Traditional Investments Approaches May Be Broken

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Traditionally, one of the safest investments strategies for folks close to or in retirement was a 60% / 40% stock bond ratio, invested in the well-run, low cost or no-load mutual funds. This article explains why “This Time It Really Is Different”, and investors pursuing that approach today may suffer profound regret.

But first check out this graph, showing how well a balanced approach has done:

(click to enlarge)

As this shows, over the last decade investors in Vanguard’s VWELX or VWINX fund would have gained more than investing in the S&P 500 (up 96% over the period), 150% and 131% respectively. Equally important, they would have done so with far less drawdowns in the crash of 2008 (24% and 48% vs S&P’S 78% drop).

In fact, as I’ve shown in a previous article in , Seeking AlpSeeking Alpha’s financial blogh, this outperformance of the 40/60 balanced approach holds well going back over another decade.

But today, I am convinced, the logic behind those patterns no longer holds.
As a consequence, both stocks and bonds will drop in sequence, rather than acting as counterbalances. This means that your 60% stock holdings could bring you a huge amount of pain, while your bonds only bring you a large amount of pain. Either way, the next effect is very painful.

I liken the moment we find ourselves that of the real estate market in mid 2006. The signs of a crash were imminent, and many smart people were warning of ludicrous values, dangerous mortgages, shady mortgage practices, and a warped property to income ratios. I remember at that time warning a friend of mine not to engage in his fourth house flipping in 10 years. Unfortunately for him, he ignored my advice, only to be later faced with a $1 million mortgage on a $500,000 equity value and monthly payments double his income.

Back in 2006, I could not tell him for sure when a crash would happen, and what event would trigger it. I just recognized that values were not sustainable. In fact my timing was a bit off. Another year passed before housing prices lost 70% of their value. As you can see in the graph of Real Estate Investment Trust prices below, real estate values climbed another 20% over the next year.

Was I wrong to warn him off his investment? Obviously not. Many small fortunes were built on the precept of “selling a bit too soon”, and far more were lost on the premise of “following the wisdom of the crowd”.

So now let’s look a today’s situation. Six factors show that these stock market valuations are not sustainable, and that a significant correction must follow soon:

  1. Shiller’s Historical Price Ratio . P/E ratios, fueled by the FED’s money printing, are at levels usually found just before market crashes.

    (click to enlarge)
    source: gurufocus.com

    The last time Shiller PE ratios were above 27 was in 1929, 2000 and 2008. The S&P 500 subsequently crashed by 90%, 33% and 47% over the next 18 months. (Readers are encouraged to visit the gurufocus site for an explanation of Shiller’s research and findings.)

  2. Corporations are propping up stocks by using “quasi-free” money by borrowing in corporate markets.

    (click to enlarge)
    source: bloomberg.com

    In the past, when borrowing levels got so high, market crashes often followed. Will this time be different?

  3. One of the biggest areas of concern, is that corporations are not making the capital investments that result in real long term growth.

    (click to enlarge)
    source: bloomberg.com

    Even the economists at the FED – not exactly innocent of a role in the decline of capital goods spending – recognize the danger in this steep decline. They attribute 80 percent of a country’s future growth to the investment in capital goods, as a recent FED study demonstrates.

  4. Corporate profits have declined over the last four quarters, yet the stock market is making higher highs. Bubble anyone?
  5. Productivity has ground to a halt.
  6. The money supply (M2) has been increasing by 6-7% a year, which has always ended in the past in inflation.

OK, so maybe you believe that a stock market correction is possible, and even probable. But why does that imply that both stocks and bonds will decline, and that the traditional haven of bonds will not hold?

The answer is: because overall bonds are overvalued. Today, if you invest in any company that can be reasonably assured of avoiding bankruptcy even in a severe market downturn, you are paid around a miserly 2% over 10 years. If long term interest rates regain even half the value by which they have dropped in the last 6 years, an investor buying those bonds would see values decline by far more than their coupon payments. If instead of selling at a loss, they hold them to term to obtain a return of capital, on a net basis they are likely to be a loser to inflation.

