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Seth Klarman On Value Investing In A Turbulent Market

Investors must employ an investment philosophy and process that serve as a bulwark against a turbulent sea of uncertainty and then navigate through confusing and often conflicting economic signals and market head fakes. Amidst the onslaught of gyrating securities prices, fast and furious corporate developments, and an unprecedented volume of data, it is more important than ever to maintain your bearings. Value investing continues to be the best (and perhaps only) reliable North Star for those who are able to remain patient, long-term oriented, and risk averse.” – Seth Klarman year-end 2015 letter to investors. 2015 was a bad year for Seth Klarman and his Boston-based hedge fund Baupost. The fund lost money for its investors, a rare event – it’s only happened three times since the fund’s founding in 1982. Click to enlarge Off the back of such a terrible performance, Seth Klarman devoted the majority of his year-end letter to investors explaining that value investing isn’t a precise science in his usual calm and philosophical manner. It’s unlikely that Klarman would have been aware what was in store for the markets in the first few months of 2016, but as it turns out, his words couldn’t have come at a better time for value investors seeking reassurance in a turbulent market. Seth Klarman: Take advantage of Mr. Market Value investors gain clarity by thinking about their investments not as quoted stocks whose prices whip around on a daily basis, but rather as fractional ownership of the underlying businesses.” – Seth Klarman year-end 2015 letter to investors . To be a successful investor, you must be able to take advantage of Mr. Market’s bipolarity. You must be able to step in and buy shares when Mr. Market offers them to you at a knock-down price, but you need to be able to ignore his calls to sell at lower levels. Klarman writes that the two extremes of human nature, fear and greed drive market inefficiency. Fear is primal, the effect of confronting the apparent loss of what you have. Your shares still represent the same fractional ownership in a business as when they traded higher yesterday, however, people are now en masse delivering the verdict that your shares are actually worth less. You have to find a way not to care or even to relish this eventuality. Warren Buffett has written that one should not invest in stocks at all if uncomfortable with the possibility of a 50% drawdown. The mistake some investors make is to accept the market’s immediate verdict as fact and not opinion, and become disappointed, even frustrated.” — Seth Klarman year-end 2015 letter to investors . Losses can cause people to lose their bearings. It’s natural to want to sell everything after your portfolio has been marked down sharply. Watching your net worth evaporate in front of you as the market falls isn’t a pleasant experience. However, this is the wrong way of thinking about equities. Klarman writes that for an investor to overcome the desire to sell at the bottom and take advantage of Mr. Market’s erratic movements, they must think not about what the market will pay for the securities today, (the stock price) but rather the true value of the securities you own based on such attributes of the underlying businesses as free cash flows, private market values, liquidation values, downside protection, and growth prospects. Klarman continues, saying that when the market, in the absence of adverse corporate developments, drives an undervalued security down in price to become an even better bargain, that’s not a reason for panic, or even for mild concern, but rather for excitement at the prospect of adding to an already great buy. When tempted to sell: Investors must think not only about what they would be getting (the end of pain that accompanies the certainty of cash) but also what they’re giving up (a significantly undervalued security which, emotion aside, may be a far better buy than a sell at today’s market price).” – Seth Klarman year-end 2015 letter to investors . This is why conducting your own rigorous due diligence is essential. The insights gained from due diligence give you the justifiable confidence to maintain your bearings – to hold on and consider buying more – even on the worst days in the market. Seth Klarman: Don’t be greedy Greed works alongside greed to eat away at your confidence and push you to make decisions that are hazardous to your wealth. The angst felt when others are succeeding while you are not can lead you to make poor decisions, on this topic Klarman cities J.P. Morgan, who said “Nothing so undermines your financial judgment as the sight of your neighbor getting rich,” and Gore Vidal who dryly noted, “Whenever a friend succeeds, I die a little.” What’s more, the fear of missing out can be a kill switch for risk aversion in that it tempts people into paying up and then holding on too long. Fear of missing out, of course, is not fear at all but unbridled greed. The key is to hold your emotions in check with reason, something few are able to do. The markets are often a tease, falsely reinforcing one’s confidence as prices rise, and undermining it as they fall. Pundits often speak of the psychology of markets, but in investing it is one’s own psychology that can be most dangerous and tenuous.” – Seth Klarman year-end 2015 letter to investors . To show just how dangerous (and damaging) fear and greed can be to investors’ returns, Klarman lets the figures do the talking. The data shows that over the 30-year period from 1984 to 2013, the S&P 500 Index returned an annualized 11.1%. However, according to Ashvin Chhabra, head of Euclidean Capital and author of ” The Aspirational Investor ,” the average returns earned by investors in equity mutual funds over the same period was ” a paltry 3.7% per year, about one-third of the index return .” Bond investors were dealt even more pain. While the Barclays Aggregate Bond Index returned an annualized 7.7% over the 30-year period from 1984 to 2013, bond funds produced an annualized return of 0.7%. The underperformance in both cases was a direct result of investors pulling money out of the funds at precisely the wrong times. In short, by letting fear and greed take over their emotions, retail investors have underperformed both the markets and the very funds in which they were invested since 1984. That’s a statistic that’s difficult to ignore. So to conclude: In the moment, public market investors have no ability to control investment outcomes, but they can control and improve their own processes. We never shoot for high near-term investment returns. Trying too hard to earn positive results, or assessing performance too frequently, can drive anyone into short-term thinking, herd-like behavior, and incurring higher risk…We believe that by remaining focused on following a well-conceived process, we will make good risk-adjusted, long-term investments. And we know that if we do that, we will indeed earn good returns over time.” – Seth Klarman year-end 2015 letter to investors. Disclosure: None.

