The information below is based on Seth Klarman (Trades, Portfolio)’s out-of-print book, "Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor."
Wall Street is plagued by conflicts of interest and short-term bias, which does nothing to improve the performance of the average investor according to Klarman.
Even though "Margin Of Safety" was written before the financial crisis, and financial markets have changed significantly since its publication, Wall Street’s short-termism remains, albeit in a different form. If you have access to published research notes or watch financial news regularly, you will know this to be the case.
The devolution of Wall Street has also had an effect on investors, but in a different way. Two decades ago, trading commissions were relatively high, but today's commissions are relatively insignificant and, in some cases, do not exist at all. This transformation has flipped the responsibility from the Wall Street stockbroker to the individual investor.
Watch your trading
There is a wealth of information out there that shows trading costs can have a drastic effect on performance. Therefore, the portfolios that trade the least outperform. For Wall Street, however, this is a catch-22 as brokers are paid to trade, and the broker who makes no trade all year may be labeled as lazy by his client. Similarly, the average investor may become bored holding the same position for years on end and look to trade to boost returns.
Klarman is well aware of this catch-22 situation and does everything he can to discourage investors from dealing with Wall Street and extending their own holding periods. Klarman's average holding period for his investments is indefinite, reducing the need to rack up trading fees that eat away at returns.
Klarman also encourages readers to remember Wall Street has a bullish bias -- once again, something someone who has access to research will understand. It is a Wall Streeters job to be optimistic, as Seth Klarman (Trades, Portfolio) puts it:
“There is more brokerage business to be done by issuing an optimistic research report than by writing a pessimistic one...”
This culture of undeniable optimism means that rather than admitting they are wrong, institutional investors only pay those Wall Street banks producing optimistic research:
"Many of the same factors that contribute to a bullish bias can cause the financial markets, especially the stock market, to become and remain overvalued…Since security prices reflect investors’ perception of reality and not necessarily reality itself, overvaluation may persist for a long time.”
“The great majority of institutional investors are plagued with a short-term, relative-performance orientation and lack the long-term perspective that retirement and endowment funds deserve.”
Not only does the optimism culture lead investors to fool themselves, but it also leads to investment fads as buyers flock to securities or sectors where the most optimism is present:
“It is only fair to note that it is not easy to distinguish an investment fad from a real business trend. Indeed, many investment fads originate in real business trends, which deserve to be reflected in stock prices. The fad become dangerous however, when share prices reach levels that are not supported by the conservatively appraised values of the underlying business.”
If you combine these factors, as well as the quarterly reporting schedule of companies and constant evaluation of institutional investors against benchmarks such as the S&P 500, you wind up with a very bad situation. Klarman claims these changes now mean Wall Street has lost the ability to manage money over the long term:
“If the behaviour of institutional investors weren’t so horrifying, it might actually be humorous…The prevalent mentality is consensus, groupthink. Acting with the crowd ensures an acceptable mediocrity; acting independently runs the risk of unacceptable underperformance.”
Performance derby
Wall Street is, in Klarman’s words, a “performance derby” where institutional managers are constantly judged against their benchmark. Money managers are also faced with several self-imposed constraints such as illiquidity. Institutional investors will not spend days researching a small-cap illiquid stock that may or may not become a winner, they move with the rest of the group. Pressure to be fully invested is another constraint.
Broadly speaking, even though Wall Street’s tunnel vision is bad news for investors in general, it presents a huge opportunity for the enterprising investor. The overly narrow categorization of stocks in the instituitional investment business (emphasis on rigidly defined categories) restricts returns; the best undiscovered opportunities lie outside the clearly defined categories, hidden away from institutional investors.
It is these undiscovered opportunities that give investors who are willing to do the legwork the opportunity to outperform over the long term.
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