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Stepan Lavrouk
Stepan Lavrouk
Articles (344) 

Seth Klarman: What Happens When Bad Money Drives Out Good Money

The dotcom bubble offers an illuminating lesson in market mania

December 02, 2019

The 1990s are a fascinating historical period, for a number of reasons. From a U.S. perspective, the decade represents perhaps the highest point of prosperity - the Cold War was won, American military dominance was unchallenged and still viewed as a benevolent presence, the War on Terror had not yet begun and the idea of a crisis like the 2008 financial crash was considered a logical impossibility.

Amid all of this optimism, it is perhaps unsurprising that the dotcom bubble got as big as it did. In any case, it is an excellent example of how markets can become untethered from common sense, and the lengths that investors are willing to go to avoid missing out on the action. I recently came across Seth Klarman (Trades, Portfolio)’s 1998 letter to investors of Baupost Group, which shed some light on the dynamics of such bubbles.

The party doesn’t last forever

In his letter, Klarman cited Gresham’s law: the idea that - all other things being equal - “bad money drives out good.” That is, when there are two forms of money in circulation with the same nominal value (for instance, paper dollars and gold dollars, as was the case in the second half of the 19th and first half of the 20th centuries), the lower-value currency will gradually displace the higher-value one. Klarman applied this principle to investment strategy:

“Gresham's Law says that the bad money (paper) drives the good money (specie) out of circulation; this accurately describes human behavior when people are confronted with a cost-free choice. I now believe it also describes people's choice of investment philosophies, especially late in a bull market, when the sloppy analysis drives out the disciplined assessment, and when the grab for return overwhelms the desire for capital preservation.

Persuading budding analysts to postpone the immediate gratification of a momentum or growth stock career for a long-term value investment philosophy is a formidable challenge indeed. Leaving this extraordinary party early, or contemplating not even going, isn't very appealing if all your friends will be there having a great time while it lasts, which appears to be well into the night. To many, the really bad hangover will have been worth it.”

In other words, when there is no immediate downside to conducting shoddy analysis and engaging in undisciplined thinking, there will be a natural shift in investors’ mindsets toward such things. It is a good rule of thumb that people will - generally speaking - follow the path of least resistance, and in euphoric bull markets like the one of the late 1990s, the path of least resistance was ignoring soaring valuations and forecasting out billion-dollar profits for companies that had yet to book a cent in profit (a situation that should be familiar to anyone who has been following tech stocks the last several years).

Value approaches to investing have been shown to work, but there is a reason why the majority of investors do not pursue value strategies. The simple answer as to why this is, is that it is hard. It’s hard to restrain oneself when one’s peers are making money by relaxing their standards. This is one reason why most investors lose money - the temptation to throw caution to the wind during good times inevitably leads to greater losses in bad times. Klarman knows this, and so should those who choose to follow his example.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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