The Power of Reality

 
About two months ago an article appeared in the Wall Street Journal titled, “Advisers Ditch ‘Buy and Hold’ for New Tactics.” The article reports that investment advisers are rethinking their traditional investment approaches like buy and hold. A growing segment of the investment community is questioning their faith in long-standing investment principles, such as controlling risk through normal diversification. The stated reason for the discontent is the increase in correlation between one investment class and another, thus reducing the ability to diversify risk. Investors and advisers alike are increasingly unhappy with the results they are getting from conventional methods. As a result, financial services companies are actively creating new products designed to respond to the discontent. Some advisers are adding increasingly exotic investments, others are trading more actively, and still others are beginning to use more unconventional approaches like hedge funds, long/short funds, managed commodities, private REITS, and currencies. Change is definitely in the air.

Forgive me if I’m a little skeptical. The reason that this buy and hold tactic doesn’t work, is because it is built on the flawed and simplistic premise that ultimately stocks will go up because that is what they have done in the past. In addition to being a truly stupid reason for risking one’s hard earned money, it is buy and hold in name only. A more accurate description would be buy and hope. So when the buy and hope strategy fails, as it ultimately does, investors go out in search of a replacement. But without an objective framework for evaluating the flaw in their thinking that led them to buy and hope, like moths to a light they are drawn to the equally flawed promise of what’s working now. Buy and hope gets exchanged for trade and hope, or alternative investments and hope, or some other foolishness. In either case the results are equally dismal.

The results of this kind of behavior have been well documented in one study after another. The sad fact is that most investors do far worse than whatever funds they are investing in, because they buy and sell at the worst possible times. One such study reviewed a twenty year period ending 2007, when the average equity mutual fund was
producing nearly 12% per year. The average investor in those funds earned less than if he bought Treasury Bills.1

The solution to avoiding this dilemma is to follow the simple advice of Charlie Munger, Warren Buffet’s investment partner for the last 50 years. He said, “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”2 As noted above, most investors, professional or otherwise do not suffer because of market declines; they suffer because of their own mistakes, both individual and collective.

Our fund managers steer clear of this trap. They ignore both conventional wisdom and Wall Street advice, and stay well within their circle of competence. This means that, if, after clear reasoning, rigorous analysis, and considerable patience, they are convinced that the value of a prospective investment is worth more than its current price, they will buy it. If it continues to drop in price, they will buy even more. They will hold it until the price is equal to or greater than the value. This is the real buy and hold. In the words of one of them, “Superior long-term performance is a function of a manager’s willingness to accept periods of short-term underperformance…while deploying an unpopular strategy.” Our managers have the conviction, patience, and experience with their decision making to understand the difference between appearing foolish and being foolish. They adhere to the warning of Lord Keynes who wrote, “It is better to be roughly right than precisely wrong.”

It appears that many investors have not learned the huge lesson from the credit bubble and subsequent market collapse: ultimately fundamentals do matter. There is always a day of reckoning when the power of reality overcomes the momentum of whatever emotion is driving the market. It is this reality which forms the foundation that drives my decision making; and gives me the confidence to ignore the false promise of what’s working now, so that however uncertain the future, we will arrive there prepared.

1 DALBAR – Quantitative Analysis of Investor Behavior 2007
2 Poor Charlie’s Almanack p.8

The Same Old Song

 
There was an interesting article in today’s Wall Street Journal, Financial Advisers Try New Tactics by Anne Teregsen and Jane J. Kim.

Teregsen and Kim write that investment advisers are rethinking their "conventional" approaches to investing. The philosophical reason for these changes is that the “correlation” among those asset classes has gone up so much that the benefits of diversification really aren’t there. They noted that there is some evidence that advisers who use traditional buy and hold approach are losing clients to managers trying new approaches.

