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The Best Interest » JL Collins’ Fun Pretzel Logic

JL Collins’ Fun Pretzel Logic

JL – if you ever end up reading this and feel like I’ve been a jerk, please let me know. It’s not my intention, and don’t want to besmirch your golden reputation. And yes, in writing this article I did hear the famous lines of Michael K Williams’ (RIP) Omar Little echo in my fingers“When you come at the king, you best not miss”.

JL’s the king. I hope my point is on target.

JL Collins seems like a great dude. He helps tons of people. He’s a great writer; go buy his book. He’s 99%+ correct about most investing topics

But he’s wrong about this one thing. And it’s important.

First, a tiny backstory.

A Little Background

Last week, I wrote about the idea that it’s “impossible to lose” in the stock market (spoiler: it’s possible). And regular reader Accidentally Retired wrote in and said, “Jesse you need to read this quote from JL Collins…”

JL once wrote:

The market always recovers. Always. And, if someday it really doesn’t, no investment will be safe and none of this financial stuff will matter anyway.

JL Collins

Ok – take a deep breath everyone.

The statement above—made by JL and echoed by countless others—is a self-defeating prophecy. The more people who believe it…the more true they want it to be…the more dollars wagered on this idea being true…the less likely the statement will hold water in the long run.


Why is JL Wrong Here?

Let’s start with one of Burton Malkiel’s famous quotes from A Random Walk Down Wall Street:

If we knew that a stock would go up tomorrow, why, it would just go up today.

Burton Malkiel

Malkiel describes the notion of “pricing in” the future value of an asset into its current price. The more confident we are about the future, the more accurately today’s price will reflect that presumed future. Read that again.

Because the more confident we are about the future, the less risk we perceive. The closer today’s price will resemble the future price. When today’s price resembles tomorrow’s price, that’s another way of saying “there’s less investment gain to be had.”

Let’s apply that idea to market recoveries. The more confident we are that markets will always recover, the more likely today’s price will already account for that presumed recovery.

How Would It Actually Play Out?

How would this actually play out? How would the market “already account for that presumed recovery?” It gets confusing. It’s pretzel logic.

If market recovery was a rule of nature, then the recovery would always be priced in. Thus, stocks would never drop in the first place. If stocks never drop, then they’re guaranteed to only increase. If they only increase, then there’s no risk involved in investing. If there’s no risk, then there should be no return. And if there’s no return, what’s the point of investing?

Whoa. That’s circular. But circular in the way that M.C. Escher’s Waterfall is circular. We end up where we started, but while turning the world upside-down.

The more people who believe JL’s claim, the more likely the claim will be rendered false in actuality.

Instead, we need to realize that the risk of permanent loss is one of the driving factors behind stocks’ returns. If stock returns were guaranteed – like a Treasury bond – then they wouldn’t outperform Treasury bonds over long periods of time. The more guaranteed an investment return, the lower that return must be.

Amending JL’s Idea

I don’t begrudge J.L. for his statement at all because it’s a paradox.

People doubting that markets will recover are synonymous with “Markets are risky.” If stocks are deemed risky, investors will demand higher rewards. Over time, any diverse stock portfolio would see high enough returns to recover sufficiently from any correction.

This would play out repeatedly, as we’ve seen throughout stock history. This is why markets have always recovered in the past! They recover only because of the risk they might not recover.

But as soon as faith in those recoveries becomes too universal, the market would never drop in the first place. After all, who would ever sell their stocks – driving down prices – if they knew that recovery was guaranteed? It doesn’t make sense. If no one sells, prices don’t fall. No fall, no recovery.

It’s pretzel logic. A self-defeating prophecy. But it’s a fun, tiny nuanced idea that ought to intrigue JL and his readership, and anyone else curious about markets, risk, pricing, and our investment future.

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7 thoughts on “JL Collins’ Fun Pretzel Logic”

  1. Oh man! What have I done?!?!!

    But in all seriousness, I do agree that this is a paradox of sorts IF everyone believed this and thought long-term. However, the fact is that most do not.

    When markets plunge, the average investor pulls their money out at the wrong time. And conversely when markets are soaring, they pour more fuel on the fire. In essence, they manage to do the opposite of the age old advice of “Buy low, Sell high.”

    So, I have no concerns of all investors getting on the same page. If humans could truly think long-term and with common sense, we could have a problem on our hands, but I do believe that markets will always recover as long as humans continue to behave and be manipulated by various short-term circumstances and incentives.

  2. Jesse if we look at the past history of the stock market in the United States, wouldn’t JL be right in asserting the markets do recover and trend upward and to the right?

    Im a little confused. Thank you.

    1. Hey Geno, thanks for the nice note and question. I appreciate you reading.

      Yes, JL is right is asserting that markets always have recovered. I 100% agree.

      After all, I state in the article:

      People doubting that markets will recover is synonymous with, “Markets are risky.” If stocks are deemed risky, investors will demand higher rewards. Over time, any diverse stock portfolio would see high enough returns to sufficiently recover from any correction.

      This would play out over and over again, as we’ve seen throughout stock history. This is why markets have always recovered in the past!

      But I think JL is wrong in asserting that markets always will recover in the future. More specifically, I think that the more people who believe JL, the more wrong his statement is.

      Does that help make things better?

      It’s like saying, “The human population will always grow.”

      True in the past? Sure.
      True in the future? Uhhhh…I really don’t know how anyone can make that assessment.

  3. Good thought experiment and I think you have a rational and logical argument. While nobody can know the future I think JL’s advice is still valid. I agree with Accidentally Retired’s comment that all investors getting on the same page is not that likely. Most people are not rational and logical…. 😉

    I heard a similar thing mentioned about ETF’s index investing. If all investors put money in the indexes it would break the markets. Keep up the interesting content!

  4. I don’t think the assumption that things are “priced in” is a correct one because there’s a lot of whales that behave in very different ways, and price equities very differently.

    That said, I think the assumption that JL makes is *mostly* accurate from the context of a USD standpoint.

    The case against JL’s argument is historical:
    – We’ve seen the German Papiermark get wiped out due to hyperinflation. Their markets by definition never recovered because the underlying currency was completely obliterated.
    – We’ve seen a few other currencies where they were “beyond repair” and the only way to save the economy was to completely restart it with another currency.

    Entire markets have been destroyed in the past and could not recover, which makes JL’s argument kind of weak.

    But the case for JL’s argument in the US dollar context is this:
    – The world reserve currency is currently in USD. It behooves most countries to keep the US market going well. If the US market tanks, the entire world suffers.
    – After the Great Depression, things were very very bad. And even then, the market recovered albeit more than a decade later when it reached normal levels.
    – The fed/govt has learned a lot from previous crises and can handle massive “woopsies” of the economy fairly well nowadays with a good mixture of fiscal and monetary policies. 2008 was an extraordinarily bad bubble. Yet, the US economy recovered relatively quickly.

    I think in the US case, the market will *generally* recover, and will recover fairly quickly. However, that’s generally when blind spots are created and something happens that makes it so that the US markets don’t recover nearly as quickly as anyone thinks, if at all.

    Not knowing what those blind spots are, I think I agree here that it’s *not* a guarantee that the market will ever recover, but for me it’s “close enough” to a guarantee that I feel comfy putting a large amount of net worth into the market.

    1. Hey Angie! That makes sense from a macro/currency point of view.

      But I’m talking about micro-econ/investor psychology.

      If everyone believed that “the market always recovers” or “the market always goes up”…then we’d have an issue.

      Index funds investors need other market participants to believe that markets go down.

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