12 Sep 2019
The complex nature of the subject with no one rule working across the board means that there are few great investors. Approaches that seem to be delivering results for a time can often be found to have been suited to one particular investment style factor which, when it goes out of fashion, can leave investors following this creed disappointed. To be successful as an investor there is a need for perceptive thinking and recognising that it is not always possible to have an edge for outperformance in all market conditions. Most investors would recognise that extra ordinary performance only comes from correct non-consensus forecasts, but they may not recognise that these, by their nature, are hard to consistently make. For an investor to achieve superior results, there is a need for non-consensus views regarding value to be held. Furthermore, these need to be accurate or, in other words, over time an investor needs to get more right than wrong.
Asset prices generally reflect the consensus view of market information. It’s important to remember that one or two years of good results doesn’t necessarily prove anything, as chance alone can produce just about any result. Someone in a casino making five consecutive winning bets on the roulette table hasn’t demonstrated skill, and in investments the same is true. Very often a manager having a good short-term run can be judged to have significant skill, but this is not actually the case. Manager talent can only start to be ascertained over a minimum of five years (typical market cycle) and ideally over longer time periods. Most asset classes are fairly efficient but this does vary depending on how well researched they are. The better an asset class is known and the broader its following, the harder it is to make a non-consensus winning bet against the herd. In some mainstream markets it can be argued that it is almost a waste of time to try and find winners, certainly without a specialised approach. Investors are more likely to find superior returns investing in inefficient markets.
Finding inefficiency can be approached in different ways with investors very often described as either value or growth style oriented. Value investors look to buy businesses at a significant discount to their intrinsic value. For this approach to be successful, working out the intrinsic value of a company is vital but not always easy. Growth investors look to find businesses that will continue to rise faster than the market expects for longer than the market expects, while other investors try to combine these approaches. Many value investors rely on mean reversion for shares and company profitability and even for economies. Even this long-standing approach has come into question in an era of QE where markets have been distorted by central bank policy and traditional businesses have suffered disruption and those with monopoly powers have hung on to super high levels of margins with little sign that these are being competed away. For investors wanting a lower risk approach, finding a manager who is rigorous about quality factors but also equally exacting about the price paid in absolute terms, can deliver results with lower than market volatility. This can be achieved in part by simply avoiding big mistakes. Investment approaches favouring quality at any price, or value at any quality, may deliver results over short time periods, but there are likely to be periods of blow ups or intermittent disappointment.
This is not to say that investors can’t make money by investing in assets that are only fair value, as over time markets do tend to rise. One important element for investors to remember is that, as well as buying at the right price, it is important to sell at the correct price. Being forced to sell at the wrong price, for liquidity reasons, can sometimes result in investors dumping stock or an asset well below its intrinsic value. Never being a forced seller of an illiquid asset is an important mantra for every investor.
Another mistake many investors make is to assume that results that have benefited from leverage demonstrate more skill. In reality, the higher returns have merely been achieved through greater risk. Leverage will magnify either gains or losses and in the case of the latter can force an investor out of an asset, meaning that they can’t stay invested long enough to see a recovery. Over the years leverage has been associated with high returns but also with spectacular meltdowns and crashes, most recently in the Global Financial Crisis. With all investment strategies it is important to remember the quote of John Maynard Keynes “the market can remain irrational longer than you can remain solvent”.
In order to make above average returns over the risk-free rate it’s imperative to take risks. This involves understanding risk and sensing when it’s high. Investors can also control risk through portfolio construction. This may initially involve deciding whether a given investment justifies the risk by considering the risk adjusted return. A traditional message is that higher risk assets give a higher return, but intrinsically this cannot be true, otherwise these investments would not be riskier. Risky investments can deliver a higher return, but only if they are bought at a time when the return is attractive relative to the risk taken. The price paid for the investment is key. Riskier investments do offer a prospect of above average returns, but also the possibility of below average returns and, in some cases, significant losses.