After finishing the article, I wrote an email to Tergesen and Kim. Below is an excerpt:

"The strategy of “Buy and Hold”

"The advisers who are exiting this strategy are doing so because they don’t know what it is. The actual strategy they are ditching is better termed “buy and hope.” This strategy is built on the overly simplistic conclusion that if you hold onto stocks long enough, they will go up, because that’s what they’ve done in the past. A strategy built on such a flimsy philosophical foundation is just doomed to failure. Those of us who have been at this long enough, know that at some point the market will behave in a manner that will challenge our most deeply held convictions. So it isn’t surprising that “buy and hope” has been swept away.

The real “buy and hold” strategy is built on the well documented fact that it is possible to make value judgments regarding investments. Careful investors will wait until they judge that the value of what they are about to buy is worth more than the price. They will then “buy” it and “hold” it until the value equals or exceeds the price. The process is not guaranteed to succeed, but it is built on logic and common sense – and unlike “buy and hope” it has both the substance to withstand challenge, and the ability to be refined and improved."

The failure of diversification

"I was a liberal arts student, so I’m doomed (or blessed) to search for the common sense logic behind all statistics. The fact that “traditional” diversification has not worked recently, does not mean necessarily that there is a permanent change in the relationship between stocks (US and Foreign), bonds, and cash. There are times diversification doesn’t work. This is not news; it is baked into the conceptual framework of putting the odds in your favor – you can never get to 100%. I’m not suggesting that there aren’t substantive reasons behind why “traditional” diversification has diminished in effectiveness. The evaluation of those reasons, and whether they appear cyclical or fundamental is a subject worthy of inquiry. It appears however that the same flawed assumptive reasoning that led advisors to dump (what they believe is) the “buy and hold” theory, is also causing them to dump “traditional diversification.”


“New” Tactics

"I confess that when I first heard the biblical phrase “there is nothing new under the sun” I didn’t really understand what it meant. But after observing investors make the same mistakes from one decade to the next, I’m getting the hang of it now. I’m afraid that the “new tactics” advisers are switching to, are driven more by “what’s working now” than any substantive change in their thinking, or any really new investments. As a result, the “new tactics” may work for a while, but as with “buy and hope” at some point down the road the market will throw up a harsh challenge to this “new” strategy, and investors will wake up wondering what they have, and why they have it. In a repeat of what is happening today, their advisers will have nothing meaningful to say, other than to point them to “what’s working now.”

"The challenge all advisers face is how to dispense not just advice, but good advice. That is, advice that is built on a firm base of common sense, experience, rigorous analysis, and realistic assumptions. I know a number of advisers who hew to that thinking and so I’m confident that there is still good advice available for investors."

Reality Check

I don’t think it will come as a surprise to anyone reading this letter that the current economic and financial dislocation is the most challenging we have ever faced. Trillions of dollars of wealth have disappeared as the excesses of the credit bubble imploded, vaporizing most of the former giants of the financial system, freezing credit, and pushing the economy into the steepest economic decline since the 1930’s. I am quite certain that 2009 and possibly 2010 will see economic distress that few people alive today have experienced.

How do we respond to a challenge like this? Should we just hang on and hope things get better? Or should we be thinking about stocking up on canned goods and ammo and heading to Montana? The government has thrown trillions of dollars at this problem with seemingly nothing to show for it. Are our leaders that incompetent, or is this financial Armageddon?

When the market drove off a cliff in October, normal diversification failed. Stocks dropped, bonds dropped, gold dropped, commodities dropped, real estate dropped. Everything dropped except cash; and the yield on cash dropped to zero. There was nowhere to hide.

So what are we going to do? How can we make investment decisions when the financial system itself appears to be in danger? Yes, the future is always uncertain, but now it’s really uncertain.

The Crisis is your Friend

In a situation as big and bad as this one, investors tend to see only two choices: run and hide, or batten down the hatches and ride it out. In the first case, the investor sells everything, and puts his money in T-bills or cash. He feels good, because the news keeps getting worse, and the markets keep going down. He thanks his lucky stars that he cashed out when he did, and decides to wait for a time when he feels confident again, before committing his money to risk. This behavior is called selling low, and buying high.

