In a previous discussion of Seth Klarman (Trades, Portfolio)’s 2009 letter to shareholders of Baupost Group, we talked about the types of situations he said value investors should be targeting - forced selling due to the delisting of stock from an index, or the liquidation of a position due to a margin call. Now, I want to turn to another theme of that letter - the idea that rather than fearing uncertainty, value investors should embrace it.
There are no laws
Economics is not a science, at least not in the way physics or chemistry is. Contrary to what is taught in undergraduate courses, there are no "laws" in economics in the sense of immutable truths that hold under all conditions. There are no certainties, only probabilities. What does this mean for an investor? It means there is no way to guarantee a particular rate of return, or to quantify the level of risk present in any given investment. In fact, thinking that you can put an exact number on anything is a sure-fire way to lose your shirt, as Klarman explained:
“You can never be sure if the economy will grow or shrink, whether the markets will rise or sink, or whether a particular investment will meet your expectations. Amidst such uncertainty, people who are too resolute are hell-bent on destruction. Successful investors must temper the arrogance of taking a stand with a large dose of humility, accepting that despite their efforts and care, they may in fact be wrong...Those who reflect and hesitate make far less in a bull market, but those who never question themselves get obliterated when the bear market comes.”
To put it another way, assuming everything is certain can serve you quite well in the short term (which is why any bull market sees its share of "lucky fools" elevated to expert status), but in the long run such an attitude is likely to blind you to the inevitable fall. Making money in good times is no great achievement; doing so in bad times is.
The brain craves certainty
Embracing uncertainty is not an easy thing to do. The human brain naturally craves certainty. This is why we tend to see men in the moon, faces on pieces of toast and patterns where there are, in fact, none. We witness events and then look for after-the-fact rationalizations for why they were "inevitable" (always in retrospect, of course). We want to believe things happen for a reason, and if we have just enough computing power and data, we can predict the future. This is not the case, however. The sooner we accept the fact that everything is uncertain, and that things happen only because other, equally likely outcomes did not come to pass, the sooner we can become better investors.
If this all seems a bit abstract, here is another passage from Klarman to bring it back to the topic of value investing:
“Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments. We always sell when a security’s price begins to reflect full value, because we are never sure that our thesis will be precisely cor- rect. While we typically concentrate our investments in the most compelling situa- tions measured by reward compared to risk, we know that we can never be fully certain, so we diversify. And, in the end, our uncertainty prods us to work harder and to be endlessly vigilant.”
Read more here:
- Seth Klarman: Exploiting Erratic Market Behavior
- Howard Marks: Negative Interest Rates Are Weird
- Is the Boeing Narrative Finally Shifting?
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