It works until it doesn't

Some investing strategies have stood the test of time, others do well in certain environments but can end badly.  Off the top of my head a few investing strategies stand out as having permanence, value investing, buying and holding growing companies, buying and holding market leaders.

There are many strategies that look brilliant for a while before ending in either a blowup, or fizzling out.  For years investing in real estate in California earned market beating returns and was extremely popular.  And for many investing in California real estate was a viable strategy, not just for a year or two, but for decades.  But for investors in the market in the mid-2000s the strategy ended badly.  Many investors were leveraged and those entering the market near the top, when enthusiasm was the highest were happy to walk away with anything more than a total loss.

California real estate isn't the only strategy that ended like this, there are many others.  Ranging from decimating outcomes like tech stocks in the 1990s to gently petering out and underperforming like the Dogs of the Dow.  The best outcome for a novel strategy investor is that the strategy simply starts to gracefully underperform rather than ending in a blowup.

The problem is investors never know what will happen next.  Even the smartest investors aren't immune to this.  Long Term Capital Management (LTCM) was a hedge fund staffed by some of the smartest investors in finance at the time.  They had designed what they considered a fool proof strategy that minted them money.  The problem was their fool proof strategy involved a lot of leverage and exposure to tail risk events, such as the Russian default.  LTCM went from being an esteemed hedge fund to being a fund in liquidation overnight.

The managers at LTCM didn't think they'd blow up.  They went to bed the night before the Russian default believing they had a strategy that would earn them livings for decades.  It worked until suddenly it didn't.

Recently I was reading a thread on the Corner of Berkshire and Fairfax message board (link here) that brought to mind some of the things I want to talk about in this post.  There are many investors who self-reported returns and strategies in that thread that seem to be working well, but I question how long they'll last.

The foundation of a strategy that's lasting is that it can withstand significant events and multiple market cycles.  Often this is accomplished by keeping portfolio leverage limited.  Leverage isn't necessarily a bad thing, levered returns are how many wealthy individuals became rich.  But risk is piled on when leverage gets too high.  A company leveraged 10% is most likely no more risky than one without leverage.  But a bank leveraged 40 to 1 such as Lehman Brothers was simply a bug in search of a windshield.  Even worse is an investor who levers their personal portfolio to invest in a highly levered company.  Doing so is like running through a dynamite factor with a flame thrower, it's possible one could make it through without incident, but it's also likely there'll be a free fireworks show.

Almost all investors have some form of leverage imbedded in their portfolio, either operational leverage or financial leverage through the companies they own.  One of the benefits of being an outside investor is having the ability to take advantage of an investment's leverage without that leverage being recourse to the investor.  The only thing we put at risk when we invest in a leveraged company is our initial investment.  The key is using this embedded leverage wisely.  I don't leverage up my personal portfolio, but some do with options or warrants.  Others go a step further and invest on margin.  A step further is to invest on margin in options on a levered company.  It's possible someone who undertakes this will never experience any financial harm whatsoever and might speak of a strategy in glowing terms.  But the danger is we never know when something will change overnight, and investors with high leverage run the risk of an unexpected margin call, or drawdown.

One of the investors on the Corner of Berkshire and Fairfax message board posted that they had a return that had generated 65% annually since 2008 whereby they invested in a single stock they felt would double each year.  While this might sound like a new strategy I believe Will Rogers created it in 1929 when he said "Buy stocks that go up; if they don't go up, don't buy them."  When someone claims to only purchase a single stock that appreciates on average 65% each year for six years the strategy starts to sound like the Will Rogers quote.  The investor is either extraordinary luckily, a liar, or has the oft sought after working crystal ball.

Is an investor who bets their entire portfolio successfully on a handful of stocks any different from the gambler at the roulette table who has a hot streak?  The difference is the gambler realizes they're lucky, the danger is the investor with a wild run starts to believe they're something special and have above average market insight.  Overconfidence is a return destroyer.

It's not to say that an expert can't navigate a niche area of returns successfully for a period and exit the strategy before experiencing a failure.  Joel Greenblatt, an extremely accomplished special situations investor did just this.  For years he earned 50% returns with his fund and then suddenly exited, wrote a book and switched his strategy.  A variety of explanations have been given for his strategy shift from one that earned incredible returns to one with more stable but lower returns.  I read an interview he gave where the interviewer asked why he switched his strategy. Greenblatt exclaimed that the environment in which they made their returns changed and they realized the results wouldn't be replicable going forward, they were happy with that they achieved and moved to something persistent.

What separates a novice from an expert is that an expert knows they're investing in a temporary strategy and they have the ability to exit before the bottom falls out.  Usually when experts get caught in a strategy washout it's because they've become too greedy.  The returns are too good, they want more and they can't imagine moving to something lower returning.

There is a common market expression that higher returns equal higher risk.  This is definitely true in some cases.  I believe it's possible to earn market beating returns with lower risk through a value strategy.  But as returns deviate from the market my personal view is that risk also increases.  There are no risk free strategies that generate 50%+ returns a year, and as returns rise the tail risk increases as well.  Like LTCM, you can only pick up free nickels in front of a steamroller for a while before getting squished.

My view probably isn't very popular, but it's well known that time in the market is a bigger predictor for ultimate wealth creation.  The best investors have survived multiple recessions and market cycles, and in the mean time beat the market by a few percent.  To me the superior investment strategy is one that survives any market cycle, and while it doesn't provide eye-popping returns in any given year it doesn't implode during downturns either.  A few percentage points of outperformance can result in a large gains when compounded over a significant period of time.

It's in bull markets where all sorts of new strategies appear that make investors fantastic returns.  There are many people who get rich doing crazy things.  Investors seem to ignore the role of luck in markets.  A gambler on a hot streak realizes they're lucky, if an investor makes money they were smart, if they lose the market went against them.  There are many investors who are just as lucky in the market as gamblers at the roulette table.  And maybe skill doesn't matter.  If the point is to create wealth then does it matter if it was luck or skill that generated the result?

Sometimes I feel like a broken record saying investors should be aware of the risk in their portfolios. But when I read message board threads where posters are saying they are disgusted by a 10% return I start to wonder what sort of environment we're in.  Others have done 25% annually and speak like they're just average and feel they can do better.  There are not many investors who've compounded capital at 25%+ or higher for decades, a small handful, but not the masses.

My final point is to do a gut check.  Are you investing in a strategy that has the potential to end badly?  Do you hold the equivalent of a number of leveraged house investments in the Inland Empire in 2003?  If so maybe recognize that it's time to take the gains and walk away lucky.