The Great Equalizer

12 Sep

The financial crisis of the past several years has had an equalizing effect on the experience of many in the investment industry.  After what’s transpired, a person with five years of experience might rightly be considered to possess similar competencies as someone with twenty-five.  The reason?  The crisis, abrupt market declines and recovery, and ongoing economic and market difficulties have been new to the experience of most current market participants.

The newest industry entrants (the last two to three years) that have just read about in school or saw it happening while they were taking classes and not actually investing others’ money do not count here.  I speak of those that have actually lived through it.  Moreover, those who’ve lived through it and taken time to understand what’s going on in the context of history have benefited the most.  We know similar events have taken place before, just not in most folks’ memories.  And that is the key point.  The same can be said of periods like the Great Depression as well as the go-go market of the 1960s that gave us the market malaise of the 1970s.  Each of these periods was preceded by a market unhinged from value and driven largely by younger folks who had not experienced a serious downturn in their (career) lifetimes.  Until they did.

This experience and historical knowledge is not always helpful, however.  For example, an historical perspective over this period gave me the knowledge that it could get a lot worse.  Yes, the market could have rallied big time (it did) but it could also drop in half over the subsequent several year period, as happened during the Depression.  Instead of falling to 10x normal earnings, it could go well past that and hit 6 times (it didn’t).  So historical perspective could have caused one to be more conservative than was warranted with perfect 20/10 hindsight.

Still, out of this period client interactions have changed, as well as the way portfolios are allocated.  The way an investor should think about longer-term objectives has also been altered.  While modern portfolio theory had largely been discredited before the market declines, it now has less credence in the industry (though it remains in widespread use; the investment and planning industries use it because it offers some degree of concreteness in a world that otherwise lacks concreteness).  But while it’s methodology may aid in allocating portfolios from a top-down perspective, what makes the most sense is not whether a portfolio is mean-variance efficient.  Fundamentals and client goals matter.  It’s not just the frequency of the event that’s important – i.e., that stocks go up over time.  It’s the magnitude – i.e., they can go down 50% the year you need the money.

The Great Equalizer effect of which I write needs qualified.  It has been easy, given the market rally and economic recovery (until recently) that ensued after the depth of the market lows in March 2009, to adopt a ‘bad couple of weeks’ mentality.  Seth Klarman has pointed this out and I agree.  In some ways, people forgot how bad it was in late 2008 and early 2009.  (Memory is extremely short in finance, that’s why we have such frequent cycles.)  The folks still in the game who remember it and stick with their post-crisis philosophical and methodological recalibrations are the ones whom I believe will be the most successful over time.  Yes, stocks will rally from time to time but they can also go down and stay there for an extended period (they just didn’t this time).  And given prevailing valuations the broad indexes are not discounting the double-digit returns of yore, unless we have a larger selloff and start at a lower base.  Mid single-digit returns look most likely here, but so does the possibility of large drawdowns.  Overall, though a well-considered, goal-oriented investment allocation that focuses on base hits is going to be a better approach than something that is trying to catch each wave but risks going out with the tide.

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