The great Warren Buffett (Trades, Portfolio) once wrote that you only find out who is swimming naked when the tide goes out. Now is an excellent time to remember those words.
For the past several years, investors have benefited from healthy returns fueled by very low interest rates, massive central bank quantitative easing programs and some genuine improvements to the global economy. Recent equity returns have exceeded long-term historical averages and have subsequently encouraged some investors to take on additional risk in their portfolios. But the prudent course of action may mean doing exactly the opposite.
Investment cycles are driven by human behavior that follows a remarkably similar pattern over time. After a major crisis—like the one that befell the global economy in 2008—it takes time for underlying fundamentals to improve and investor confidence to return. As sentiment gets better, investors become willing to accept increasing amounts of risk. But as the cycle progresses, risks start to pile up in the system and valuations get more and more stretched. At the same time, investors feel more confident; they let down their guards and take risks they had previously shunned. Ironically, this happens not in the absence of supportive positive evidence but in its presence; positive returns make investors feel more comfortable while the underlying system is actually getting riskier. And that’s when the proverbial tide starts to go out.
In later phases of an investment cycle, it therefore becomes even more important to be diligent with the risks taken in your portfolio. But swimming against the tide can be very difficult to do—you’ve got to be willing to look a little stupid in the short run. Nearly everyone thinks they will fight the tide but, in practice, very few succeed at it. Admittedly, it’s hard to stay strong when your neighbours and colleagues are riding high.
Having a disciplined, systematic process can help. A well-defined process protects investors from their greatest investment enemy: themselves. At Mawer, we stick to a consistent, bottom-up, “boring” investment process which ensures that our investment decisions are removed from emotion. Following this process, no matter what the market cycle, allows our team to put the odds of long-term investment success in our clients’ favour.
It will take years for the full consequences of today’s investment decisions to be visible. Investors who fear missing out must remember that building a successful long-term strategy is more important than trying to ride short-term waves.
When the tide goes out, you don’t want to be the one caught naked.
