By MoneyMorning.com.au
If you want to make a name for yourself in the financial markets, pick a crash.
If you want to build lasting and long-term wealth, pick a bull market and invest in stocks to take advantage of it as it rises.
OK, it’s not that simple or clear cut.
Many people have built a fortune from predicting a stock market bust – Jim Rogers, Dr Marc Faber, John Paulson…er, there are probably a few more.
While that’s an impressive (but short) list, there are two simple reasons why the list isn’t longer. It’s hard to predict a stock market crash, and it’s less lucrative.
That’s why we prefer to invest on the long side. Historically, stocks tend to rise more than they fall, and more importantly, you can make more money from buying stocks than short-selling them…
If you look at the market over the past 40 years it’s easy to come to a simple conclusion: over the long term stock markets go up. We can show you a chart to ‘prove’ it.
This is a chart of the US S&P 500 since 1974:
Case proven, right? Not quite. For a start, 40 years doesn’t cover the complete history of stock markets. And second, 1974 roughly coincides with the beginning of the greatest asset bubble in living memory – the end of the Gold Standard and the start of the ‘paper money’ experiment.
So, those are legitimate reasons for caution. There’s no guarantee that this enormous rally will go on forever. But what if the greatest asset bubble in living memory has barely begun? What if this asset bubble plays out for another 10, 20 or 50 years?
It seems unthinkable. And yet, it’s entirely possible…
It’s Hard to Pick These Violent Market Moves
But before we explain why this asset bubble could last many more years, we’ll quickly go over what we mean about predicting crashes and why they’re less lucrative than betting on a bull market.
Predicting a crash is a great way to get people to notice you. Getting it right is an even better way to get people to notice you. There’s no argument that the big names who predict a market crash get more fame than those who predict a bull market.
Why is that?
First of all, it’s hard to predict a crash. An overvalued market can easily become more overvalued. Valuations can keep rising as investors believe earnings will catch up with prices. This can keep going until the valuations become so stretched they become impossible to sustain.
The second reason is that crashes happen quickly and violently. You can see that on the chart above. A crash from beginning to end may only last a few weeks or perhaps a few months.
If you can predict that move and tell everyone about it, it’s fresh in their mind as it’s happening. On the other side, a bull market for stocks can take years, sometimes more than a decade to play out. By the time it’s proven that they’re right everyone has forgotten about it.
There’s something ironic about that, because as rich as you can become from short-selling the market and profiting from a crash, short-selling actually involves investors taking on big risks in order to make finite returns.
From a risk/reward perspective it’s something we’ve always found hard to justify as a long-term investment strategy. Here’s why…
Weigh Up the Risk and Reward
When you short sell a stock the most you can make is a 100% return on your money (assuming you don’t use any leverage). If you short sell $1,000-worth of stock and the share price goes to zero, your maximum profit is $1,000.
Assuming you didn’t use leverage on the trade, you would have deposited $1,000 in your brokerage account as ‘margin’ for the trade. That means you would have made a $1,000 profit on your $1,000 stake – a 100% gain.
If you want to increase the percentage returns, then you can leverage the position. But the maximum dollar gain is still the same.
On the other hand, if the share price goes up rather than down, you potentially face unlimited losses. You could lose two, three or four times your initial investment. That’s a big risk.
That’s why we prefer the long side. To begin with, there are no limits to your gains. If you back the right stock at the right time you can make unleveraged gains of two, three, five, 10 or more times your initial stake.
Now, those gains won’t necessarily happen overnight. As we mentioned before, stock market gains can take years, or even a decade or more to compound into big profits.
But on a risk/reward basis the numbers certainly stack up better than being short.
Don’t Sit Around Losing Money
That’s not to say we object to short selling or think that you shouldn’t do it. If you’re after short-term gains then short selling should be part of your investing toolkit. After all, on any given day there’s a 50/50 chance of a stock rising or falling.
If you’re not short-selling you’re missing out on half the market action. The problem with many short sellers is that they tend to sit around doing nothing or losing money when the market is going up.
So we don’t see betting on falling markets as a way to build long-term wealth. Just look at the Bloomberg Billionaires list. How many of the top 100 wealthiest people have built a fortune by short-selling stocks or businesses?
We can’t see a single name on the Billionaires list of someone who has built wealth that way. That’s not to say no-one has ever done it. But if you’re playing the numbers game, the odds suggest that if you want to get rich (or just build a decent nest egg) your best bet is to invest in good companies and watch your wealth grow as those companies grow revenues and profits.
We won’t pretend it’s without risk, because there are plenty of things that can go wrong. But if we’re right…if stocks continue to benefit from cheap money, and if the cheap money and low interest rate era has further to go, then now remains a great time to buy stocks.
Cheers,
Kris
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