In the second case, the investor decides to grit his teeth and ride it out. He has been investing for five years, and in his mind, he is in this for the long-term. Given that the market has already fallen over 50%, his comfort level is already on thin ice. As the economy and the market continue to deteriorate, his ability to withstand his portfolio moving up and down finally breaks down. He may very well survive the bottom, but at some point in some rally, he will cash out, glad to have recovered some of his losses, vowing never again to gamble in the stock market. This behavior is called buying high and selling low.


There is a third choice. Many years ago, we had a house guest: an extremely brilliant and wise Rabbi. I asked him one day how he dealt with problems that appeared to have no good solution. He said that when he comes across a challenge like that, he reframes the entire issue in his mind, and this change of reference can transform a previously intractable situation into one with workable options. This behavior is called thinking outside the box.

So I have reframed the situation. At first blush (maybe the second blush too), the idea seems preposterous: The current worldwide financial crisis and severe economic dislocation is a once in a lifetime opportunity to build wealth with a reduced level of risk. Forty years ago you could have legitimately wondered if I was smoking something strange. But those days are gone, so either I have completely lost it, or perhaps there is a germ of truth in this.

If you will humor me a bit longer, I will make the case for how we can not only survive this very dangerous situation but how we can use it to our benefit. Nothing will change except our perspective.

Reality: Better than the Alternative

I recently got an email from a friend. It appears that a small winery needs to raise cash, and they are selling cases of award winning premium wine for $5.00 a bottle. I did a little checking, and five years ago the same wine was selling for $23.00 a bottle. Two years ago it was selling for $18 a bottle, and late last year it was available at $10 a bottle. If I had bought the wine on sale at $18 and loved it, and I bought some again at $10 and felt the same way; wouldn’t it stand to reason to back up the truck at $5.00 a bottle? That’s how our value managers think.

“The investment world has gone from underpricing risk to overpricing it.” So wrote Warren Buffett in his most recent letter to shareholders. “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late 2008 may be regarded as equally extraordinary.”

US Treasury bubble? Aren’t US Treasuries inherently safe? As it turns out, the answer depends on your perspective. If your concern is just whether they will pay interest and principal on time, they are safe. Nevertheless, the history of investing teaches us that nothing is “inherently” anything. For the investor who is trying to make good investment decisions, price is a far more reliable indicator of safety than reputation. Given the price (or yield) of Treasuries today, despite the guarantee, there is considerable risk to owning too many of them for too long.

Risk is an elemental part of the investment landscape. There is risk in every investment, and there is risk in every investment decision. You can no more avoid risk than you can avoid gravity. Our strategy with risk is to understand it, measure it, and respect it. If we understand risk, we know where it is lurking. If we can measure risk, we know when it’s appropriate to take some on. And if we respect risk, we know that being prepared for a risk that doesn’t actualize is far better than being unprepared for a risk that does.

There is no way to know if investments that appear to be bargains today won’t become even greater bargains tomorrow; or whether the investments that appear to be risky will actualize their risk. Over short periods of time, markets are voting machines; and they can drive prices to levels that have no relationship to their value, whether perceived or actual. The reason that the value proposition is such a powerful tool is because ultimately, markets are weighing machines; and if there is value to be realized, markets will adjust to recognize that value. That is not a prediction; it is the nature of the market mechanism itself.

Three and a half years ago, in the fall of 2005, I began to write in this newsletter about the complacency in the investment world at large, suggesting that it was an appropriate juncture for all clients to reassess risk. I had no idea how long the calm would last, or how much higher the market would go. But it was clear that investment risk was increasing and building some cushion was a sensible response.

Today, the complacency has been replaced by fear. And just as complacency can lead investors to forget there is risk, fear can lead investors to forget there is opportunity.

The purpose of changing our perspective is to gain a measure of clarity – so we can understand the world as it is, not only as it feels. There is still a lot of danger out there, and we need to respect that, and make sure it is reflected in our investments. But increasingly, there is also opportunity. That is the nature of fearful times. Accordingly, we can acknowledge our fear without letting it get in the way of making good decisions, knowing that it is a far more acceptable price to pay than the alternative.