A dangerous idea and a simple solution

It’s 2008. Markets are riding high. We’re at the top of a real estate bubble. It’s boomtime.

But you see problems. You spot weaknesses in the banking system. And you don’t just predict there’s trouble ahead. You actively go short – and bet on the banks failing.

When the banks go under… you make a killing.

A dream for most of us. But not for Michael Burry. He’s the man who inspired the film The Big Short. If you haven’t seen it, read the opening three lines of this letter again as a synopsis. Spoiler alert. Actually it’s a bit late for that, given I’ve just told you the plot. Apologies.

Burry’s story is a good one. There’s something magnetic about the idea of someone seeing what others can’t – or won’t. The 2008 crash is a great example of that. So few people in power saw it coming. That makes those that did special.

But was it really so hard to see coming? I’d argue not. It just so happens that people who predict unlikely events tend to be ignored, scorned or laughed at, until it’s too late.

What Burry got right was his timing. And his capacity to take risks enabled him not just to see what was coming, but make a lot of money when it did.

I say all this because last week Burry made some interesting comments. He thinks we’re in a similar situation to 2008 right now. Just not with property and collateralised debt obligations. He thinks we’re seeing the same thing with the shift towards “passive” investment.

If that’s Greek to you, passive investment is simply the idea that you “own the market”. You don’t actively try and pick good businesses at good prices. You simply buy everything in a market. Then you hope it goes up, because markets tend to rise over time.

It’s become a popular strategy, particularly since the 2008 crash. Case in point: almost half of all capital invested in the US is now “passively” managed. That’s roughly $4.3 trillion. A lot of money.

I think it’s a dangerous idea. It wasn’t always so. Passive investment came about because lots of active fund managers effectively charged a lot of money to simply own the market. Passive investment cuts that fund manager out and cuts down on the fees involved. Good news all around. (Unless you’re an active fund manager.)

But it has morphed into something far more dangerous. It’s become an excuse for people to simply throw their cash at the market. Forget what you’re buying. Forget price. Forget value. Forget growth. Forget everything. Just buy. Buy it all.

And the reverse of that will be true, when the time comes. Forget everything. Forget price. Forget value. Just sell. Sell! Quick!

That’s part of what Burry is worried about. He’s also concerned that the institutions who “create” these passive funds are using complex derivatives and other options to “match” the performance of an index. He thinks that could lead to problems.

As he put it, “This fundamental concept is the same one that resulted in the market meltdowns in 2008. However, I just don’t know what the timeline will be. Like most bubbles, the longer it goes on, the worse the crash will be.”

There are plenty of people out there who will tell you to invest passively. You don’t get to $4 trillion plus in assets without a good story. So I am going to give you some alternative advice. It’s a simple antidote to a dangerous idea.

Don’t be passive. Be extremely discerning with where you invest your money.

It’s your money. You worked for it. You made sacrifices. You didn’t spend, you saved. Why you would then take the fruits of all that effort and throw it at a market “passively” I have no idea.

Remember that when you make an investment.

Exactly where you invest your money is your call. It depends on your circumstances. And you can execute different strategies with different chunks of cash.

For instance, you might hold 10% of your pot in gold and silver as a hedge against inflation and rapid currency depreciation. You might hold another 50% in high-quality long-term ideas or trends. Companies you believe in. Trends that will continue for a long time.

You might have another chunk in income-producing investments. If you’re nearing retirement this might well increase.

For instance, this week I’ve been leading a masterclass designed to show you how you can boost your investment income. It involves a technique that Barron’s described as “a proven method for enhancing stock returns and reducing risk… one of the greatest strategies in existence”. 

How does it work? The first thing you have to do is make a mindset change. Focus on income, not capital gains. Some people find this hard. They want the chance to double their capital and make a big income. Not possible. Not without enormous risks, anyway.

Instead, there’s a trade you can make that allows you to boost the income you collect on big dividend-paying stocks. Simply put, if you promise to make a small profit not a big one, you can collect upfront income.

In other words, if the stock doubles (which with big dividend payers is unlikely) you’ll miss out on a lot of the potential profit. Instead you’ll make a small profit. And you’ll generate upfront – and often repeatable – income for doing so.

As I said, it’s a mindset shift. You sacrifice big profits. But you can generate a lot of income in the process.

And you may well have 10-15% in more speculative ideas. Let’s face it, you wouldn’t be reading a letter called Exponential Investor if you weren’t interested in these. I would characterise these ideas as “less likely to come off, life changing if they do”. Ideas like this can create enormous and rapid wealth. But they’re by nature speculative.

What exactly those ideas are is your call. There are plenty of different options. Mining stocks. Tech stocks. Small caps. Cryptocurrencies. Breakthrough biotech stocks. Take your pick.

Research has a wide spectrum of different advisories dedicated to ideas like this. For more, follow this link and check out everything we do.


Nick O’Connor
Publisher, Southbank Investment Research

Category: Commodities

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