A Vanguard Buy And Hold Mutual Fund Strategy With 9% Growth And -6% Maximum Drawdown

All of my previous investing strategies have focused on tactical asset allocation to reduce risk in a portfolio while maintaining moderate growth. My objectives for a low risk, moderate growth tactical strategy have been: 1) 10% Compounded Annual Growth Rate [CAGR], 2) -5% Maximum Drawdown [MaxDD], and 3) all positive years of return. In my research, I have found a combination of five Vanguard mutual funds that can be bought and held (rebalanced annually) that nearly meet my objectives. A passive strategy holding these funds eliminates the need (and cost and risk) of updating every month in a tactical asset allocation strategy. This article will describe the components of this buy & hold strategy and present backtest results from 1988 to the present. As an overview, portfolio growth of this buy & hold strategy is presented below. (click to enlarge) Click to enlarge The five Vanguard funds are: 1. Vanguard GNMA Fund (MUTF: VFIIX ), 2. Vanguard High Yield Tax-Exempt Fund (MUTF: VWAHX ), 3. Vanguard Health Care Fund (MUTF: VGHCX ), 4. Vanguard Long-Term Treasury Fund (MUTF: VUSTX ), and 5. Vanguard Short-Term Treasury Fund (MUTF: VFISX ). Five different classes of funds are represented in the basket of funds: 1) a GNMA bond fund, 2) a high yield municipal bond fund, 3) a healthcare equity fund, 4) a long-term treasury bond fund, and 5) a short-term treasury bond fund. The correlations between these funds can be seen below (taken from Portfolio Visualizer [PV]). It can be seen that the funds do not correlate well with each other, as desired. (click to enlarge) Click to enlarge Backtesting was performed from 1988 – present using PV. In order to backtest to 1988, Fidelity Limited Term Government Fund (MUTF: FFXSX ) was substituted for VFISX. The backtest results are shown below. For comparison, results of an absolute momentum strategy and the Vanguard Total Bond Index Fund (MUTF: VBMFX ) are also presented. The absolute momentum strategy buys and holds all five funds unless any fund has a one-month total return that is less than a money market return. If that occurs, then the money from that fund is diverted into a money market fund until the one-month return is greater than the money market return. (click to enlarge) Click to enlarge (click to enlarge) Click to enlarge (click to enlarge) Click to enlarge (click to enlarge) Click to enlarge It can be seen that the buy & hold strategy has the highest total return with relatively low drawdown. The CAGR is 9.0% and the MaxDD is -6.0%. The worst year is -0.9% in 1994, and the only other year with negative return is 1999 (-0.4%). All other years have positive returns. The risk adjusted return numbers are: Sharpe Ratio = 1.2, Sortino Ratio = 2.2, and MAR (CAGR/MaxDD) = 1.5. The monthly win rate is ~73%. The buy & hold strategy has the highest annual return (over the other two investment vehicles) in 16 of the 28 years presented. Usually, an absolute momentum strategy such as the one presented here will help reduce drawdown at the expense of annual growth. And, indeed, we see that kind of result here. The absolute momentum tactical strategy has a CAGR of 7.4% and a MaxDD of -3.0%. So there is a tradeoff, higher CAGR for the buy & hold passive strategy (9.0% vs. 7.4%), or lower MaxDD for the absolute momentum active strategy (-3.0% vs. -6.0%). In this case, I would prefer the higher growth buy & hold strategy because of its simplicity and -6.0% MaxDD is still quite low. Disclosure: I am/we are long VFIIX, VWAHX, VGHCX, VUSTX, VFISX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

