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The Essence of Cycles

I’m going to conclude by pulling together some of the book’s paragraphs that I think hold the keys to understanding cycles, their genesis, and how they should be dealt with. I’ll alter them only as necessary to allow them to stand alone here, out of context. This won’t be a summary of the book, but rather a recap of some of its key observations. (And for those who wish, reading just the bolded sentences will provide a good synopsis of the recap.)

Investment success is like the choosing of a lottery winner. Both are determined by one ticket (the outcome) being pulled from a bowlful of tickets (the full range of possible outcomes). In each case, one outcome is chosen from among the many possibilities.

Superior investors are people who have a better sense for what tickets are in the bowl, and thus for whether it’s worth participating in the lottery. In other words, while superior investors—like everyone else—don’t know exactly what the **re holds, they do have an above-average understanding of **re tendencies.

The odds change as our position in the cycles changes. If we don’t change our investment stance as these things change,we’re being passive regarding cycles; in other words, we’re ignoring the chance to tilt the odds in our favor. But if we apply some insight regarding cycles, we can increase our bets and place them on more aggressive investments when the odds are in our favor, and we can take money off the table and increase our defensiveness when the odds are against us.

In my view, the greatest way to optimize the positioning of a portfolio at a given point in time is through deciding what balance it should strike between aggressiveness and defensiveness. And I believe the aggressiveness/defensiveness balance should be adjusted over time in response to changes in the state of the investment environment and where a number of elements stand in their cycles.

The key word is “calibrate.” The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive. When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back. Calibrating one’s portfolio position is what this book is mostly about. (page 12)

In the world investors inhabit, cycles rise and fall, and pendulums swing back and forth. Cycles and pendulum swings come in many forms and relate to a wide variety of phenomena, but the underlying reasons for them—and the patterns they produce—have a lot in common, and they tend to be somewhat consistent over time. Or as Mark Twain is reputed to have said (although there’s no evidence he actually said it), “History doesn’t repeat itself, but it does rhyme.”

Whether Twain said it or not, that sentence sums up a lot of what this book is about.

Cycles vary in terms of reasons and details, and timing and extent, but the ups and downs (and the reasons for them) will occur forever, producing changes in the investment environment—and thus in the behavior that’s called for.

The fact is that the performance of these things is heavily influenced in the short run by, among other things, the involvement of people, and people are far from steady. Rather they fluctuate from time to time, often because of things we can lump under the broad heading of “psychology.” Thus people’s behavior varies . . . certainly as the environment varies, but sometimes in the absence of changes in the environment, too.

The cycle oscillates around the midpoint. The midpoint of a cycle is generally thought of as the secular trend, norm, mean, average or “happy medium,” and generally as being in some sense as “right and proper.” The extremes of the cycle, on the other hand, are thought of as aberrations or excesses to be returned from, and generally they are.

While the thing that’s cycling tends to spend much of the time above or below it, eventual movement back in the direction of the midpoint is usually the rule. The movement from either a high or a low extreme back toward the midpoint is often described as “regression toward the mean,” a powerful and very reasonable tendency in most walks of life.

But it can also be seen that the cyclical pattern generally consists as much of movement from the reasonable midpoint toward a potentially imprudent extreme as it does going from an extreme back toward the midpoint.

The rational midpoint generally exerts a kind of magnetic pull, bringing the thing that’s cycling back from an extreme in the direction of “normal.” But it usually doesn’t stay at normal for long, as the influences responsible for the swing toward the midpoint invariably continue in force and thus cause the swing back from an extreme to proceed through the midpoint and then carry further, toward the opposite extreme.

It’s important to recognize and accept the dependability of this pattern.