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Sam Sivarajan holds a doctorate in behavioural finance and has led wealth management teams at several of Canada’s largest financial institutions. His latest book, Making Your Money Work: The Secrets to Financial Health, is coming out shortly.

In the late 1970s, there was a TV show called Man from Atlantis and it featured a survivor from that lost civilization who could breathe underwater. As a young boy, I tried it for myself and quickly realized that I wasn’t from Atlantis – and faced the same laws of nature as my friends.

In the early 2000s, the former chairman of the U.S. Federal Reserve, Alan Greenspan, talked about “irrational exuberance” in the markets, criticizing a widely held belief that there was a “new normal.” In this new normal, markets don’t go down. Over the past two years, investors in the stock market have acted like it was the new normal again.

But those who believed the fable of a new normal are now receiving a crash course on how the laws of nature apply to the stock market as well.

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The law of gravity says that what goes up must come down. So far this year, the markets are all down: Nasdaq by 25 per cent, S&P 500 by 15 per cent, TSX by 6 per cent. It’s further proof that nothing goes up forever. In March, 2000, Cisco Systems Inc. was worth US$465-billion (or three times the annual revenue of California). Exuberant analysts were confidently predicting that Cisco would be the first US$1-trillion company. The tech wreck started shortly thereafter and today – 22 years later – Cisco is worth … about US$200-billion. In restaurants, it is the sizzle that sells the steak. But a bad steak will be sent back. Similarly, investor expectations drive stock prices, but future stock earnings must justify its price.

Related is the law that water finds its own level – whether poured into a glass or rushing down a mountainside, water determines its own equilibrium, given time. The same phenomenon occurs in stock prices. Irrational exuberance may push prices high temporarily, but eventually, they find their own level. For stocks, this level is an old-fashioned concept, espoused by investors such as Warren Buffett, called fundamentals: revenue, earnings, cash flow.

The law of conservation of energy says that energy is neither created nor destroyed, but simply converted from one form to another. In investing, wealth is sometimes created but, in most cases, it is merely converted – for example, natural resources to consumer goods. Or transferred from one individual’s pocket to another – think meme stocks.

The laws of motion dictate that greater force is required to turn an oil tanker 90 degrees than a tugboat. The same phenomenon applies in investing. Consider Apple Inc. In 2007, it was worth US$175-billion, sold 1.36 million iPhones for sales of US$120-million. In 2021, Apple was worth almost US$3-trillion, sold 242 million iPhones for sales of US$196-billion. To get a 10-per-cent rise in share price based on fundamentals – US$300-billion – Apple would have to introduce a new product line that could rival the iPhone. If it were only so easy.

The laws of mathematics remind us to be wary of percentages and the bases to which they are applied. Cathie Wood, the manager of the ARK Innovation ETF, was celebrated for her investing prowess in “disruptive innovation.” ARK’s share price hit a high of US$152 in February, 2021; this month, it is around US$40. As noted by commentators, when ARK was trading at US$95 in December, 2021, Ms. Wood predicted her fund would grow at an annualized 40-per-cent rate over the next five years. At current prices, the fund would have to return an annualized 70 per cent to achieve this prediction. There has been no fund that has ever delivered anything like that level of sustained performance. Simple math shows us that after a loss, you need a much higher gain to simply break even. ARK, and other losing shares, will have to significantly overperform to climb back out of their hole.

Finally, the nature of human behaviour suggests we always believe that this time is different. Flooding in the Czech Republic late last century, during a once-in-a century megaflood, resulted in people building significantly farther back from the riverbank for the next 25 years. The grandchildren of the flood’s survivors then started to move back to the riverbank, repeating the cycle. Forty years after Hurricane Betsy pummelled New Orleans in 1965, Hurricane Katrina wreaked havoc in 2005. City planners ignored all the lessons from Betsy. Investing cycles are the same – investors forget. Market bubbles form because of the belief that this time is different. Market bubbles burst when we realize this time is no different. Therefore, if investors can resist the urge to challenge the laws of nature, their portfolios will be the happier for it.

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