they revere.” – Voltaire
Wow. Thank you.
Thanks so much for the article Tod it’s spot on. I’ve learned so much from your teaching this past year. I’m currently taking the your Step 3 7 Steps to 7 Figures course and it has been incredible. Your are truly offering an incredible service sharing your knowledge and experience through this sight and the course. Unfortunate that some don’t see that.
Thank you! I appreciate your support!
Todd, I appreciate you taking the time to thoughtfully plot the patterns you’ve seen in your decades of experience in the market.
I’ve had similar visceral reactions to points you’ve shared in your writing, course and coaching. Instead of getting upset at you, I reflected on why I was reacting that way and focused the attention inward. A good coach will help catalyze a reaction, so the way I frame it, the podcast in question helped you achieve that outcome at scale.
As a sidebar: it’s curious that the upset folks from the FIRE community who hold a conservative view of expense management don’t welcome a similar mental framework to investment management, too.
Hah! I appreciate your perspective on the “scale reaction”. Thanks for sharing!
Excellent post and I agree 110%. I’m worried and Ive recently written about this very subject (risk and the need to diversify holdings to non-correlated assets & raise cash!).
Great article, Todd. I am within two years of retirement, so I need to rethink my risk level. I’ll probably move into more of a cash position. Also, I just ordered your book to evaluate the amount needed for retirement. Thanks for sharing your knowledge.
Hey Todd, enjoyed the read. Definitely a wake-up call with the specifics you mention. I’ve had a lot of anecdotal concerns that something has to give as well. Thanks for sharing your thoughts.
Good to hear from you Chad!
First off, thank you for this article and the education. I have been pursuing FIRE for about 10 years and am almost at the end.
I do diversify a little into stocks and real estate but most of my holdings are in VTSAX equities. I too was outraged that you would blaspheme my beloved buy and hold VTSAX on that podcast. But then I stepped back and realized I was being ignorant and passing up a chance to learn something.
So, I’ve been digging through your site for the past couple months and love your writing. Some of it is over my head, which is good as I’m getting an education. You’ve made me rethink my current strategy.
I appreciate the actionable items you listed in the article. Some of your action items jive with what Personal Capital’s tools have been telling me for a while (I ignored them for also blaspheming my VTSAX). I will incorporate some of your actionable items into my personal investment strategy, but have some questions.
By “deep diversification” do you mean investing in industry sectors to balance against the SP500 market cap weighting? E.g. if the SP500 is currently market cap weighted 40% towards technology, I would then invest directly into other industries like health, finance, oil & gas to achieve source diversification?
I currently don’t have an exit discipline but want one. Would it look something like “I’ll maintain an 80/20 split of SP500 & bonds, but will sell my SP500 if the PE ratio exceeds 50 and will exit my bonds if the Fed interest rate falls below 2%”? If not, can you provide a sample? I’m looking for the structure, not your financial advice.
What’s your opinion on REITs vs actual ownership of real estate properties – rentals?
Again, thank you for the education. I look forward to more of your articles.
I’m glad you ultimately found some value in the discussions. Yeah, I learned my lesson on that podcast. Telling that community there’s more to FIRE than buy and hold VTSAX is like walking into a gathering of religious fundamentalists (specific denomination not important) and telling them their God never existed. I was blown away be the aggressive, emotional response and got to learn a good lesson about how to communicate my message so it can be more helpful. Anyway, regarding your questions, it’s too much for a blog comment so I’ll answer what can be answered briefly. See this post here for the fundamental flaw in the premise behind your questions https://www.financialmentor.com/investment-advice/investment-strategy-alternative/what-is-a-good-investment/5977 You’re still thinking in terms of investment product, when the issue is you’re lacking an investment process. The process solves the product question, not the other way around. Regarding “deep diversification”, my intent is to get people thinking about diversifying by source of return for the strategy employed. The problem with product diversification is correlations rise toward 1 for usually all types of investment products regardless of historical correlation coefficient (except 1 – either bonds or commodities/gold depending on type of bear) so conventional product based diversification works the 95% of the time you don’t need it, and fails miserably the 5% of the time you desperately need it to work. However, when you diversify by strategy source of return the correlations tend to remain stable even during extreme market conditions. Hope that helps and points you in the right direction!
Todd, I found this article very helpful. Some of it is over my head, but that is a good thing, because I have much to learn and have found a place to learn it. I especially like that your intent is to educate and you don’t hold back. I have bought 2 of your books and devoured them. Thank you.
I am invested 85% RE (single family homes) and 15% equities (unbalanced-skewed to Amazon) – I chose the RE route because I want the income flow that comes from rents and because I am a realtor and understand that asset class. My diversification doesn’t look so hot in light of your article. I am wondering if there is a mix of asset classes that provides the annual income that RE does that I can use to diversify.
Can you speak to “Deep diversification”? I am not knowledgeable in commodities and don’t know of any businesses (that are inverse to the stock market) to invest in (prefer to invest in myself). Found, shockingly, through reading articles and your books that I am already FIRE (based on 4% and 25% rules), just wanting to stay that way.
Any comments you can make would be welcome.
As taught in my Expectancy Wealth Planning course, deep diversification is diversification by source of return (rather than just asset class). The reason this is important is because most asset classes will correlate to the downside during severe bear markets which means normal diversification (by asset class) works the 95% of the time you don’t need it, and fails the 5% of the time you desperately need it. However, non-correlated sources of return tend to be more stable during severe market conditions, and if configured correctly they can even be inversely correlated during severe markets. Again, all of this is taught in detail in my Expectancy Wealth Planning course.
Would it be possible to get the link to the podcast in question? I think it would be very helpful and instructive to be able to hear all the arguments and points made within it.
Thank you so much,
Chris, I intentionally didn’t link to, or mention it by specific name, because of the way it’s referenced in the post. I don’t believe negative or disparaging references add value and I like the guys who run it and believe they are trying to do something positive/constructive. However, the problem is they completely fail to moderate their community comments or uphold a certain minimum standard thus allowing destructive, herd mentality to run among the lowest common denominator within the community. Again, there’s a lot of good people in this community with excellent intentions, and there’s also an inexperienced, outspoken, self-righteous sect that mistakes the small, simplistic understanding they’ve accumulated as “the truth”, which then hurts the quality of conversation.