The four most dangerous words in investing: ‘this time it’s different.’

– Sir John Templeton

This is one of the most important quotes in investment history. Unfortunately, it’s often misunderstood. Of course, things are always different from one era to the next, but what does not change from era to era is human behaviour and the formation of market extremes.

In the past decade and a half we have had several great examples of investment sector extremes. Remember the gurus that explained the dot-com years by stating it was a new era and the old metrics of valuation did not apply? How about the housing boom? Recall the experts in late 2005 stressing why this time was different, and that the record shattering valuations weren’t a problem?

Identifying extremes is easy in retrospect, but for most investors it’s very difficult in the moment. That’s because the natural human tendency is to chase performance, and the brighter the glow, the more average investors clamour to buy.

Here are a few things to consider regarding equity sector extremes. Timespan is important, extremes take years to develop; a year, two, or even three is typically not enough. The thing to look for is outperformance above the broad market for more than three years. Sectors in a classic bubble formation have usually outperformed for more than four years.

Both the dot-com and housing sectors maintained outperformance for just over five years. For the average investor outperformance for three or four years is an almost irresistible buy, yet history clearly shows us that performance extremes do not last, and when they fail the damage to investors is usually substantial.