A previous discussion ofSeth Klarman (Trades, Portfolio)’s "Margin of Safety" centered around the idea that even big, well-funded and well-staffed financial institutions can make investing mistakes, and that they are by their very nature inclined toward behaviors that are not value-adding in the long term. It got me thinking about two related questions: Why are big institutions almost always so bullish on the economy and on the stock market, and what does this mean for ordinary investors?
Why so bullish?
Big banks and other financial institutions have a natural predisposition toward bullishness. One big reason for this is that investment banks make a lot of their money by underwriting initial public offerings and issuing bonds to investors. It is a lot easier to do these things if the market is in an uptrend and clients are feeling good about themselves and their investments. Moreover, some large institutions function as market makers - they create a market for equities and other securities - which means they benefit from the price increases of assets they are temporarily holding on their books.
Moreover, investment banks need to cultivate close relationships with companies, which means their equity departments are comparatively more likely to issue buy recommendations than sells. This isn’t to say that analysts are actively dishonest, but it does make for a pretty powerful incentive to skew to the bullish side.
And it’s not just investment banks that have this bias. Hedge, pension and sovereign wealth funds have a vested interest in stocks going up. Ordinary 401k investors want stocks to go up. Governments (who want happy voters) want stocks to go up. The business media wants compelling bull stories to report on. Pretty much the only players who don’t have an active bullish bias are traders (who don’t care which way the market is moving so long as there is volatility to make money from).
Of course, there is one group that has a vested interest in pushing a bear narrative - shortsellers. But they control a tiny amount of capital compared with the groups mentioned above, and their activities tend to be focused on a small number of companies that they deem to be fraudulent or radically overvalued, rather than on talking down the market as a whole. By contrast, those investors who are long tend to promote the narrative that everything else is going up.
What does this mean for ordinary investors?
An important takeaway from all of this is to treat analyst recommendations with a pinch of salt and recognize that while they are probably rooted in some truth, they are likely to be biased. The second point is that investors should try to consume as wide a range of news as possible - don’t just read things that tell you that stocks always go up. You’ll be better off for it.
Read more here:
- Seth Klarman: Why Institutional Investors Lose Money
- Jim Chanos Is Still Bearish on Tesla
- 'The Black Swan' Author Doesn't Think the Coronavirus Crash Was Unforeseeable
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