Bull markets can play tricks on investors perception of risk. So much so, that the end result can be costly.
Since the instant people recognized markets move in cycles, it’s been a recurring theme. Each bull market produces a fresh crop of investors — new investors absent experience and experienced, but absent-minded investors — believing it can never get worse.
It leads investors into a false sense of security through optimism and overconfidence, confusing skills with luck, “brains with a bull market,” believing high returns are easily earned and risk is nonexistent.
The longer a bull market drags on, it gets easier to forget what came before it. The result is investors take chances they normally wouldn’t take but leave themselves dangerously exposed to what inevitably comes next.
It’s one of the easiest mistakes to make. It’s probably one of the most warned about too.
Seth Klarman did exactly that to the MIT Sloan Investment Club in October 2007.
Warren Buffett often quips that the first rule of investing is to not lose money, and the second rule is to not forget the first rule. Yet few investors approach the world with such a strict standard of risk avoidance. For 25 years, my firm has strived to not lose money — successfully for 24 of those 25 years — and, by investing cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio — and with risk comes losses. Some investors target specific returns… The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.
When the herd is single-mindedly focused on return, prices are frequently bid up and returns driven down.
By the time the market drops and bad news is on the front pages, it is usually too late for investors to react. It is crucial to have a strategy in place before problems hit, precisely because no one can accurately predict the future direction of the stock market or economy. Value investing, the strategy of buying stocks at an appreciable discount from the value of the underlying businesses, is one strategy that provides a roadmap to successfully navigate not only through good times but also through turmoil. Buying at a discount creates a margin of safety for the investor — room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies. Following a value approach won’t be easy for everyone, especially in today’s media-dominated, short-term oriented markets, in that it requires deep reservoirs of patience and discipline. Yet it is the only truly risk-averse strategy in a world where nearly all of us are, or should be, risk-averse.
When so many others lose their heads, speculating rather than investing, riding the market’s momentum regardless of valuation, embracing unconscionable amounts of leverage, betting that what hasn’t happened before won’t ever happen, and trusting computer models that greatly oversimplify the real world, there is constant and enormous pressure to capitulate. Clients, of course, want it both ways, too, in this what-have-you-done-for-me-lately world. They want to make lots of money when everyone else is, and to not lose money when the market goes down. Who is going to tell them that these desires are essentially in conflict, and that those who promise them the former are almost certainly not those who can deliver the latter?
The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions. Success in the market leads to excess, as bystanders are lured in by observing their friends and neighbors becoming rich, as naysayers are trounced by zealous participants, and as the effects of leverage reinforce early successes. Then, eventually, and perhaps after more time than contrarians would like, the worm turns, the last incremental buyer gets in, the last speculative dollar is borrowed and invested, and someone decides or is forced to sell. Things quickly work in reverse, as leveraged investors receive margin calls and panicked investors dump their holdings regardless of price. Then, the wisdom of caution is once again evident, as not losing money becomes the watchword of the day.
Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.
Simply put, the existence of a bull market is the reason to be ready for the next bear (the reverse is equally true). Investing is, and always will be, about risk management. Your strategy should account for turns in the cycle.
But it also means being mentally prepared. Bear markets can be painful. So having a grasp of what’s possible will make it easier to handle in real time.
Seth Klarman MIT Sloan Speech Oct. 2007