(April 25, 2012) — It is imperative that long-term investors display patience to weather market volatility while not underperforming in bear markets, explains Jeremy Grantham, the co-founder of Boston-based investment firm GMO Capital Management, which in 2006 predicted the housing crash.
The result: protection of investors’ jobs and their clients’ money.
The central truth of the investment business is that investment behavior is driven by career risk, according to Grantham. Career risk, he says, drives market volatility, and thus, it is imperative that long-term investors have the patience to wait about three years to see if an investment strategy will payoff.
The market moves 19 times more than is justified by the underlying economic engines, according to Grantham, fueled by career risk and a lack of long-term thinking. According to Grantham’s most recent quarterly letter, the prime directive within the investing business is first and last to keep your job. “To do this…you must never, ever be wrong on your own,” Grantham explained. Therefore, to prevent this, professional investors pay ruthless attention to what other investors in general are doing.
“This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest,” according to Grantham.
This herding mentality explains the discrepancy between a remarkably volatile stock market and stable GDP growth. Thus, in order for investors to survive betting against bull market irrationality, they should satisfy three conditions, Grantham outlines. Firstly, investors should allow a generous margin of safety and wait for a real outlier before making a big bet. “Too big a safety margin and we are leaving too much money on the table. We are probably protecting our jobs rather than attempting to maximise our clients’ return,” he says. “Too narrow a safety margin and clients may fire us, as some have done in the past.”
Second, investors should try to stay reasonably diversified.
Third, according to Grantham, investors should never use leverage.
“The cardinal rule is to not underperform in bear markets. And though it may be a cardinal rule, there are, as we all know, no useful guarantees in our business,” he concludes.
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