A decade-old letter from famous value investor Seth Klarman is a useful re-read today
Updated on: 17-Oct-2022 •Dhirendra Kumar
A few days ago, I came across an article that was more than a decade old but which is worth a careful re-read. It was an excerpt from a letter to investors written by US fund manager Seth Klarman in 2009. The letter was written in late 2009 or early 2010, and the excerpt consists of 'lessons that were either never learned or were forgotten by most market participants during the global financial crash of 2008-2009. There are a total of 20 lessons that should have been learned and 10 that should not have been learned, that is, false lessons.
You can google and read the whole set, but I find a few of them of especially great utility to Indian equity investors - not just currently, but always.
Here's one: Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking and to focus on new opportunities while others are distracted or even forced to sell.
There's a reason why principles like diversification and asset allocation are important in everyone's investments. Even if you think that you would like to take some risks and make aggressive investments, investors who are entirely focused on such investments and keep doing that in all phases of the markets rarely do well eventually. No matter what happens, some investments are safer than others, some will fall less and recover easily. Every investor knows who they are. One should always have some exposure to safe, conservative investments. Most importantly, as Klarman points out, if you wait till they are needed, then it will be too late.
Here's another one: Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty - such as in the fall of 2008 - drives securities prices to especially low levels, they often become less risky investments. And another related point: You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
Klarman is channelling the famous saying that the time to buy is when there's blood on the streets. For a given investment, as long as your judgement of that investment does not change, it's true that the higher the price, the higher the risk. The corollary of that is that the lower the price, the lower the risk. From that, it follows that when the markets start getting weaker, then the risk is lower. So why do the headlines always say and imply the opposite? They do so because they're taking the punter's view, not the investor's. The idea that uncertainty (and volatility) is not the risk is hard to absorb, but it's important to do so, especially because formal definitions of risk always focus on volatility.
And one more, but this is one of the false lessons: Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities, when they come under pressure because declines will quickly be reversed.
The false lesson is a cautionary tale against believing too deeply in the previous lesson. Yes, a lower price means lower risk but only in assets that were otherwise worthwhile. Junk that is cheaper is still junk. In fact, when markets crash after a euphoric period, there are always stocks that never recover. This was amply proven in that very crash to Indian investors with some infra and telecom stocks. Those who held on to these or bought them at the crashed prices later, thinking that they were doing value investing, lost all value.
As the world enters another period of uncertainty, looking back at tough episodes in the past can provide a useful perspective on how to deal with the current one.