Imagine you have to engage in a sword fight you can never win, fighting the same opponent who never gets tired your entire life. You don't fight to win in such a fight, but you fight to survive as long as possible. Also, imagine this opponent has periods when he gets stronger and periods when he gets weaker. The opponent here is the capital markets that threatens to decimate your portfolios, and its fluctuations in strength are the economic cycles.
What are the economic cycles?
The productive members of the global society drive our economy, not the lazy couch potatoes. In other words, it's the businesses that run our economy. Companies engage in fierce competition with each other trying to take as much market share as possible. They have to borrow money to boost their short term profitability, front-run their competitors and pay back the debt later while maintaining their superior position in the market.
Initially, companies will spend/consume a lot with their borrowed money on anything that helps their profitability and growth. When it comes time to cut back on borrowing and pay back the loans, their consumption level will decrease.
The above diagram depicts the overall economy's short-term and long-term economic cycles. For instance, when we read about the "recession" in the news headlines, they mean the dip in the short-term cycle.
How the sword fight goes wrong
Previously I compared your portfolios at battle with the capital markets. Let's say that when your investments appreciate in value and thus ride the economic upcycle, it seems like you are winning the battle. What should be going through your mind as you witness your portfolio grow and profits increase month after month? How much of your success comes from picking the right company stocks and real estate properties, or is it because of the broader economy's growth? Even with an army of financial analysts, this is often impossible to assess.
In a sword fight with an opponent who is impossible to beat, your decision should never be throwing the heaviest possible decisive strike that leaves you wide open to a counter-attack that could end your life. If you are to play a 50/50 betting game in a casino and you are not allowed ever to stop playing, you would be a fool to bet all-in at any given time because you need to continue to play the game. These examples sound very obvious, but more than 70% of the investor population do precisely this and lose their entire investments. Their failure is because they haven't mastered the art of sword fight.
- They don't realise that they are in an endless battle; the enemy never gets eliminated in this battle.
- When the enemy gets weaker, they start to land successful consecutive strikes. At the height of their success, they pool all the cash they can get their hands on, even borrowing (margin investing), and decide to swing their heaviest strike to an invincible enemy.
- The enemy suddenly gets stronger, hitting all your companies hard. Their portfolios take all the blows without even the strength to hold up their shields to protect themselves.
Mastering the dance of the sword fighting
Looking at the economic cycle diagram again, you can see that the up-cycle is much longer than the down.
The period of downward Deleveraging is only about 30% of the entire cycle, and the up-cycle, including Debt Accumulation and Reflation, happens about 70% of the time. This means your portfolio will be making profits most of the time, making you feel like you are winning the battle. However, the more successful strikes you land in this sword fight, the more sceptical you should be of the enemy waiting to lunge at you with a swift deadly strike.
It's important to note that the portfolio participating in the battle is not your passive ETFs portfolio. The passive portfolio is not fighting because you constantly make periodic contributions to this portfolio regardless of market conditions. The fighter portfolio should be much smaller in size than the passive portfolio. A ratio of 7:3 is reasonable initially, and it should be ever more asymmetrical as you get wealthier to 9:1.
- When your fighter portfolio has its time making lots of profits, you should start selling to realise some of the gains into cash.
- Since the realised profits mean you are that much wealthier, you should contribute some of that cash into the passive portfolio. Make sure to hold a good chunk of cash still.
- Chances are, the economy will continue to grow, and your fighter portfolio will continue to make profits. Repeat step 2.
- At the peak of the economic bubble, you will have a bigger passive portfolio, lots of cash, and tiny investment holdings in your fighter portfolio.
- When the economy suddenly flips, and the enemy strikes hard, do nothing. Your portfolio will hold its ground, and there will be red blood all across the board in your passive portfolio and the fighter. Do not panic when this happens. Your passive portfolio is a life-long investment without ever selling. The fighter portfolio has been reduced to a tiny size, so its red is insignificant.
- During the economic downturn, the enemy is ruthless and slaughter many fighters. There will be blood everywhere. Hide behind your shield and patiently withstand the storm. Your moment to strike back will come when the enemy thinks it has slaughtered everyone and lets its guard down.
- Use all the cash in the fighter portfolio to buy all the assets that had their prices collapsed. Seize this moment to strike back the hardest with rage.