“Risk comes from not knowing what you are doing”
– Warren Buffett
In last month’s article, we focused on “humility” as one of the great qualities to adopt for anyone who wants to become a great investor. This month we focus on a similar, but slightly different quality…Great Investors Are Observant
To become a great investor, one must adhere to firm beliefs which are formed by the observation of markets over many years. In our opinion, the diligent observation of market behavior over many market cycles will reveal certain Universal Truths, or Natural Laws which govern investment markets and investor behavior over time, and which the wise investor can attempt to exploit.
Although such Universal Truths may be difficult to see, particularly through the lens of a short term market perspective, they may be revealed over time to the patiently observant investor. Although markets appear to be always changing and presenting investors with new opportunities and challenges, the fact is that markets simply present investors with the same challenges and opportunities over and over, and tempt us to lose our perspective when we begin to think “This time is different”.
There is a well-known folly called the “This Time Is Different Syndrome” in which investors fall prey to the newest fads in investing, and forget that, in investing, it is never different. Investing strategies must stand the test of time, and investors are wise to employ the same strategies which have worked in the past to address the challenges and opportunities of today. Great investors are those who are observant of the timeless strategies that work time and again, and employ them with disciplined execution over a long period of time.
No matter how smart, or skilled the investor, it is wise to never overestimate your ability to be “right” every time, and the wise investor makes healthy allowance for the possibility of being wrong.
The Infallible Logic of Value
Warren Buffet is regarded as the greatest investor of our time, because he represents a classic example of a patiently observant investor. Early on in his investing career, Buffett became an apostle of the work of investment strategists Benjamin Graham and David Dodd, who wrote the famous book Security Analysis. Graham and Dodd identified a fairly simple Universal Truth about investing success: If one endeavors to find stocks which are trading at prices which are “cheap” relative to certain measurements of their intrinsic value, such as book value or the ratio of earnings per share price, over time those stock prices will rise, and become “expensive”. Their work in identifying this truth about market behavior became the basis for a style of investing called Value investing, which Warren Buffett has leveraged to become the world’s wealthiest man.
Like most things in life, the pursuit of investing success using Value investing is simple, but not easy. The concept is certainly simple to understand, and it seems a rather obvious Universal Truth that buying stocks when they are “cheap”, and holding them until they become “expensive” is a good idea in the long run. It is simple logic that an investor who is able to identify a stock to buy when it is “cheap”, will profit when eventually the rest of the world realizes the same thing, and the price of that stock rises to reflect its true intrinsic value.
However, this pursuit is also not easy, for one important reason: although it seems obvious that a cheap stock will eventually rise to its real intrinsic value, eventually can sometimes take a very long time. In fact, sometimes that stock may become even cheaper before the rest of the world recognizes its real value! A skillful Value investor may do a wonderful job of selecting undervalued stocks to purchase, only to watch her portfolio holdings decline in price for some period of time, before the market finally decides to favor those undervalued companies.
It is the gap between today and “eventually” that can make Value investing difficult, as it sometimes can take a great deal of time for the Universal Truth of Value investing to work. Inevitably, during this gap in time, those less committed Value investing disciples may begin to doubt the validity of their approach. They will begin to wonder if the world has changed in such a way that the Natural Law of Value investing has changed – that in fact “This time is different”. They may even become so impatient that they abandon their value investing strategy altogether – usually right around the time it is about to start working.
It is only the most committed, and most patient investors who will realize that it is never different. The Universal Truths of investing don’t change, they can just take time to express themselves. At such times investors such as Warren Buffett will continue about their business with patience and discipline, simply biding time until the market rewards their patience.
Exploiting the Herd
For the diligent observer of market history, there are many Universal Truths which can be gleaned from the history of investing. While the Value investing discipline espoused by Graham and Dodd has been proven over time to work, there are other market tendencies which a great investor may observe, and exploit. Our team at Concentus Wealth Advisors has identified a slightly different set of observations about market behavior, and we have built our investment discipline on the foundation of the following:
Global Markets are dominated by major secular trends in Asset Classes:
- Investment markets has been marked by significant, multi-year “Secular” periods, during which asset classes cycle against one another. (Note: We define “Asset Classes” to include Domestic Stocks, International stocks, Commodities, Bonds, and Cash)
- During these secular periods, a single asset class tends to dominate the investment landscape, as investors flock to that asset class over a long cycle, driving its price up over that period. Investors who identify such a trend early on tend to earn superior returns.
