By Dan Hallett on March 14, 2023
In 2016, the Philadelphia Federal Reserve published a paper of its study of the bankruptcy filings of individuals living in close proximity to the winners of large lottery jackpots. They found that when an individual wins the lottery, people in the winner’s neighbourhood are more likely to go bankrupt. (Thanks to personal finance expert and neuroscientist Preet Banerjee for alerting me to this fascinating study.)
This keeping-up-with-the-Joneses phenomenon is closely related to FOMO or fear of missing out. While the lottery study pertained to people wanting assets like those of their lottery-winning neighbours, a similar behaviour applies to trendy investments generating striking short-term returns or strategies that seem like sure things.
The investments you own drive how well or poorly your portfolio performs. Since trendy investments tend to be just that – short lived trends – simply avoiding investing FOMO can help portfolio performance by avoiding steep losses or disappointing returns.
Here are three investment strategies or themes that were once hot that we have happily avoided:
In 2018, in the wake of cannabis’ legalization, we spent time analyzing the group of stocks in this industry. We concluded that investing at the time would be a money-losing proposition – which I detailed in an October 2018 blog post. I wrote that in order for Cannabis stocks to be a good investment at that time, those businesses would have to achieve the (nearly) impossible:
- generate high revenue growth for a decade (like Google in its early days);
- be profitable right away (they were all bleeding cash);
- sport wide profit margins (like those of spirits companies); and
- continue growing – forever – at a fast rate while maintaining high profitability.
Anything short of that would result in a money-losing investment. Since publishing our view more than four years ago, the Horizons Marijuana Life Sciences Index ETF – HMMJ (Canada’s first Cannabis ETF) has lost more than 80% of its market value; equal to a loss of about -32% per year through late February 2023.
Sky-high returns from Bitcoin and other crypto assets through the 2010s stoked many a dream (or fantasy) of quickly building a life-changing amount of wealth. We began investigating Bitcoin five years ago. But when it took off after the March 2020 stock market lows, we expected the price surge – and the resulting media coverage – to trigger questions from clients. Accordingly, we deepened our investigation to better understand Bitcoin so that we could provide thoughtful, informed answers to our clients’ questions – and determine whether it deserved a spot in client portfolios.
Every investment we place in client portfolios has a purpose – a role to play in pushing clients toward their goals. We must, in turn, understand what drives each investment’s value and estimate its future return. We emerged from our analysis seeing no investment merit in Bitcoin or other crypto assets. And while Bitcoin’s early years featured price changes that were seemingly unrelated to how stocks and bonds performed, the pattern of Bitcoin’s up and down price swings have grown more aligned with the stock market – technology stocks in particular. That change in behaviour weakened its role as a portfolio diversifier.
The table below shows correlation coefficients for Bitcoin with each of a handful of selected tech stocks – calculated for two distinct time frames using daily data from Yahoo!Finance. I don’t know if Bitcoin returns will become more or less strongly correlated with tech stocks going forward. But the correlation has gone from nothing to significantly positive over the past few years. And despite the strong returns since I wrote my first article on Bitcoin, its lack of fundamentals gives us no reason to change our view that it has no investment merit.
Covered Call Writing
While we view Crypto and Cannabis as pure speculation, selling options against a stock portfolio – known as covered call writing – falls into a different category. It is a legitimate investment strategy – but in the class of strategies that plays into the average investors’ unhealthy infatuation with all things yield.
Covered call writing involves buying a stock, but then also selling a call option on the stock – which results in the buyer of the option paying a premium to the option seller. Accordingly, an investor using this strategy own shares of a company, and then collect a premium up-front in exchange for selling the call option – which in turn may oblige the option seller to sell their shares at a set price. Proponents of this strategy love its “high yield” and view the up-front premiums received from selling call options as free money.
We will dive deeper into this strategy in a future blog. In a nutshell, this strategy gives up too much upside when stock prices zoom higher, while capturing virtually all of the price declines. What many investors view as “yield” is not yield at all. And what they think is essentially free money, is simply compensation for a future liability – so it’s not free. If you think you have found a free lunch in financial markets, it’s likely that you’re footing the bill.
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