If, on the other hand, you go for higher interest rates to protect from possible future inflation and interest rate hikes, you are now faced with greatly increased risks of default and total loss of principal.

But wait, you say, there is no inflation anywhere on the horizon! Watch out, says Federal Reserve Alan Greenspan. If he is right, we may get both a drop in the markets AND higher inflation, and consequently higher interest rates. In a recent interview with Bloomberg News, Greenspan commented: “I know if you look at human history, there are times and times again where we thought that there was no inflation and everything was just going fine. And I just basically say, wait. This is not the way this thing ordinarily comes up. I don’t know. I cannot say I see it on the horizon. In fact, commodity prices are soggy. The oil prices has had a terrific impact on global inflation. It’s not about to emerge quickly, but I would not be surprised to see the next unexpected move to be on the inflation side. You don’t have inflation now. And you don’t have it until it happens.”

There is one scenario that is good for bonds, and in this author’s opinion is more likely to happen. That is a severe and prolonged recession affecting most of the global economy. In that case the central banks of the world may decide to keep interest rates low and possibly even go negative, as Europe and Japan have already done.

A strong corporate or government bond bought today with a duration of 10 years would see appreciation of 10% , 20% and even 30% in the event of a decline from 2% levels to levels of negative 1% and negative 2%. Unfortunately, such an outcome is not only a likely result of a severe drop in stock markets and real returns worldwide, but also may even exacerbate those conditions – due to its negative psychological impact on investor confidence and disruptive impact on careful capital allocation.

So the small gain you might see in the 40% of your portfolio held in bonds could be more than swamped by the disruption in your stock portfolio.

It is these dismal future prospects that have led people Warren Buffett to project that future decades will not bring the 9% averages a long term investor could aspire to, but rather much lower averages in the 2-4% range.

This view is shared by Bill Gross, one of the most successful bond managers of the last 20 years and current manager of the $1.5 billion Janus Global Unconstrained Bond Fund: “I don’t like bonds; I don’t like most stocks; I don’t like private equity,” Gross, wrote in his recent monthly investment outlook Wednesday.”

An overall mixed portfolio that could yield 8% to 10% on average in the past is more likely to product 2% to 4% in the future, with a lot of short term pain along the way.

Just so that we don’t end up on a completely pessimistic note, there are strategies than can outperform even in these confusing and distressed times. Conservative investors may want to look at this post while investors able to tolerate more volatility would want to look at a mean-reversion algorithmic approach, as described in a previous post. Here’s how that has performed in historic backtesting:

Same Bumps, But A Lot More Ride

  • Long Short Mean Reversion
  • Performance-based limited selection
  • Less conservative hedging allocation
  • Mean reversion methodology
  • Goes short and long simultaneously
  • Not compatible for IRA’s

(click to enlarge)


Jan 4, 2003 – July 17, 2015

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Disclosure: The material presented on this site is for illustrative and educational purposes only. The graphs shown above represent back tested results and do not reflect actual investing results. Investing in options involves risk of loss, and these losses can be substantial. Only risk capital should be used when trading options. We do not currently own any funds discussed in this article. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. This report is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance. Do not rely solely on this research report when making an investment decision. Other factors may be important too. Consider seeking professional advice before implementing your portfolio ideas.

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What Do Negative Interest Rates Really Mean?

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More and more of my clients are puzzled about the impact of negative interest rates. Some economists believe there is nothing special about negative interest rates, and that their impact will be just “business as usual”.

I disagree. Interest rates are the price of money. When it is negative, money turns free. When money is free, a lot of bad business decisions are made. Profits are sought in levered, and super-levered constructions of obtuse financial instruments, and real capital formation is postponed.

Remember the tower of Babel?

Confessions of An Unrepentant Bear

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For those of you who have not yet discovered the blog, I recommend HedgeEye, a great place to find those market moving early data insights that can make a big difference to your medium term and long term investment strategies.

As we approach the period of summer doldrums in 2016, I cannot help but scratch my head in wonder as the market makes new highs in spite of all the looming signs of a world economy on the precipice of a severe and prolonged decline. This kind of reminds me of the tech boom of the 2000′s, as ridiculous business propositions earned sky-high valuations based on pumped up “eyeball” counts.

