Yesterday, I had the opportunity to attend a panel discussion that included a prominent investment manager named Seth Klarman. I’d like to share some of what he had to say.
First, some background if you’re not familiar with Klarman. The simplistic version of his biography would be to say that he is a hedge fund billionaire. And while that’s true, it really doesn’t do him justice. Klarman is more like a cult hero in the investment world. Some call him the “Oracle of Boston.” Google his name, and you’ll see him described as “the next Warren Buffett.” Search YouTube, and you’ll find a grainy, 10-year-old interview with thousands of views. And if you look up Klarman on Amazon, you’ll find used copies of his nearly thirty-year-old, out-of-print book selling for $1,000 or more. In short, Klarman is full of wisdom and commonsense advice that, I think, could benefit any investor. Here are four observations he shared yesterday:
When you’re building a portfolio, you have to “pick your poison”
In today’s world, with the availability of index funds, it’s not difficult to build a portfolio, but the question is: What kind of portfolio do you want to build? Or, to put it another way: What are you trying to accomplish? Here’s how Klarman summed it up: “Do you want to trail the market when it’s going up or when it’s going down?”
In other words, you can structure your portfolio to be more aggressive than the overall stock market. That will help you when the market is going up but hurt you when it’s going down. Or, you can structure things to be more conservative than the market, in which case you’ll trail when the market is going up but lose less when the market is going down. But you can’t have it both ways.
While this seems like common sense, Klarman is making an important point: To a great extent, investment returns are within our control. Many people—myself included—worry about the stock market, but Klarman’s point is that it doesn’t need to be that way. If you don’t want to lose sleep worrying about the market, you don’t have to. It’s all about the asset allocation choices you make. This is good advice, especially when the market is still near all-time highs. If you’re feeling any amount of angst about a potential drop-off in the market, that tells you it’s probably time to revisit your asset allocation.
When it comes to investments, “there’s no such thing as a perfect 10”
In other words, no investment is ever going to be perfect, and we shouldn’t expect it to be. In traditional finance textbooks, investment decisions are presented as a trade-off between risk and return. If you want more return, you have to take more risk. But if you want less risk, you have to be satisfied with lower returns. Klarman’s view, however, is that this traditional risk-return framework is overly simplistic. (He also views it as wrong, but that’s a topic for another day.) In evaluating investments, investors should think things through much more carefully. In addition to risk and return, consider an investment’s fees, complexity, liquidity, tax treatment and the overall level of certainty or uncertainty.
Be willing pay more when warranted
In making this statement, Klarman was referring to the management fee embedded in an investment fund. His view: It’s worth paying more if it will add value. Most investors are sensitive to fees and taxes—and they should be—but Klarman’s comment is a good reminder not to take this too far. If you’re suffering with an overpriced, underperforming fund, for example, should you live with it forever just because you would have to pay some taxes if you sold it? Klarman’s view: Of course not. Don’t be afraid to incur a cost if you think it will pay off in the long run.
“Don’t fall in love with an investment”
This statement is a corollary to Klarman’s “pick your poison” and “perfect 10” ideas. Just as there is no perfect investment on the day you buy it, there is no investment that you should expect to remain perfect for all time. I see this as particularly applicable to thinking about index funds—an investment that appears awfully close to perfect right now. Like many people, and as the data indicates, I believe that index funds are indeed the best way to invest. But we should never be too comfortable. Right now, I believe indexing works exceptionally well, but I also accept that it may not work forever. Markets are dynamic. Indexing might begin to work less well, or other forms of investing might begin to work better. Klarman’s advice: Anything can happen, so be careful. When it comes to your investments, you don’t want to be blinded by love.