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Monday, March 27, 2017
Howard Marks Redux: "There They Go Again" - Why Stock Investors Develop Amnesia
One of our favorite memos is his May 2005 piece where Marks discusses why investors develop amnesia when it comes to share-market history. It’s a must read for all investors.
Here’s an excerpt from that memo:
Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory.
. . . There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
John Kenneth Galbraith - A Short History of Financial Euphoria, Viking, 1990
The above observation has appeared in lots of my memos, second only to Warren Buffett’s reminder that our need for prudence in a given situation is inversely proportional to the amount of prudence being displayed by other investors. Neither of these favorite quotations says much for the average investor: Buffett urges us to adopt behavior that is the opposite of John Q. Investor’s, and Galbraith points out how prone John Q. is to repeating the mistakes of the past.
It may sound cynical, but most outstanding investors – especially members of the “us school” (see “Us and Them,” May 7, 2004) – understand that the path to superior results lies in taking advantage of other people’s mistakes. (The alternative is to think everyone can succeed simultaneously.) It’s when most investors take a trend to excess, or the price of an asset to an extreme, that the few people smart and resolute enough to abstain from herd behavior can make truly exceptional profits.
I think both Buffett’s and Galbraith’s dim views of the average investor are well founded. Although there exist a few rules and reminders that can make it easier to avoid the costliest investing mistakes, most investors rarely heed them.
Investors truly do make the same mistakes over and over. It may be different people doing it each time, and usually they do it in new fields and in connection with new assets, but it is the same behavior. As Mark Twain said, “History doesn’t repeat itself, but it rhymes.”
Rarely is the same error repeated in back-to-back years. Usually enough time passes for the repetitive pattern to go unnoticed and for the lessons to be forgotten. Often it’s a new generation repeating the errors of their forefathers. But the patterns are there, if you observe with the benefit of objectivity and a long-term view of history.
Why do the mistakes repeat? That’s a good question, but not much of a mystery. First, few investors have been around long enough to recognize reoccurrence of the errors of twenty or forty years ago. And second, the greed that argues for ignoring “the old rules” easily trumps caution; hope truly does spring eternal. That’s especially true when the good times are rolling. The tendency to ignore the rules invariably reaches its apex in periods when following them has cost people money. It is thus, as Galbraith points out, that those who harp on the lessons of the past are dismissed as old fogies. What are some of the recurring mistakes investors make?
It’s Different This Time – Trends in investing are carried to their greatest (and most punishing) extremes by the belief that something has changed – that rules that applied in the past have been rendered obsolete by new circumstances. (E.g., the traditional standards for reasonable valuations weren’t applicable to shares in tech companies whose products were likely to change the world.)
It Can’t Miss – The fact is, anything can miss. There’s no asset so good or trend so strong that you can’t lose money betting on it. No investment technique is guaranteed to deliver high returns or keep risk low. Smoothly functioning markets don’t permit the combination of high return and low risk to persist – good results bring in buyers who raise prices, lowering future returns and elevating risk. It’ll never be otherwise.
The Explanation Couldn’t Be Simpler – By this I mean to poke some fun at investors’ tendency to fall for stories that seem true on the surface but ignore the workings of markets. The stage was set for some of the greatest debacles by platitudes that were easy to swallow – but too simplistic and, in the end, just plain wrong. These include “For a company with good enough growth prospects, there’s no such thing as too high a price” (1969 and 1999) and “Emerging markets are a sure thing because of the terrific potential for growth in per capita consumption” (1994).
This Tree Will Grow to the Sky – The fact is, no trend will go on unabated forever. Most trends are limited by cycles, which are caused by people’s reaction to developments. Buyers, sellers and competitors respond to trends, altering the current landscape and the future.
The Positives of Today Will Still Be Positives Tomorrow– From time to time, some combination of optimism and greed convinces people that the favorable elements in the current environment – responsible for today’s high asset prices – will stay that way. But (a) things usually turn less rosy, and (b) even before they do, investors take prices to levels that are too high even for today’s positives.
Past Returns Are a Good Guide to Future Returns – The greatest bubbles stem from the belief that high returns in the past foretell high returns in the future. The most successful investors – the longest-term survivors – believe in just the opposite: regression to the mean. The things that have appreciated the most will slow down (or decline), and those that lagged will catch up or move ahead. Instead of being encouraged by months or years of price appreciation, investors should be forewarned.
It’ll Always Beat the Cost of Borrowing – Speculative behavior usually features the belief that assets will always appreciate faster than the rate of interest paid on money borrowed to buy them with. We saw a lot of this in the inflationary 1970s. But for the most part, statements including the words “always” and “never” are usually a sign of trouble ahead.
The Supply/Demand Picture Doesn’t Matter – The relationship between supply and demand determines the price of everything. The higher the demand relative to the supply, the higher the price for a given asset or strategy. And, the higher the price, the lower the prospective return (all else being equal). Why can’t investors remember these two absolute rules?
Higher Risk Means Higher Return – There are times, especially when the prospective returns on low-risk investments appear inadequate, when people reach for more return by going out further on the risk curve. They forget that riskier investments don’t necessarily bring higher returns, just higher projected returns. Forgetting the difference can be fatal.
Anything’s Better Than Cash – Because it entails the least risk, the prospective return on cash invariably is lower than all other investments. But that doesn’t mean it’s the least desirable. There are times when the valuations on other investments are so high that they entail too much risk.
It May Be Too Good to Be True, But I Don’t Want to Miss Out – There’ve been lots of times in my career when people knew something was unlikely to keep working but jumped on the bandwagon anyway. Usually they did so because they thought there was a little bit more left in the trend, or because not being aboard – and watching from the sidelines while others got rich – had become too painful.
If It Stops Working, I’ll Get Out – When people invest despite obvious danger signs, they usually do so under the belief that they’ll be able to get out when the market turns down. They rarely ask how it is that they’ll know to sell before others do, or to whom they’ll sell if everyone else figures it out simultaneously.
As I sit here in 2005, the picture seems “as plain as the nose on your face.” Investors have found new darlings – real estate, private equity, hedge funds and crude oil – to replace the favorites of ancient history (that is 1999) – technology-media-telecom, biotech and venture capital funds. As I read articles about the new favorites, I find myself saying one thing over and over: “There they go again.”