Rather than recounting again the myriad signs of trouble on the horizon, I’d like to simply tell my readers : be very cautious. In this video, Mike O’Rourke, Chief Market Strategist at Jones Trading gives a good explanation of what ill winds blow:

Market Warning Signs At All Time HIgh

So what’s a safe strategy in times like these? Check out my recent article on Steepener Bonds written for Seeking Alpha, combined with a long term bearish option hedge.

Hedged Steepeners: True Yield for Difficult Times

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2015 – A Strategy for All Seasons

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Trounce The Market With Less Risk

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Doomsday Revisited

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Have we dodged the bullet? After the near meltdown of the world international economy in 2008, the central banks of the world rallied. Collectively, they went into a frenzy of money-printing, bank underwriting strategies to avert what they felt was imminent doom, the complete and utter collapse of consumer confidence worldwide.

Fast forward 6 years to today. The US is in the first year of a recovery, albeit an excruciatingly slow one. Europe is showing the first signs of life after its near death experience. Japan may be emerging from its 20 years depressionary funk. Only China – the world’s only bright sign in the recent past – is showing worrisome signs.

So can we all now breathe a sigh of collective relief? Did we the dodge the bullet of all bullets?

According to a few very bright authors and researchers, the answer unfortunately is a very emphaptic NO.
With his somewhat cryptic but equally brilliant book “Anti-Fragile”, Nassim Nicholas Taleb has shown just how fragile our global economic system has actually become and how the least little think could create an avalanche of turmoil that could cause a crisis that is unprecedented in world history.

More recently, and somewhat less cryptically, James Rickards takes the analysis a bit further in his recent New York Times Bestseller “The Death of Money”. That book, in dramatically chilling detail, exposes the many cracks in the world monetary system that are becoming visible for those who care to look.

Rather than try to summarize his book, I’ll let the author speak for himself, as he does in this video interview:

Seeking Alpha – 3D Printing

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The Sun Also Rises

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One of the most significant macro-economic issues facing the world economies today are linked to the availability and cost on electrical energy. Many skeptics believe that this industry exists only due to government magnanimity and without those subsidies, could not survive on its own merits.

This view, in my opinion, greatly underestimates the power of exponential growth in technology, which will cause such a dramatic drop in the price of photo-voltaics, power transmission, power storage and energy distribution, that it is almost impossible to fathom it.

As this article by Amory Lovins, in a recent debate on The Economist, clearly demonstrates, we are already at the stage when solar power is coming into its own. Investors who ignore the solar sector may rue the day they did not take note of these trends:

Amory Lovins
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Amory Lovins

Solar photovoltaic cells (PVs) produced about 0.7% of global electricity in 2012 from 100 gigawatts (billion watts) of capacity, wind power 3% from 283GW and other renewables (excluding big hydro dams) about 1.5% from 97GW. Yet many utilities consider these modest sources’ plummeting costs, increasingly competitive prices and swift scaling to pose a mortal threat, or a transformational opportunity, or both.

Solar-cell prices fall 30% with each doubling of cumulative production. They fell at least 30% in 2012 alone. Once $100 per watt, then $10, they are now around $0.60, soon will be $0.40. Already halved “balance-of-system” costs—customer acquisition, approvals, interconnections, installation, wiring, inverter—keep falling too. By adding 30GW, Germany cut installed system costs to half the American average for the same equipment. Yet even at twice the German cost, utility-scale solar power in sunnier American regions has fallen below $70 per megawatt hour (mWh) net of a 30% federal tax credit (smaller than many non-renewables’ subsidies). That’s three times the lowest Mid-Western wind-power price, half the Hinkley Point nuclear price and cheaper than efficient new gas-fired power plants.

Gas prices are rising, and the market value of their volatility adds at least $10-20/mWh. Yet solar power, like wind power, typically sells on 30-year fixed nominal-price (declining real-price) contracts, hedging the gas-price risk. Moreover, solar power on your roof, like most in Germany, avoids a $30-50/mWh delivery cost.

