GMO Commentary- Memo to the Investment Committee: Dare to Be Different

Executive Summary

The conventional 60/40 portfolio of today is not going to generate the kind of returns that investors say they need. Investors must seek to embrace the terrifying concept of being different. As the ghosts of many great investors past have amply demonstrated, being different is the path to investment success. However, such advice falls into the simple but not easy category, to borrow Warren Buffett (Trades, Portfolio)’s expression.

Both human nature and the institutional imperative are serious impediments to the budding contrarian. There are few quicker ways to lose one’s job than being alone and “wrong.” But the appalling forward-looking returns to a standard 60/40 portfolio leave no choice. Owning U.S. equities today virtually ensures low long-run returns. Instead, investors should own as much international and, in particular, emerging market equities as they can.

Emerging markets are trading on a Shiller P/E of 13x. This is the level of valuation that generally gets me excited. We have not experienced permanent impairment of capital from this level outside of markets that have shut down due to war. This doesn’t guarantee short-term returns or that we have reached a bottom: cheap stocks can always get cheaper. But it does provide a compellingly attractive entry point for those with a long horizon.

Even better are the value stocks within emerging markets, which trade on single-digit Shiller P/Es. So, embrace career risk, dare to be different, and recall the motto of the Special Air Service: Who Dares Wins.

60/40 Won’t Cut the Mustard

The biggest single challenge facing investors today, in my humble or otherwise opinion, is that the returns to a conventional 60/40 portfolio look set to be somewhere between very low and zero. For example, Exhibit 1 shows the expected (and realised returns) to a 60% S&P 500/40% 10-year U.S. Government Bond portfolio. If you assume mean reversion in equity market1 valuations, the return in real terms (after inflation) is on track to be around 0% p.a. for the next decade. Even if you assume valuations stay where they are in equity space, you are only looking at around a 3% return from a 60/40 portfolio.

EXHIBIT 1: EXPECTED AND REALISED RETURNS TO A 60/40 PORTFOLIO (10-YEAR ROLLING RETURNS AND FORECASTS)

As of 12/31/19 | Source: GMO

Deploying capital in a 60/40 portfolio today falls short of Ben Graham’s definition that “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” By investing in a 60/40 portfolio today, you are taking on risk with little to no hope of a return. Of course, as Exhibit 1 also shows, this portfolio has done remarkably well over the last decade, which makes the advice I am about to offer even more unpalatable than usual. But the past is not prologue, and few things in life are as dangerous as driving while focused on the rearview mirror.

Sadly, doing what is right is often not easy. This is as true in investing as it is in many other aspects of life. If you were to seek advice on investing from some of the great luminaries of the past, one of the common themes would surely be to take a contrarian stance. To wit, Sir John Templeton noted, “It is impossible to produce superior performance unless you do something different from the majority. If you buy the same securities everyone else is buying, you will have the same results as everyone else.” John Maynard Keynes opined, “The central principle of investment is to go contrary to the general opinion on the grounds that if everyone agrees about its merits, the investment is inevitably too dear and therefore unattractive.” In short, the ghosts of investing past would urge you to dare to be different.

Human Nature

However, such advice whilst simple is not easy (to purloin a famous modern-day contrarian, Warren Buffett (Trades, Portfolio)’s, turn of phrase). Both human nature and the institutional imperative force us to want to behave like others. Let’s start with human behaviour. Human beings are (generally at least) a social species. Like many social species we implicitly recognise that it is warmer and safer in the middle of the herd.

It transpires that herding animals (such as zebras) don’t actually provide an accurate depiction of our species. In his wonderful book, Why Zebras Don’t Get Ulcers, Robert Sapolsky points out that although zebras may have apparently stressful lives (after all, that sound of long grass swaying might be the wind or a hungry lioness on the hunt for dinner), they have been well-honed by evolution to deal with the environmental stresses they face.

Sapolsky suggests that we humans are much more akin to baboons. He has been studying one troop of baboons for a long time, a group fortunate enough not to have to devote very much time to finding food. Regrettably, this leaves them with a significant amount of time on their hands to be unpleasant to one another, something that it turns out baboons excel at. These primates have a complex social structure and have strict social pecking orders. Sapolsky has observed that the baboons at the nadir of the social hierarchy (the socially excluded) undergo rapid weight loss, loss of hair, and even physiological changes in brain structure. It isn’t a big stretch to see similarities with humans under social pressure.

Social psychologists have studied the tendency for conformity in humans as well, represented by the classic work done by Solomon Asch in the 1950s. He set up an experiment in which a participant was asked to select which of three lines was closer to another line being shown (as per Exhibit 2). Now, this may not seem to be a hard task, but Asch had one study participant sit in a room with a number of other people who gave their answers before this lone subject did. Unbeknownst to this person, the other people in the room worked for Asch and were briefed to answer incorrectly on a number of occasions during the study.

EXHIBIT 2: THE SOLOMON ASCH EXPERIMENT

Source: Asch (1950)

Exhibit 3 shows the results from the Asch experiment. When faced with any number greater than 3 people in the room, there was a roughly 30-35% probability that the genuine study participant would go along with the clearly incorrect answer that the group was reporting. Such is the pressure to conform and be a part of the crowd.

EXHIBIT 3: CONFORMITY IN ASCH’S EXPERIMENT

Source: Asch (1950)

Just in case you were wondering about the relevance today of psychological studies done in the 1950s, it turns out that modern versions of Asch’s experiment produce very similar results.2 This is only to be expected. After all, our brains are shaped by the glacial process known as evolution and a mere 70 years is nothing on such a scale.

Other studies in the field of psychology have explored the opposite side of the equation: How does it feel when we are left out, socially excluded, and on our own? Eisenberger, Lieberman, and Williams3 designed an experiment in which the participant controlled one avatar who was playing a game of catch with two other avatars. At some point during the game, the other two ‘players’ stop passing the ball to the subject. The researchers tracked where the reaction to this behaviour was located in the brain. It happened that this social exclusion was registered in exactly the same places as real physical pain (measured by having people keep their hands submerged in buckets of ice water for long periods of time).

Effectively, the human brain has both push (the pain of doing something different) and pull (the desire to belong) factors moving it towards conformity. Taking the contrarian path is potentially akin to having your arm broken on a regular basis.

Institutional Imperative

As if these innate human tendencies were not enough, we live in a world that seems to be governed by Keynes’ edict (aka career risk):

It is the long-term investor – he who most promotes the public interest – who will in practice come under the greatest criticism whenever investment funds are managed by committees or boards or banks. For it is the essence of his behavior that he should appear eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for one’s reputation to fail conventionally than to succeed unconventionally.

Not only is doing something different likely to lead you to feel something close to physical pain, it is also very likely to get you fired. No wonder so few dare to be different.

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