Many investors define risk as volatility although some would argue that a better definition of risk is absolute loss of the capital invested. The risk of permanent loss is the biggest one an investor should worry about. At times the correct course and the most prudent one may be to avoid taking the level of risk necessary to keep up with an irrational market. The amount of risk in an investment is only a judgement; it is not something that can be measured with complete certainty. Much of risk is therefore subjective and hard to quantify. Even those using risk tools such as value at risk (VaR) or portfolio beta, are reliant on the past data set and the metrics analysed which can alter over time. Many risk systems only look back over the last 10 years, so the Financial Crisis period will have been stripped out from these risk metrics and may be focused solely on data gathered in a long running bull market, during which interest rates have mainly been falling and central bank policies including QE have arguably distorted markets.
Some investors have lived for years off a great market forecast of an extreme event, but little is proven by this as such calls are not necessarily repeatable. Furthermore, in a bull market, the best returns go to those who take the most risk. An investor can be right for the wrong reasons, but wrongly credited with great skill for the call. When looking back at history there has only been one outcome, but at the time when an investment is made there are many probabilities and potential outcomes. When deciding whether a manager has skill or luck, the job of an advisor or analyst is to try and work out how likely these favourable outcomes were when the investment was successful. There is a difference between probability and outcome and some probable events don’t occur at all. When making investments, as well as having a central expectation, it is necessary to have a sense of other possible outcomes and the likelihood of these. Statistical models can rely on the assumption that future events will be distributed normally but, as we have seen in investment markets, tail risk occurs and, in an age of disrupted markets and commerce, fatter tails are likely. At the end of the day risk can be more a matter of opinion than fact until after the event. Even a sophisticated VaR system with 99% probability can see the 1% happen.
For most people investment risk is invisible before the fact. This is because the future is impossible to accurately predict. Most investors’ projections cluster around what has happened in recent history and only small deviations are expected. In the GFC many people’s worst-case assumptions were exceeded. Even looking at averages of negative outcomes can be misleading. For example, investment grade bonds have shown an average default rate of 1% p.a. over long time periods but this 1% could all occur in a very short space of time.
Investors should never forget that it will only pay them to take on extra risk at the correct price or valuation level. Understanding risk can start with recognising when investors are paying too little regard. Valuation can be the best risk control in an investor’s armoury. This is demonstrated with market sentiment as, when investors are not worried and risk-tolerant, they will buy equities at higher valuation levels than when pessimism pervades. Attempts by investors to avoid risk by buying absolute return products has shown that, investing in an area totally dependent on manager skill for return, can be extremely risky (or unrewarding) in itself. Central Bank policy has encouraged investors to minimise their concept of risk and to buy riskier assets. In bull markets investors worry more about the risk of missing out than the risk of absolute loss. Another mistake is for investors to not understand that part of a higher return from an investment may be due to pricing illiquidity which makes the underlying investment inherently risky over the longer term.
Central bank policy today with zero or negative interest rates has tempted or encouraged many investors to make riskier investments than are suitable for their own personal objectives. As Warren Buffett has stated “it’s only when the tide goes out that you find out who’s been swimming naked”. When the current bull market ends, this will be seen in practice. In the corporate bond-market some covenant lite issuances have once again occurred, even though it was this part of the market that caused problems in the 2007 credit crunch. On the other hand, in 2009, when most investors regarded anything risky as unviable, excellent returns could be made for the risk taken.
Whilst risk is unavoidable, or often invisible, as is the possibility of loss, observable loss only occurs when risk collides with negative events. Successful investing can result in over confidence as the favourable outcome that occurred wasn’t guaranteed at the time the investment was made. The fact that the environment didn’t turn out to be negative didn’t mean that it couldn’t have been.