Bloomberg New Energy Finance recently forecast solar power would reach grid parity in three-quarters of world markets in 18 months. Today in 20 American states, private firms install rooftop solar power with no down payment and beat utility prices. As solar costs fall and utility tariffs rise, “no-money-down” could turn to “cash-back”, further speeding adoption. The San Diego utility expects solar output to idle its fossil-fueled power stations on sunny afternoons by 2015-16. And by 2015, China aims to boost its solar power to 35GW—about what the world installs each year.

Solar power increased by 60% a year during 2007-12 because it is a mass-produced manufactured product. In the decade needed to build a multibillion-dollar electricity-generating cathedral, you can build each year a PV factory, making solar cells each year that can produce each year as much electricity as your central station. Thus solar cells are proliferating faster than mobile phones. In poor countries, 1.4 billion people without electricity can sidestep power lines. In all countries, solar power and other equally unregulated products can add up to a “virtual utility”, bypassing electricity companies just as mobile phones bypassed wire-based phone companies. This gives utility executives nightmares and venture capitalists sweet dreams.

In liberalized power markets, wind and solar power are destroying utilities’ traditional business model: competition makes central stations run less and get lower prices. Germany’s wholesale power price has fallen by three-fifths since 2008, and on hot afternoons when electricity is often most valuable and profitable, solar output is greatest. Some wrong-footed utilities and fuel vendors spread disinformation about their renewable rivals—especially about Germany’s impressive successes.

A persistent fiction holds that because PV and wind power are variable, they are unreliable, needing back-up by “24/7″ or “base-load” fossil-fuel and nuclear stations. Actually, those giant stations’ intermittence (unforecastable failures) requires costly reserves so the grid can back up failed plants with working ones. But well-designed renewable portfolios often need less back-up. The grid can offset varying solar and wind output (both more accurately forecastable than demand) by diversifying their type and location, then integrating other renewables (dispatchable whenever needed), flexible demand, and distributed storage in smart electric vehicles and ice-storage air conditioning. Such a portfolio can reliably power the isolated Texas grid with 100% renewables, with no bulk electricity storage and only 5% leftover renewable energy.

As flexible demand and distributed intelligence make the grid more agile, such choreography made Europe’s most reliable electricity (in Germany and Denmark) respectively 23% and 41% renewable in 2012, and in the first half of 2013, Spain’s electricity 48% and Portugal’s 70% renewable. Ignoring such data, flat-earthers still proclaim minuscule renewable potential.

The renewable revolution is accelerating. Half of American and 69% of European capacity added in 2012 was renewable. China, Japan, Germany and India now produce less electricity from nuclear power than from non-hydro renewables, which in 2012 added more Chinese electricity than all nuclear and fossil sources combined. Globally each year, non-hydro renewables win $250 billion of private investment and add more than 80 billion watts, with solar expected to pass wind power this year.

Modern renewables are taking over the market because they have lower costs and risks than fossil or nuclear energy. Together with rapidly evolving energy efficiency, they more than suffice to power the world profitably and resiliently.

Rocky Mountain Institute’s 2011 synthesis “Reinventing Fire” showed how a 2.6-fold bigger 2050 American economy could eliminate coal, oil and nuclear energy and cut natural gas use by one-third, treble energy efficiency, shift from one-tenth to three-quarters renewable supply, emit 82-86% less carbon, make the grid resilient and save $5 trillion—all without internalization, new invention, or acts of Congress, the transition led by business for profit. So far, solar costs have fallen much faster than we assumed. Efficiency and renewables could well save the world, not at a cost but at a handsome profit. We just need to notice what’s happening.

Profit by Predicting The Future?

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The future is not written, so nobody can predict it right? This thought, whether true or false, remains at the core of our understanding of the cosmos and our role in it. Most of us were raised believing in “free will”, which leads us to believe that any human action is possible. The corollary of that thought, of course, is that “nothing is pre-ordained”. And if nothing is pre-ordained, if follows that change cannot be predicted. If change is not predictable, you cannot benefit in your investments by predicting change.

