Memo Date
November 29, 2022
Topics Touched
Macro ForecastsShort-TermismVolatilityAsymmetryPrinciples
- How much will the Fed raise interest rates to fight it? Will those increases cause a recession? How bad and for how long? The bottom line, I told the attendees, was that these things all relate to the short term
- In late 2015, virtually the only question I got was “When will the first rate increase occur?” My answer was always the same: “Why do you care?
- It’s very difficult to know which expectations regarding events are already incorporated in security prices.
- Hard to know what’s already priced in
- It’s very difficult to know which expectations regarding events are already incorporated in security prices
- One of the critical mistakes people are guilty of – we see it all the time in the media – is believing that changes in security prices are the result of events
- Security prices are determined by events and how investors react to those events, which is largely a function of how the events stack up against investors’ expectations
- So, at the most elementary level, it’s not whether the event is simply positive or not, but how the event compares with what was expected
- Macro events and the ups and downs of companies’ near-term fortunes are unpredictable and not necessarily indicative of – or relevant to – companies’ long-term prospects. So little attention should be paid to them.
- Due to the presence of so much uncertainty, most investors are unable to improve their results by focusing on the short term.
- What accounts for this? It must be the fact that, in the short term, the ups and downs of prices are influenced far more by swings in investor psychology than by changes in companies’ long-term prospects. Because swings in psychology matter more in the near term than changes in fundamentals – and are so hard to predict – most short-term trading is a waste of time
- If you ask Warren Buffett to describe the foundation of his approach to investing, he’ll probably start by insisting that stocks should be thought of as ownership interests in companies
- Are the buyers buying because this is a company they’d like to own a piece of for years? Or are they merely betting that the price will go up?
- Each time a stock is traded, one side is wrong and one is right. But if what you’re doing is betting on trends in popularity, and thus the direction of price moves over the next month, quarter, or year, is it realistic to believe you’ll be right more often than the person on the other side of the trade?
- While none of this is easy, as Charlie Munger once told me, carefully weighing long-term merit should produce better results than trying to guess at short-term swings in popularity.
- I feel there are three ingredients for success during good times – aggressiveness, timing, and skill – and if you have enough aggressiveness at the right time, you don’t need that much skill
- In good times, the highest returns often go to the person whose portfolio incorporates the most risk, beta, and correlation. Having such a portfolio isn’t a mark of distinction or insight if the investor is a perma-bull who’s always positioned aggressively
- One of the recurring themes in my memos is the idea that the quality of a decision cannot be determined from the outcome alone
- However, when outcomes are considered over a long period of time and a large number of trials, the better decision maker is overwhelmingly likely to have a higher proportion of successes.
- I define risk as the probability of a bad outcome, and volatility is, at best, an indicator of the presence of risk. But volatility is not risk. That’s all I’m going to say on that subject.
- Everyone cites Sharpe ratios, including Oaktree, because it’s the only quantitative tool available for the job
- Volatility is particularly irrelevant in our field of fixed income or “credit.”
- Most of the time when you buy a bond with an 8% yield, you’ll basically get the 8% yield over its life, regardless of whether the bond price goes up or down in the interim.
- “Volatility” is often a misnomer. Strategists and the media often warn that “there may be volatility ahead.” What they really mean is “there may be price declines ahead.” No one worries about, or minds experiencing, volatility to the upside.
- Thinking of Hedge funds as delivering high return @ low volatility
- Volatility should be less of a concern for investors:
- Whose entities are long-lived
- Whose capital isn’t subject to withdrawal
- Essential activities won’t be jeopardized by downward fluctuations
- Haven’t levered up with debt
- Potential common problem with overvalued PE stakes… If a GP boosts or smooths returns,...investment managers within LP organizations can report artificially higher Sharpe ratios, alphas, and top-line returns, such as IRRs, to their trustees or other overseers… might improve their internal job security or potential labor market outcomes
- As with most things, any inaccuracy in reporting will eventually come to light.
- Develop the mindset that you don’t make money on what you buy and sell; you make money (hopefully) on what you hold
- But you have to take a position [on short-run events], don’t you?
- No, not if you don’t have an advantage when doing so
- What really matters is the performance of your holdings over the next five or ten years (or more) and how the value at the end of the period compares to the amount you invested and to your needs
- Investment professionals should:
- Study companies and securities, assessing things such as their earnings potential
- Buy the ones that can be purchased at attractive prices relative to their potential
- Hold onto them as long as the company’s earnings outlook and the attractiveness of the price remain intact
- Make changes only when those things can’t be reconfirmed, or when something better comes along
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- Of critical importance, equity investors should make their primary goals (a) participating in the secular growth of economies and companies and (b) benefiting from the wonder of compounding
- Think of participating in the long-term performance of the average as the main event and the active efforts to improve on it as “embroidery around the edges.”
- Investors should find a way to keep their hands off their portfolios most of the time.
- Having alpha allows an investor to enjoy profit potential that is disproportionate to loss potential: asymmetry
- For example, most of us have an inherent bias toward either aggressiveness or defensiveness. For this reason, it doesn’t mean much if an aggressive investor outperforms in a good year or a defensive investor outperforms in a bad year. To determine whether they have alpha and produce asymmetry, we have to consider whether the aggressive investor is able to avoid the full loss that his aggressiveness alone would produce in a bad market and whether the defensive investor can avoid missing out on too much of the gain when the market does well. In my opinion, “excellence” lies in asymmetry between the results in good and bad times.
- As I’ve said before, the average of all investors’ thinking produces market prices and, obviously, average performance. Asymmetry can only be demonstrated by the relatively few people with superior skill and insight.