Famed value investor Jeremy Grantham says the best returns on investments do not come from taking biggest risks, but from buying cheapest assets.
He says the lesser an investor pays for a stream of earnings, the higher will be the chances of his return over time.
“You don’t get rewarded for taking risk; you get rewarded for buying cheap assets. If the assets you bought got pushed up in price simply because they were risky, you are not going to be rewarded for taking the risk; you are going to be punished for it,” he told investors in his quarterly letter.
Jeremy Grantham is a British investor and Co-founder and Chief Investment Strategist of Grantham Mayo Van Otterloo (GMO), a Boston-based asset management firm.
Grantham has a reputation for accurately predicting about three major market bubbles: Japan’s asset-price bubble in 1989, the dot-com bubble in 2000, and the US mortgage crisis in 2008.
Grantham’s investment strategy
Grantham’s investment strategy is built on the idea of mean reversion. He makes his investment choices by looking for irrationally priced stocks.
He says financial assets can be too expensive or too cheap at any given moment, but will always go back to average. The worst thing investors can do is to get in or out of an investment for the simple fear of lagging behind their peers, says he.
Why individual investors are at an advantage
Grantham says the basic truth of investment is that investor behaviour is driven by career risk. He feels most investment managers fear taking bold calls and prefer going with the flow and doing what their peers are doing, because it is the safest option to survive in the investment industry.
Grantham says individual investors can take advantage of this practice of investment managers, as it creates herding and thus drive prices well above or below their fair values.
“The prime directive is first and last to keep your job. To do this, you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority ‘go with the flow’, either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price,” says he.
Giving the example of the Internet Bubble, he says companies that were suffering big losses and had no future were getting billion-dollar valuations and fund managers were buying them at excessive prices, just because they feared missing out or deviating from the performance of their peers.
10 lessons for individual investors
Grantham lists out 10 timeless investment lessons for individual investors setting out on dangerous investment voyages.
1. Believe in history: In investing, history tends to repeat itself and all investment challenges pass away in due course. Investors should try and survive the tough times and ignore vested interests of the industry who try to mislead them from time to time about the market, says Grantham.
“The market is gloriously inefficient and wanders far from fair price but eventually, after breaking your heart and your patience (and, for professionals, those of their clients too), it will go back to fair value. Your task is to survive until that happens,” he says.
2. Don’t be a lender or a borrower: If an investor plans to borrow capital for investment, it tends to interfere with their survival in the industry. The temptation to borrow has proven to be so seductive that individuals have shown themselves to be incapable of resisting it, as if it were a drug.
“Unleveraged portfolios cannot be stopped out, leveraged portfolios can. Leverage reduces patience, an investor’s critical asset. It encourages financial aggressiveness, recklessness and greed. It increases your returns over and over until, suddenly, it ruins you. For individuals, it allows you to have today what you really can’t afford until tomorrow,” he says.
3. Don’t put all of your treasure in one boat: It is best not to put all the capital into one investment, as several different investments give a portfolio resilience and the ability to withstand shocks. “Clearly, the more investments you have and the more different they are, the more likely you are to survive those critical periods when your big bets move against you,” he says.
4. Be patient and focus on the long term: It is important for investors to have patience to exploit favourable market conditions. There will always be ups and downs in the market. So it is best to invest for the long term when a good investment opportunity arises. “Wait for the good cards. If you’ve waited and waited some more until finally a very cheap market appears, this will be your margin of safety. Now all you have to do is withstand the pain as the very good investment becomes exceptional. Individual stocks usually recover, entire markets always do. If you’ve followed the previous rules, you will outlast the bad news,” he says.
5. Recognise your advantages over the professionals: Individual investors have a big advantage over professional managers as they don’t have to report their results to anyone but themselves. Also, they don’t have to match the market’s return every year and don’t have the fear of getting fired. Also, unlike a professional investment manager, individuals can afford to hold a temporary loser for a winning outcome in the long run which is a huge advantage for many reasons like minimising taxes and transaction costs.
“The individual is far better positioned to wait patiently for the right pitch while paying no regard to what others are doing, which is almost impossible for professionals,” he says.
6. Try to contain natural optimism: Although optimism is often regarded as a positive survival characteristic in the investment world, it comes with a downside, especially for investors who don’t like to hear the bad news. “In a real stock bubble like that of 2000, bearish news in the US was greeted like news of the bubonic plague; bearish professionals were fired just to avoid the dissonance of hearing the bear case, and this was an example where the better the case was made, the more unpleasantness it elicited,” he says.
Investors should not be overly optimistic and learn to give importance to both the good and the bad news of the investment industry. One should be willing to hear bearish, bad news about the risks they have taken with their capital and make informed decisions about them.
7. On rare occasions, try hard to be brave: Professional investors have the ability and the skill to often spot bargains, but they can’t and don’t always act on it. This is due to the fact that professional investors don’t want to risk lagging behind their peers and lose their jobs if they go wrong on an investment bet.
But Grantham feels individuals don’t have that worry and they should trust their research if they find an investment that looks cheap even if it’s likely to be out of favor for a while. “You can make bigger bets than professionals can when extreme opportunities present themselves because, for them, the biggest risk that comes from temporary setbacks – extreme loss of clients and business – does not exist for you. So, if the numbers tell you it’s a real outlier of a mispriced market, grit your teeth and go for it,” says he.
8. Resist the crowd, cherish numbers only: It is toughest for investors to resist the enthusiasm of a crowd. “Watching you neighbours get rich at the end of a bubble while you sit it out patiently is pure torture,” he says. So, Grantham advises investors to do their own simple measurements of value, or find a reliable source and check their calculations from time to time.
He says investors should ignore especially the short-term news like the ebb and flow of economic and political news. “Stock values are based on their entire future value of dividends and earnings going out many decades into the future. Shorter-term economic dips have no appreciable long-term effect on individual companies let alone the broad asset classes that you should concentrate on. Leave those complexities to professionals, who will on average lose money trying to decipher them,” he says.
9. In the end it’s quite simple. Really: Investors should look to calculate estimates and forecasts of an attractive investment proposition by using simple methodology and shouldn’t let any external factors affect their research. “These estimates are not about nuances or PhDs. They are about ignoring the crowd, working out simple ratios and being patient,” he says.
10. This above all, to thine own self be true: To become successful, it is imperative for investors to know their limitations as well as their strengths and weaknesses. “If you can be patient and ignore the crowd, you will likely win. But to imagine you can, and to then adopt a flawed approach that allows you to be seduced or intimidated by the crowd into jumping in late or getting out early is to guarantee a pure disaster. You must know your pain and patience thresholds accurately and not play over your head,” he says.
He also believes that if investors cannot resist temptations, then they should absolutely not manage their own money. People can either hire a manager who has those skills to manage their money efficiently or they can pick a sensible, globally diversified index of stocks and bonds for investment which they should never look at again until they retire, says he.
Grantham also feels that if individuals have patience, a decent pain threshold, an ability to withstand herd mentality, some basic college level education in math, and a reputation for common sense, then they can be successful in the investment world.
“In my opinion, you hold enough cards and will beat most professionals which is sadly, but realistically, a relatively modest hurdle and may even do very well indeed,” he says.
(Disclaimer: This article is based on Jeremy Grantham’s GMO Quarterly Letter).
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