Renowned value investor Seth Klarman (Trades, Portfolio) is not shy of chastising those in his own industry. In his 2004 year-end letter to investors, he explained why holding cash in times of high valuations is preferable to chasing suboptimal returns. In a nutshell, it comes down to optionality -- having the power to swiftly deploy capital if prices suddenly come down. However, he does not expect many to follow his example.
Holding cash is great, but professionals don’t do it
So if holding cash is such a good strategy, do institutional investors do so? To Klarman’s mind, not so much:
“Those in the investment business compete on the basis of short-term, relative (not absolute) investment performance, and prefer to follow the herd (at the price of assured mediocrity) rather than stand apart (risking severe underperformance). From a business perspective, how much better to be actively deploying capital, even if the investments are mediocre, than to be stalled in neutral; the employees keep busy, while the clients confuse decisions with diligence, activity with insight, and a fully invested posture with a worthwhile portfolio.”
Let that sink in. Professional money managers, who are supposedly the smartest and most rational investors in the markets, care more about following each other’s lead than shooting for overperformance. Moreover, Klarman reckons that the pressure on them to be busy rather than idle also contributes significantly to this behavior.
Better to go your own way
The big takeaway here is that it is sometimes better to be an independent investor. Sure, you don’t have access to as much data or computing power as the big players. But you are also free to make your own decisions and go at your own pace, without worrying about clients complaining about underperforming some benchmark over the course of one quarter, or trying to outcompete a rival portfolio manager.
With that said, Klarman says that he expects that most investors would make the same choice, independent or not. The psychological urge to get involved in the game is just too strong, he said. The fear of losing out overpowers the fear of buying high. A paragraph that seems eerily applicable to today, almost 15 years later, breaks down the difference between opportunity cost and actual cost:
“Betting that the markets never revert to historical norms, that we are in a new era of higher securities prices and lower returns, involves the risk of significant capital impairment. Betting that prices will fall at some point involves opportunity cost of uncertain amount. By holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital, and agree wholeheartedly with the sentiment espoused by respected value investor Jean-Marie Eveillard, when he said, 'I would rather lose half our shareholders. ... than lose half of our shareholders’ money …'”
In other words, better to lose out on making money, than losing money.
Disclosure: The author owns no stocks mentioned.