- These secular trends tend to persist far longer than most investors expect they will. As a result, it is wise to continue investing in the trending asset class for as long as it continues trending, and only sell when there is evidence that the secular trend is shifting.
- As evidence for this belief, the chart shown below depicts the return history of various asset classes from 1970 to the present. As the chart shows, we can see that there were distinct periods during which one asset class took the position as the “Lead Dog”, and handily outperformed the other asset classes in the “Pack”. These periods generally demonstrate the kind of multi-year secular trends described above.
Trend Following, or “Momentum” is an important factor for selecting investments:
- We at Concentus believe firmly in the importance of Momentum as a factor in making investment decisions. Asset prices tend to move in long term cyclical trends, and our investing discipline is built on the effort to exploit those trends over time by owning those securities or asset classes that have been showing superior recent price movement, and then own them for as long as their superior momentum continues.
- This philosophy can seem a bit counter intuitive to many investors (especially Value Investors), because it actually does imply that past performance of security prices can be used as an indicator of future success. This can be a tough pill to swallow to someone who wants to “buy low and sell high”. Nevertheless, there is significant academic evidence that momentum can be a very important factor in investment markets over time.
- We believe that price trends exist due to psychological or behavioral biases exhibited by investors, which reliably recur over time. Such biases include anchoring to most recent past performance and expecting it to continue, and herding into or out of an investment, such as the tech buying frenzy of the late 90’s or the extreme selling of 2008. As quoted in The Little Book of Behavioral Investing by James Montier:
“We tend to hang onto our views too long simply because we spent time and effort coming up with those views in the first place. This leads to confirmation bias and an anchoring to strongly held beliefs even if the evidence fails to support them anymore.”
- In other words, most people generally expect what is happening right now to continue happening forever. As a result, investors have a tendency to “Herd” into, or out of, those investments which have been performing best, or worst, most recently. That herding process can take a long time, and result in the kind of long range secular asset price trends identified in the chart shown above.
- Trend following is simply an attempt to identify when investors are beginning to “herd” into or out of a particular investment early on, using price movements as an indicator, and then take advantage of that “herding” process for as long as it lasts – usually much longer than most people think it will.
A reliable way to identify and exploit this investor behavior is through the use of empirical, not subjective research.
- We have observed that the study of price trends tends to remove the emotion from investment decision making, because price data is empirical in nature, and not susceptible to subjective biases. It is our view that observation of price movements and trends is the most reliable way to identify these opportunities for performance.
- Fundamental data can be subject to over-reactions because it is a reflection of the investor’s “view of the world” which can be subject to emotion. In particular, it is easy to become “shaken out” of the prevailing trend, when fundamentals appear to change, but price trends continue to persist. The result is that many investors bail out of the prevailing trend far too early, and fail to allow their winning positions to continue winning.
- Trend following using price data is a way to remove the “human” element of trying to guess, predict or forecast what the future holds for the market, asset classes or individual securities. That process is replaced by one based on rigorous academic discipline, where investment decisions are driven by empirical evidence and probabilities.
Where is the Herd?
There are many investing truths, or Natural Laws that the wise observer can glean by studying the behavior of markets and investors over time. Although some may be constantly tempted to believe “This time is Different”… It is never different.
Value investing, as well as Momentum investing, are just two of the timeless investment strategies built upon observation of these “Natural Laws” which govern markets over time. However, neither discipline works all the time, they only work over time. Just as Value investing can be tricky in the short term, trend following strategies can also be difficult to execute. Sometimes it can be tough to determine which way investors are herding, even with the most disciplined and unemotional research data. Sometimes the herd can shift directions quickly and unexpectedly, in a way that seems to defy the trend.
For any investing strategy, the key to long term success is to remain disciplined about the execution of the strategy, and allow it to work over time – even though it may not be working for a temporary period of time.
Having a Plan
The very best investors have a disciplined approach to making portfolio decisions, and always stick to their plan, no matter what the rest of the world is doing. They observe the fundamental realities of market history, make a rational assessment of the present conditions which are being presented, and attempt to position their investments to take advantage of those conditions, with a healthy respect for the Universal Truths of investing success.