This article has been contributed by Amay Hattangadi and Swanand Kelkar of Morgan Stanley Investment Management.
Just ahead of the annual meeting of Berkshire Hathaway, held last month, an interviewer from a business magazine quizzed Warren Buffett on what kind of deals he would like to do with almost $60 billion of cash on the balance sheet.
In his usual earthy style, Buffett simply said “ones we can understand, where the price is right and we like the management”. He said that he can’t narrow down the criteria any further as it is difficult enough to find investment opportunities that fulfil just these three requirements.
Every investor, overtly or covertly, aspires to imitate Buffett’s style of investing. When clients invest with professional money managers they too love to hear a well-articulated investment philosophy and process, and if it sounds like the ‘Buffett style of investing’ even better.
However, this essay does not purport to be one more analysis of what makes Buffett’s investing style click. There are countless books and columns that have already attempted to do that. Rather it tries to bring to the fore how investors (and their clients), while wanting to imitate ‘Buffett-type’ of investing, simultaneously want to achieve a near perfect ‘Madoff-type’ consistent returns. And no matter how good an investor one is, the two simply cannot co-exist.
Bernie Madoff, sentenced to a 150-year prison sentence in 2009 for running what was a $65 billion Ponzi scheme disguised as an investment vehicle, had for many years clients queueing up to invest. Fairfield Greenwich’s Sentry Fund, a feeder fund that had invested its entire corpus with Madoff serves as a good proxy for his track record. In almost 18 years of running the Fund, Fairfield beat the S&P500 index by about 2% annualised. More importantly, it boasted of 92% positive return months with annual volatility of only 2.5%, compared to the S&P 500 index’s volatility of 14%! And yes, investors believed that.
Of course we now know that there were no real investments in Madoff’s fund and it was all just a ponzi scheme, but just the stability of returns is what lured clients into investing in Madoff’s fund.
Contrast this with the performance of Berkshire Hathaway. Its book value has outperformed the S&P 500 by 9.5% annualised over its 50 years of existence. However this has come with its fair share of ups and downs. It has lagged the index in 11 of those years, including four of the last five years. Interestingly, Berkshire has beaten the index in every year in which the index yielded negative returns.
This is where we see the dichotomy. You cannot have Buffett’s style of investing and Madoff’s consistency of returns rolled into one. Markets by their nature are volatile. A smooth upward sloping - almost 45 degree - performance graph with near zero correlation to market movements is an investing unicorn. It just does not exist. No investor can possibly get every trade right or out-perform in every market move.
This brings us to a behavioural bias known as loss aversion. Psychologists Kahneman and Tversky have demonstrated through experiments that we feel the pain of loss almost twice as acutely as the pleasure derived from gains. Hence investors (and their clients) go to great lengths to reduce fluctuations, often compromising on potential gains in the process. If an investor had invested in Berkshire Hathaway and Fairfield Sentry around the time of the latter’s launch in 1991 until its closure in 2008, she would have earned annualised returns of 17% and 10.5% respectively. The latter as we know was achieved (read: manipulated) with negligible volatility. In fact Madoff too realised this and is quoted as saying that the lack of volatility of his investments was illusory based on monthly or annual returns and that on an intra-day, intra-week or intra-month basis the volatility was ‘all over the place’.
It is this aversion to loss that leads most individuals to under-allocate their wealth to equities as an asset class. Stock prices are available with high frequency allowing an investor to mark-to-market his or her portfolio with every move on the ticker tape.
Many investors prefer to invest in assets such as real estate, bank deposits or even art because they cannot bear to see daily mark to market movements in their portfolios, particularly when the returns are negative. Professional investment managers and investment committees too succumb to the pressure of daily (or short term) performance and may end up making investment decisions that do not achieve the desired returns over the long run.
To conclude, investors are well advised to be prepared for volatility when investing in an asset class like equities, rather than sacrificing opportunities just because there could be periods of negative mark to market returns. It’s better to go with an investment philosophy that one understands (a la Buffett) rather than succumb to the lure of stable but illusory returns (a la Madoff). As they say, if something is too good to be true, it just might be.