When many investors focus on finding an investment that can deliver outperformance versus its benchmark, this is only one half of the equation. Another approach is to find skilled fund managers who can deliver the same type of return, but by taking much less risk. There are funds today that have demonstrated this historically, or in other words, have given market type or better returns with lower than market volatility or drawdown. Focusing on this type of approach is a perfectly legitimate way to look at portfolio construction. Investors successfully controlling risk understand that they don’t know the future with any certainty, but they do understand that there can be negative outcomes and try to guard against this. In today’s world of low rates, risk avoidance will probably result in very low returns, but understanding and controlling the risk taken is more important than ever before. For long-term investment, avoiding losers is just as important as finding winners.
Within equity-markets, changes in earnings aren’t the greatest profit or loss drivers. Changing valuation is driven by investor psychology and this psychology swings back and forth like a pendulum. Investors entering the market from mid-2009 through 2010 were buying at a time when the pendulum had swung to extremely pessimistic levels, which is why the returns have been so strong since then. Prior to this and in the lead up to the Financial Crisis, some conservative fund managers, aware of the risks that could lie ahead and the current market valuation levels, had lost client assets through delivering what were considered subpar returns at the time, but in hindsight protected investors capital far better. The fear of missing out demonstrates the influence of the crowd. Investor herd instinct can provide opportunities for valuation and risk conscious investment strategies.
Over the years there have been many investment bubbles and bubbles are troublesome for everyone. In the initial stages they are painful for those who refuse to join the herd as seemingly easy gains have been missed. In the later stages, when the bubble blows up, there is significant capital destruction. Over the life of a pension fund, investment for most individuals avoiding bubbles is one way to generate above average returns with below average volatility. This is much easier to write about than deliver in practice as greed and human error push investors the other way.
To increase the likelihood of success the investor needs to have a strong sense of intrinsic value and to be prepared not to be caught up in herd behaviour. If a price diverges from intrinsic value in either direction it is vital to act. Understanding past cycles is important but more difficult in today’s world which is challenging for even experienced investors. It is also necessary to understand investor psychology or behavioural finance aspects when constructing a portfolio. Investors also need patience as market valuations tend to overshoot on both the upside and downside. Most investors follow trends, but the most successful investors do the exact opposite. Initially an investor may appear to be wrong and possibly foolish but always remember that, at the most extreme point in markets, most investors, and therefore the conventional wisdom of the day, will be wrong.
To combat herd behaviour investors can rely on contrarianism but this will only work if the intrinsic value of an investment has been successfully worked out, and even then, there may be a period where it doesn’t work in the years to follow. This can be extremely painful and very often investors will capitulate at the wrong time when the trend is going against them. For a contrarian approach to be successful there must be a catalyst when this change is accepted by the wider marketplace. This is one reason why diversification in a portfolio is important and why holding assets where the return appears attractive versus the risk is significant.
In an environment of central bank support for market cycles, downturns have been suppressed in the short term, but over longer periods the ups and downs remain inevitable. Unfortunately, the timing of a cyclical change is as unpredictable as the extent to which it will occur.
Investment is not an exact science. The future can’t be predicted with certainty and specific actions won’t always produce specific results. Over the short term a lot of investing is ruled by luck. Nicholas Taleb explored some of these concepts in his book Fooled by Randomness. It’s important to consider this when assessing a fund as luck or randomness can strongly influence the results of the fund manager, especially over shorter time periods such as less than a full economic cycle. When an investor takes a decision, it is done without certainty and what Taleb refers to as “alternative histories” could have occurred. Many investors achieve prominence because they took considerable risks and won, whilst those that took similar risks and lost are quickly forgotten (or fired!). This is also true in war where the phrase ‘lucky general’ came from.