HARKing Back: Lessons In Investing From Science

Confirm Ye Not Here’s what ought to be a really boring idea – we need scientists in general and psychologists and economists in particular to stop hypothesising after results are known (HARKing, geddit?). Instead, they need to state what they’re looking for before they conduct their experiments because otherwise they cherry pick the results they find to confirm hypotheses they never previously had. The underlying problem is our old foe, confirmation bias . And the solution for scientists and social scientists alike is known as pre-registration. It would be no bad thing for investors to demand a similar process for fund managers and financial experts. Or, for that matter, to apply some of the ideas to their own investing strategies. No No Negatives It’s been known for years that a lot of scientific research isn’t very reliable. There are numerous problems, chief amongst them being the non-publication of negative results: an issue known as publication bias . There’s no kudos in showing that your hypotheses were wrong, so researchers and corporations tend to bury the data, but it’s still valuable information that should be shared: scientists see further by standing on the shoulders of others, we shouldn’t be encouraging them to shrug them off because they’ve got bored. Worse still, though, is the fact that many studies turn out not to be replicable. The ability to re-run an experiment and produce the same result is an absolute cornerstone of the scientific method : science works because it’s not built on faith, it’s constructed out of evidence. If it turns out that the evidence is unreliable then what’s being done isn’t science, it’s more like religious studies with instruments. Or economics. Repeat, Again Once we move to the social sciences then the problems are even worse. Human beings are terrible things to experiment on , being inclined to change their minds, develop opinions about the experiments and to second-guess what the researchers would like them to do, just to be nice. All too many experiments in the social sciences turn out to be flawed because of social or situational factors that didn’t seem important at the time. Given this, you’d think that repeating experiments to make sure the results held would be even more important for psychologists than it is for researchers in the hard sciences. Well, guess again. According to research by Matthew Makel, Jonathan Plucker and Boyd Hegarty , only a little over 1% of psychology studies have ever been replicated. Everything else is simply a matter of faith in the integrity and lack of bias of the original researchers. Which is not science: in the words of John Tukey, quoted at the head of their paper: “Confirmation comes from repetition. Any attempt to avoid this statement leads to failure and more probably to destruction.” Pre-Register The best solution to this we’ve yet found is known as pre-registration: studies have to be registered in advance, and the hypotheses under investigation stated up front before the research is done. This prevents the experimenters from looking at their data after the event and picking out interesting positive correlations which they didn’t control for, but which are likely to get published. Where pre-registration has happened the proportion of studies giving positive results has fallen dramatically: analysis of studies into treatments for heart disease have shown a frightening drop in positive results since pre-registration was mandated: “17 out of 30 studies (57%) published prior to 2000 showed a significant benefit of intervention on the primary outcome in comparison to only 2 among the 25 (8%) trials published after 2000”. Some of this may be because the low-hanging fruit on the subject was picked earlier, but it’s a scary result all the same. It seems likely that because the researchers can no longer consciously or unconsciously pick the results, they prefer they remove the possibility of confirmation bias – and the fall is so dramatic it places the previous results in question. And, of course, it’s not clear how many of those have been replicated. Creative Scientists Pre-registration isn’t universally popular: there is much rending of white coats and grinding of molars over the issue. Opponents argue that it risks putting scientists in a creative straight-jacket. Although when respectable peer reviewed journals start publishing papers alleging the existence of extra-sensory perception based on … “Anomalous processes of information or energy transfer that are currently unexplained in terms of known physical or biological mechanisms” … then you have to wonder whether the creative juices maybe need a touch of reduction – oh, and the results of this experiment don’t seem to be replicable, bet they never saw that coming. So, what other group of people do we know who are given to making ad-hoc hypotheses, investing loads of money in them, and then ignoring the results while cherry picking specific successes in order to publicly claim that they were successful? OK, apart from politicians. Investing Feedback Investors have all of these faults, and a few more. If we truly wanted to become better investors, then we’d pre-register our hypotheses – including our expected timescales – and then measure our results against the results. Doubtless the outcome would frequently be embarrassing, but the evidence that we do have suggests that getting real feedback about our performance is the only way to improve predictive capability in complex systems like the stock market (see: Depressed Investors Don’t Need Feedback. Everyone Else Does ). The other thing this would do would be to force us to face up to the reality that we can be successful by luck and can fail through no fault of our own. In complex adaptive systems, we simply cannot predict every possible situation; we can only hope to be able to predict a little better than average. But a little better is enough to make a turn, so every percentage point improvement we can make is worth it. Commit and Document So I wonder if some enterprising developer out there fancies setting up a pre-registration website for investors keen to improve their returns, rather their personal status? Public commitment backed up by a positive rewards system has been shown to produce powerful results in a whole variety of situations. For example, in Tying Odysseus to the Mast: Evidence from a Commitment Savings Product in the Philippines , Nava Ashraf, Dean Karlan and Wesley Yin showed: “Commitment-treatment group participants have a 12.3 (9.6) percent higher probability of increasing their savings by more than 20 percent after six (twelve) months, relative to the control group participants, and an 11 (6.4) percent higher probability of increasing their savings by more than 20 percent, relative to the marketing group participants. The increase in savings over the twelve months suggests that the savings response to the commitment treatment is a lasting change, not merely a short-term response to the new product” I suspect that even a non-financial reward system based on peer support would facilitate uptake. HARK, hear… Avoiding HARKing is the future of the hard and the soft sciences. And, by analogy, as investors, if we don’t have hypotheses about what we’re investing in, then we’re simply the modern equivalents of astrologers. And, if we have hypotheses, we should write them down and test whether they’re right, not simply crow about the random successes and ignore the equally random failures. It’s worrying, of course, that this isn’t already the basic investing process. But to be honest it’s even more worrying that it doesn’t seem to be the basic scientific process. Genius and creativity has its place in all human activity – Kepler came up with his third law of planetary motion by mapping orbits to harmonic ratios , believing these to be a sign of heavenly perfection. But Kepler was a mad genius who happened to be correct, so here’s my hypothesis: relying on mad geniuses for humanity’s future and your family’s well-being is probably not prudent.