But I reject that conclusion. At the risk of appearing blasphemous, I think the concept of “free will” is very tenuous at best. While we have the impression that we go through life making choices which we are at whim to alter, the choices we make are entirely framed by our past experiences, by the culture passed down from our parents and societies, by our natural environment and by our biology. So these choices are inevitably predetermined to fall within a predictable range of possibilities.

If you accept my contention that most human actions are shaped by our biology, our natural environment, our culture and our life experiences, does that then allow us to predict the future?

Of course not. We don’t have all the relevant data at our disposal – and if we did – we certainly don’t know yet how to factor in all the variables that impact a given process. You may expect the be able to
watch the morning news report tomorrow morning as you eat breakfast, but your electricity could be taken out by a natural disaster you did not foresee. As computer processing advances, our abilities in to study, weight and incorporate more and more variables that impact our lives will grow, but we’ve still got a long way to go.

Despite this caveat, it still makes sense to try anticipate changes, and to weigh how those changes create trends upon which we can successfully make investment decisions. We’ll be wrong at times, but we can hope to be right far more often then we are wrong.

To understand change, we can start by classifying it into three types:

  1. Cyclical change
    • planting and harvesting
    • birth and death
    • day and night
    • tides and phases of the moon
    • seasons
    • migrations
    • stock prices
    • economic recessions and expansions
    • building and real estate activity
    • seasonal sales
    • interest rates
  2. Linear Change
    • aging (of individual)
    • growth of population
    • cell growth and senescence
  3. Exponential Change
    • technological process
    • spread of disease
    • growth of data and knowledge
    • growth of networks

The most difficult part of attempting to predict change is to analyze whether the force or forces under consideration fall into the first or the latter two categories.  Cyclical changes revert in a fairly predictable manner (the bell curve) back to a given starting point, then subsequently swing to its opposite. Linear and exponential changes feature trends that never revert to their starting point.

If a force is found to be guided by cyclical patterns, reaping profit from that takes a careful application of determining when a cycle is likely at its peak or trough and betting (or investing) on the impending reversal. By being patient, one is bound to be right. Thus has Warren Buffett, America’s most successful investor, made his fortune, following his motto: “Be greedy when others are fearful, and fearful when others are greedy.”

Similarly, look for biological roots in cycles and identify how those cycles impact economics. For those thinking that America’s real estate slump is purely a question of greedy bankers and lax regulators, you may want to more closely examine the 5 and 7 year cycles of the adjustable loans granted to home mortgage owners. It is more than coincidence that the boom of 2002 finally burst in 2007 – the same year all those balloon payments started coming due.

Recognizing that cycles exist – and are overpowered by other cycles – adds complexity to these issues, but does not prevent their analysis.  Thus anyone predicting a resurgence of real estate in another 5 to 7 years – a turn of that cycle – would be wise to pay attention to the larger generational cycle : namely how 80 million people are going to retire and downsize their homes due to aging of the population at a time only 50 million new generation X’s step into the markets to buy homes. The laws of supply and demand allow a confident prediction of continued pricing declines.

A trader recognizes cyclical changes and knows how to benefit from them. As Shakespeare wrote: “There is a tide in the affairs of men which, taken at the flood, leads on to fortune.”  A modern-day Wall Street trader might reword that as “sell when the price is overbought on both the stochastic and rsi charts”.

Linear and exponential changes are what bring about the “new” in change, and actually permit progress over time. Identifying those trends accurately  is probably what  distinguishes an  investor from a trader. Finding investments in companies or industries likely to benefit from linear and exponential growth are the essence of successful long term investments.

One of the foremost scientific and literary minds of our time is Ray Kurzweil, who in his book “Approaching the Singularity”,  dissects the forces guiding technological change.  Understanding these forces – the distinction between linear and exponential growth – is actually one of the most difficult processes of human understanding.

Our brain is naturally wired to think things in the future will change at about the same pace as things changed in the past. We have grave conceptual problems dealing with exponential growth.

