Investors are currently facing a very uncertain market. On the one hand, it looks as if asset prices have been rescued from further declines by the Federal Reserve's efforts.
On the other hand, the coronavirus crisis is still rumbling on, and there's no telling how much longer the outbreak will continue to drag on the economy. Then there are the potential trade wars with China and Europe to consider, as well as the risk of inflation.
All in all, it's quite hard for investors to plan for the future right now, and it's impossible to answer the question of what's next for markets.
Searching for advice
At times like these, looking back at the advice of some of the market's most experienced and successful investors can be a great help.
For example, Seth Klarman (Trades, Portfolio) has been managing his hedge fund, Baupost, for more than three decades. During this time, he's experienced a handful of severe bear markets and bull market recoveries.
In the late 1990s, Klarman was trying to navigate the dot-com bubble. The value investor didn't like what he could see was happening in the market and didn't want to join the party. As a result, Baupost started to underperform.
But Klarman stuck to his guns, and rather than trying to predict what might happen next, he followed his tried and true investment strategy of buying undervalued stocks while keeping a large amount of cash on hand at the same time.
Here's how he described his positioning in his December 1997 letter to investors of the Baupost fund:
"The most favorable position going into a sudden downdraft (if you could correctly anticipate one) is to hold market hedges and/or cash (or better still, short positions, but short sellers have been aging in dog years for a long time). We hold both, although never enough in a downturn, because both are costly. Hedges, like any insurance, involve paying a premium. Premiums have skyrocketed in lockstep with the market's surge over the past two years, and have risen even more in the current volatile environment. Cash provides protection in a storm and ammunition to take advantage of newly created opportunities, but holding cash involves the considerable opportunity cost of foregoing presently attractive investments. Given the choice between holding mostly cash awaiting the periodic market tumble or finding compelling investments which earn good returns over time but fluctuate to a certain extent with the market amidst turbulence, we choose the latter. Obviously, we could not have earned the returns we have from investing, without investing."
As he went on to explain, Baupost wasn't going to be dragged into the market euphoria. Instead, it would stick to what it knew best, buying undervalued companies that it understood. As Klarman went on to explain:
"The upside of the recent market episode is that many good bargains have become even better ones, and numerous attractive new situations have surfaced. We are selectively deploying cash into what we believe are wonderful, long-term values, and are also repositioning ourselves, adding to some positions while reducing or deleting others, to take advantage of the lay of the present landscape. The opportunity to invest more money at lower prices will certainly be to our long-term financial benefit."
Key takeaways
The lessons we can learn from this are quite simple. If we don't know what the future holds, there's no point guessing. There's also no point trying to protect your portfolio with hedging instruments if they are too expensive or too complex to understand.
The best hedge is often cash, both in terms of the flexibility it provides and its simplicity. Klarman has never tried to overstretch himself or follow market trends.
The same can be said about Warren Buffett (Trades, Portfolio), Charlie Munger (Trades, Portfolio), Mohnish Pabrai (Trades, Portfolio) and many other guru investors. We can learn a lot from this simple approach to what can be a complex topic.
Read more here:
- Learning From Warren Buffett's Early Investment Strategy​
- Learning Charlie Munger's Investment Strategy Through a Case Study
- Compound Interest Can Both Help and Hinder Wealth Creation
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