Jeremy Grantham of GMO has released his latest quarterly letter (embedded below, but you will have to come to the site to view it) in which he discusses the tension between keeping your job and protecting your clients’ money:
The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend as shown in Exhibit 1.
The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines! …
Ridiculous as our market volatility might seem to an intelligent Martian, it is our reality and everyone loves to trot out the “quote” attributed to Keynes (but never documented): “The market can stay irrational longer than the investor can stay solvent.” For us agents, he might better have said “The market can stay irrational longer than the client can stay patient.”
So how does one go about betting against bull market irrationality? Three ways:
- “First, you must allow a generous Ben Graham-like “margin of safety” and wait for a real outlier before you make a big bet.” (See these notes on Seth Klarman’s excellent Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor and while you are at it, you can read Klarman’s annual letters from 1995-2001 here).
- “Second, you must try to stay reasonably diversified.” (This has becoming significantly more difficult post-Lehman as correlations have increased – see here in chart form!)
- “Third, you must never used leverage.”
How do you bet against bull market irrationality?
Author Disclosure: None