There is an old fairy tale that perfectly exemplifies this inability to conceptualize exponential growth. The fairy tale starts with a king who is very thankful towards one of his counselors who delivers a simple herbal remedy that saves the kingdom’s livestock from a fatal disease. The king is so thankful that he offers the counselor a castle, or the hand of one of precious daughters or anything the counselor wishes, if it is withing his means to grant. To his infinite surprise, the counselor asks for nothing more than one grain of wheat for the first square on a checkerboard. But for each subsequent square, the king is to double the quantity of grains. Thus 2 grains for the second square, 4 for the 3rd square and so forth.  

The king immediately grants the counselor his wish. Little does he realize, that by the time he’s gotten to the 64th square, he owes the counselor more grain than is produced in his entire kingdom. Such is the power of exponential growth.

This same difficulty of thinking in anything but linear fashion caused the entire American Academy of Sciences to predict it would take 30 years to map the human genome by deploying a majority of scientists to the task. It took scientific maverick, J. Craig Venter,  to understand the impact on genome research of an exponential increase in computer power. Venter confidently predicted he could do it with a small team in one – sixth that time, and one hundredth the budget. The academe of science scoffed at the notion but Venter went on to do just that.

Similarly, today, we repeatedly hear technological experts and investments gurus scoff at the idea that solar power will play an important role in solving energy problems within our lifetimes.  They are once again demonstrating the human brain’s reluctance to accommodate exponential growth.  They are thinking that a technology that represented about 1% of our total energy consumption in 2003 could not possibly make a meaningful difference over the next few decades. What they ignore is the fact that technology improvements are doubling the capacity and halving the costs of solar energy every two years.  Consequently, as pointed out by  Ray Kurzweil in a 2011 University of Florida speech, solar energy will overtake oil-based energy in cost efficiency within 6 years , most likely by the year 2017.

The implications for any investing strategy are obvious: expect the sales of solar energy companies to grow at rates of 35% and more over the next decade.

From there to knowing which solar company to invest in is more difficult, but their is little doubt this will be a dominant industry within the next decade. The stock prices of the leading companies in the sector will increase manifold.

Do you like investing in the automobile sector? If you think people will still be driving cars – and I do – you’d better make sure the car companies you invest in are leaders in electric car technologies.

More and more fields of discipline and human endeavour are being impacted by the digitalization of knowledge. Identify those fields, and you can make savvy investments in industries sure to grow.

Medicine, for example, for years was a field that was labeled a science of discovery. New advances resulted from careful observations and trial and error of the administration of different remedies, some of which proved beneficial and others fatal. Consequently, the advance of knowledge in the medical field was one that grew in a linear fashion.

The advent of the personal computer and the exponential power increases in chip technology changed all that. These gave tremendous impetus to new developments in the fields of microsurgery, biotechnology, drug testing and microphotography, which in turn led to our understanding of the human body as a complex mechanism which responds to the software embedded in our DNA. Having mapped the human genome, we are now not only learning which gene controls which bodily function, but also are able to directly manipulate those genes to affect our health outcomes. As a consequence, medicine itself has now become a field of knowledge growing at
an exponential pace, rather than a linear one.

One simple implication of that, but a far reaching one, is that human longevity will increase at a faster pace than most of us can conceive of. For a middle-aged Americans, their grandparents lived into their late 60′s, parents into their 80′s. They tend to see themselves living into their 80′s and perhaps their 90′s. Yet many of them – due to the rapid pace of scientific advances – will live to be centenarians. Their grandchildren, futurists like Kurzweil claim, will be able to choose to live forever.

An investor today who wishes to successfully invest over the next 10 years must keep the following precepts in mind:

  1. Learn to distinguish the cyclical trends that affect the investment.
  2. Assess when a larger cyclical trend will override a smaller one.
  3. Distinguish between linear and exponential changes, and favor investments that benefit from the latter
  4. Do not ignore our tendency to overestimate the speed of technological change at first, then to grossly underestimate it thereafter.
  5. Finally, realize that the pace of change is increasing constantly, so whole fields of human endeavour will rise and fall ever faster. Yesterday’s burgeoning software giant (Microsoft or Intel ?) quickly can become today’s dinousaur. Conclusion: don’t fall in love with any one company or industry.
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