Prudent Behavior in a Low-Return World
The 2005 memo I mentioned earlier, “There They Go Again,” proceeded from the discussion of the low and flat risk/return curve contained in “Risk and Return Today” to ponder what investors might do in times of low prospective returns and risk premiums. The possibilities fell into just a few categories:
- Go to cash – not a real alternative for most investors.
- Ignore the lowness of absolute returns and pursue the best relative returns.
- Forget that elevated prices might imply a correction, and buy for the long run.
- Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.
- Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness.
Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by). I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
Here’s what I wrote in May 2005:
Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier (or at least less traditional) investments. But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher. This may be exactly the wrong time to add to risk in pursuit of more return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so.
Even six years later, I can’t think of any responses to a low-return world beyond those enumerated above. Limit risk, sacrificing return. Accept risk in pursuit of return, and pray the consequences will be tolerable. Or strive to find ways to augment returns through means other than risk bearing.
None of these possible solutions is perfect and without pitfalls. In fact, each brings its own form of risk. Staying safe entails the risk of inadequate return. Reaching for return increases the risk of financial loss. And the search for “alpha” managers introduces the risk of choosing the wrong ones. But, as they say, “it is what it is.” When it’s a low-return world, there are no easy solutions devoid of downside.
The Right Approach for Today
One of the things that makes investing interesting is the ever-changing nature of the route to profit, the pitfalls that are present, and the tools and approaches that should be employed. Conscious decisions regarding these things should underlie all efforts to manage capital, and they must be revisited constantly as circumstances and asset prices change. What’s right today?
First, should you prepare for prosperity or not? By prosperity I mean a return to the happy days of the 1980s and ’90s, when reported economic growth was strong and consumers were eager to spend. My answer is that we’re not likely to see anything like that, in large part because in those decades the gap between stagnant incomes and vigorous consumption growth was bridged through buying on credit. Instead, in the years ahead I think (a) growth in employment and incomes will be sluggish, (b) consumers should be restrained in their borrowing as a result of having experienced the crisis, (c) consumer credit shouldn’t be available as readily, and (d) borrowing against home equity will be much less of a factor, especially because home equity is so scarce.
Second, should you worry more about losing money or about missing opportunities? This one’s easy for me. First, the macro uncertainties tell me we won’t be seeing a highly effervescent economy or market environment. Second, other people’s increasingly aggressive behavior tells me to seek cover. And third, since I don’t see many compellingly cheap assets, I doubt there will be gains big enough to make us kick ourselves for having invested too cautiously.
And that brings me to my third question: what tools should you employ? In late 2008 and early 2009, you needed just two things to achieve big profits: money to commit and the nerve to commit it. If you had caution, conservatism, risk control, discipline and selectivity, you probably achieved lower returns than otherwise (although having factored those things into your analysis might have given you the confidence needed to implement favorable conclusions in that terrible environment). The short answer was simple: money and nerve.
But what if you had money and nerve in 2006 or early 2007? The results would have been disastrous. In those times you needed caution, conservatism, risk control, discipline and selectivity to stay out of trouble. In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility.
So then, which is the right set of equipment for today? I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:
- the so-so U.S. recovery;
- the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;
- the economic impact of deleveraging and austerity;
- the over-indebtedness of peripheral eurozone countries;
- the possibility of rekindled inflation and rising interest rates;
- the uncertain outlook for the dollar, euro and sterling; and
- the instability in the Middle East and resulting uncertainty over the price of oil.
With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right. (Of course that’s not an unfamiliar refrain from me.)
The other day, the investment committee of a non-profit on which I sit decided to take the first steps toward marshaling resources and managers so as to be ready to buy into beaten-down assets after the next round of bubble and bust. And it wasn’t even my idea!
We can never be sure what will happen – and certainly not when – but it’s important to be prepared for what’s likely to lie ahead. And understanding the inevitable pendulum swing in the way investments are viewed – from weeds to flowers and back – is an essential ingredient in being able to do so.
May 25, 2011
P.S.: I hope you’ll consider rereading “Risk and Return Today” (November 2004) and “There They Go Again” (May 2005) (see http://www.oaktreecapital.com). Hopefully they’ll strengthen the case for reflecting on past patterns and help you think through the current conditions. You might also take a look at “The Cat, the Tree, the Carrot and the Stick” in “What’s Going On” (May 2003) for a metaphorical look at the process of risk acceptance. Today’s echoes of those past times are worth noting.
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