Tuesday, December 16, 2008

Back to Basics

A long time ago, I had a conversation with an investment manager for relatively small firm with a good performance record. There was no secret to his process, he said. "We just buy stock in high-quality companies and hold on to it for a long time."

Bernie Madoff blows up as investors are shocked--SHOCKED-- that a strategy which reported rock steady monthly returns through 20+ years of market volatility was proven to be fraudulent. Newspaper articles go to great lengths to explain the intricacies of "split-strike options."

Today's WSJ notes that a manager who ran a fund which is down 82% this year has "stepped down." STEPPED DOWN? What were they thinking when the fund was down 50%? Why didn't they fire him then?

Hedge funds closing or restricting redemptions in the face of abysmal returns. One of the largest and most prominent is down by 50% this year, and it's got plenty of company. It becomes an accepted tenet of mainstream institutional investment philosophy that common stock investments are shunned in favor of allocations to hedge funds, private equity funds, commodity funds, and other "alternative assets".
Not so many years ago, a large pension fund would invest its assets in three categories: stocks, bonds, and cash. Today, the Harvard university endowment's asset allocation chart shows 11 separate categories of non-cash investments, about three quarters of which are things other than domestic stocks and bonds.

I'm generally a subscriber to the efficient markets theory. I believe that information gets disseminated quickly, and reflected in the market just as quickly. So you think that the economy's gonna be bad for the next six months? No kidding-- so does everyone else. That's why the stock market has fallen 40% or so. But what do you think that everyone else will be thinking next? That's the question! As Keynes said, successful investing lies in anticipating the anticipations of others.

Everyone's looking for an edge. Everybody wants to find the stock, or the asset class, or the manager or strategy that produces outsized returns (and with minimal risk, too). People stood in line, like cattle headed to the slaughterhouse, for a chance to invest with Madoff or some high-profile hedge funds.

There are literally thousands of investment management firms, ranging from esoteric black-box hedge funds to the sleepiest rural bank trust department. They're all looking at generally the same data. Some have vastly superior resources to provide for sophisticated computer analysis or local surveys of Tibet yakherders cellphone purchase intentions. But in the end they all think they can outperform the market. Some do, for a time. But even the most heralded, like Bill Miller or a prominent hedge fund, eventually find that their luck runs out. As Nassim Taleb would say, if you have 1000 monkeys picking stocks over 10 years, one of those monkeys will rank as the #1 stockpicker with the best 10-year average.

So why don't we just buy stock in high-quality companies and hold on to it for a long time? Well, for one thing it's not in the best interests of asset managers, or brokers, or investment committees, or consultants, or fund-of-funds, or most analysts. It probably isn't such a good thing for writers of financial blogs, either. But it probably is a good thing for you.

1 comment:

  1. Bloomberg news had a story a while ago about how the Harvard endowment was down more than 20% this year. That in itself is a shock...

    The real shock was the next sentence in the article, which went something like this:

    "The loss does not include the performance of their real estate or private equity portfolios"

    20%? They wish