I recently discussed some comments made by Seth Klarman (Trades, Portfolio) in the late 1990s at the height of the dotcom bubble.
As might be expected of a value investor like Klarman, he was pretty skeptical of the mania that he saw unfolding around him and correctly predicted that the rally would not be around for much longer. What gave him the confidence to make such a statement and the discipline to stay on the sidelines while other asset managers were getting pulled into the bubble?
Arguably, it all comes down to having a clearly defined philosophy and the right personality. In a set of remarks that he delivered at the MIT Sloan School of Management back in 2007, Klarman identified what this means.
What holds investors back
Why do investors find it difficult to resist the siren’s call of market mania? Klarman believes the reason for reckless investor behavior is an inability to ignore short-term phenomena. Even though the day-to-day activity of the market is just noise (in the vast majority of cases), it’s hard to not overreact when you see markets going sharply up or down.
He also thinks the pressure that investors face, both from themselves and from their clients, to produce short-term results makes it much harder to take a longer-term perspective:
“Human nature involves the extremes of investor emotion - both greed and fear - in the moment; it is hard for most people to overcome and act in opposition to their emotions.”
What to do about it
Klarman believes most investors have everything backwards. When we think in terms of trying to make money, rather than trying to not lose it, we run the risk of getting sucked in by promises of easy gains, particularly if we are managing money on behalf of someone else. By adhering to Warren Buffett (Trades, Portfolio)’s first rule of investing, which is to not lose money, investors can flip the paradigm on its head and focus on protecting what they have, instead of chasing what they wish they had.
This is very similar to Charlie Munger (Trades, Portfolio)’s technique of "inversion" - instead of trying to make something happen, think about what the opposite of that outcome is and then do everything you can to avoid it. For instance, if you want to build your retirement portfolio, think about what might cause you to lose money, and then make sure you don’t endanger your savings.
Consequently, Klarman believes that having a specific target for how much you want to make as an investor is a bad idea. If a pension fund targets an annual return of 8% and falls short of that target, they can do one of two things: revise the target downward or take on more risk. No asset manager wants to disappoint their clients, so often the only option is the latter. This, of course, is a slippery slope.
I’ll leave the last word to Klarman himself:
“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.”
Read more here:
- Warren Buffett and the Problem of Executive Compensation, Pt. 2
- Warren Buffett and the Problem of Executive Compensation, Pt. 1
- Seth Klarman: Lessons From the Dotcom Bubble
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