When assessing investment results it is necessary not to be fooled by randomness or returns generated through luck. In a bull market the highest returns will typically go to those taking the most risk, especially if they apply leverage. The converse is true in bear markets. This helps explain why the number one fund in any particular year can often be amongst the worst performers twelve months later. It’s easy for investors to convince themselves that luck is skill. Trying to ascertain whether the decision made at the time was optimal is a useful way to assess manager skill. Investors making the biggest or riskiest calls can of course get one or two of these correct but, over longer time periods, find themselves succumbing to the law of averages. Investment skill can be more accurately ascribed to those who have delivered results over a larger number of smaller bets, rather than placing everything on red or black. Just because a particular investment strategy worked doesn’t imply that the decision behind it was wise. It’s equally as important to consider whether the decision at the time would not have proved to be disastrous in different scenarios or outcomes. Being happy that the decision made was logical and informed is perhaps more important than whether, as a one-off event, it proved successful. Prudent investors will look to build a diversified portfolio that will not try to maximise returns in one scenario but that will provide positive outcomes in different situations and avoid disaster in worst case outcomes. Many fund managers argue that it is easier to find consistent valuation anomalies on stock by stock basis rather than making big macro calls between asset classes.
A further approach can be described as investing in a defensive manner, with part of the reason behind this being that it is possible in the investment world to win by avoiding major mistakes or making less mistakes than other investors. Avoiding large losses is a way in which investors can afford to stay exposed to potentially volatile assets and avoid the psychological problem of wanting to sell out of something that has seen a severe price decline. Even if this approach only delivered average results over full cycles, if it was delivered with below average volatility, it would suit many clients’ investment objectives. This is not a negative mindset, as it is trying to deliver higher returns through not having to recover from pronounced lows. An investment that falls by 50% needs to rise by 100% to recover the losses incurred.
Over longer investment periods such as the life of a pension fund for an individual, there will always be some large stock market drawdowns and, avoiding the full extent of market losses in these crashes, is an important way of delivering above average returns over the longer term. In market crashes concentration and leverage are often two features of a badly hit portfolio and both are typically a result of over confidence by an investor who believes they can forecast the future with certainty. Markets do tend to go up over the longer term, so having a portfolio that is able to get through the tough times and then enjoy the payoff from investing in risk assets, has a lot to be said for it. This can involve foregoing maximising returns in good times.
Another element in defensive investing is what Warren Buffett calls “investing with a margin of safety, or margin for error”. These are investments that will still produce reasonable returns, even if the future does not unfold as expected. This is where valuation is important as investing when valuations are low gives a margin of safety and is ultimately the best long- term risk control. Whilst arguments persist about whether past performance is an indicator of the future, there are certain fund managers and certain companies with a proven record of navigating through difficult periods without suffering the full rigours of a market or economic downturn and these have often proved to be repeatable investment strategies. A portfolio positioned for several outcomes, or in other words diversified, whilst perhaps looking boring or pedestrian in good times, over a number of market cycles is likely to produce the better returns, whilst also avoiding the behavioural finance risks of heavy losses. It can be hard for an investor suffering heavy losses to avoid the power of herd psychology.
In any form of forecasting, whether it’s stock markets or the weather, there is a tendency to extrapolate the recent past into the future. This can work for a time but will miss turning points, which can result in large amounts of money being lost or opportunities to make significant returns missed. Investors need to allow for outliers and, ever since the mini crisis caused by the failure of hedge fund LTCM in the nineties, it’s clear that even the brightest people fall into this trap. Understanding portfolio correlations and how to diversify these away without being part of a zero-sum game are very important elements in portfolio construction and generally not well understood. Psychological forces known by behavioural finance analysts understand that these factors are behind many unsuccessful investment strategies. Successful investment involves not succumbing to optimism at a high point of the cycle but also avoiding pessimism at the low point. In the run up to the Financial Crisis many investors mistook leverage for genius.
For any investor to achieve superior results they need to have superior insight and successful investors recognise that this isn’t always possible. It’s also vital to have a good understanding of value, with valuation the best form of risk control. Even if an investment is held for a long time period, overpaying for it rarely mitigates from this error. Economies and markets have both up and down cycles and these don’t last forever. The investing herd move in pendulum, like patterns from optimism to pessimism, and this allows opportunity for those able to look at markets in a rational, unemotional way to risk and control risk at the core of defensive investing. Unlike in sport it is possible to win in investment simply by making fewer mistakes than the average.
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