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Robert Stephens, CFA
Robert Stephens, CFA
Articles (386) 

Seth Klarman: A Cautious Investment Strategy Can Pay Off

Over-optimism in this bull market may hurt your portfolio's returns

August 10, 2020

The recent stock market surge may cause some investors to become increasingly optimistic about the stock market's future.

In my view, this could be dangerous. The economy faces an uncertain period, while political risks could rise as November's election draws closer.

Therefore, a cautious strategy such as that used by Seth Klarman (Trades, Portfolio) could be more useful to value investors. The Baupost Group co-founder's long-term perspective may explain his market-beating returns.

Bull markets do not last forever

Investor enthusiasm can reach extreme levels during bull markets. Increasingly upbeat earnings forecasts can encourage investors to take even greater risks in the hope of generating further positive returns on their capital.

However, no bull market in history has ever lasted forever. Therefore, it could be prudent for investors to adopt a cautious mindset when valuations are rising and margins of safety are narrowing. Otherwise, they may end up purchasing stocks that offer high risks and low return prospects.

In fact, selling stocks during a bull market may be a more logical approach than buying them. If improving financial prospects are already accounted for via higher valuations, the investment appeal of stocks may be relatively low.

As Klarman once said, "Any contrarian knows that just as a grim present is usually precursor to a better future, a rosy present may be precursor to a bleaker tomorrow."

Ignoring other investors

One factor that makes it more difficult to adopt a cautious strategy during a bull market is improving investor sentiment. Other investors can influence your views, and may cause you to feel a fear of missing out on future gains. This may mean that instead of selling stocks, you end up buying them.

No investor can accurately predict the future performance of the stock market. Therefore, listening to the views of others is unlikely to provide an insight into how your portfolio will perform.

A better idea may be to focus on company fundamentals. This may allow you to judge whether there are attractive long-term buying opportunities on offer. Equally, it may provide evidence that the bull market has caused stocks to become overvalued. In this scenario, it might be the right time to adopt a cautious strategy and sell your existing holdings.

As Klarman once said, "It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success."

Cash holdings

Holding cash is unlikely to produce impressive returns in the long run due to low interest rates. Therefore, some investors may decide that investing in overvalued stocks in a bull market is a better idea than achieving ultra-low cash returns.

However, holding cash in the short run could be a prudent strategy if valuations have reached excessive levels. It is illogical to buy any stock that is unlikely to produce high returns in the long run based on its rich valuation. Waiting for it to eventually trade at a lower price and holding cash in the meantime may be a more efficient allocation of your capital.

Klarman has always been comfortable holding large cash positions in bull markets, with the aim of investing in stocks when they are priced at more attractive levels:

"We tend to only make investments when we think there is a compelling opportunity being presented. And often we will hold a third or half in cash or even more, awaiting such opportunities."

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