Career Risk: The ultimate investment fundamental

Yorkshiremen have a reputation for plain speaking. So it should come as no surprise that it takes a Yorkshireman, in the form of Jeremy Grantham, the co-founder and chief investment strategist of Boston, Massachusetts-based Grantham, Mayo Van Otterloo (GMO), a big investment management firm, to get down to the realities of investing. Forget about putting client interests first. For virtually all investment professionals the real fundamental that drives behaviour is keeping their job.

“The central truth of the investment business is that investment behaviour is driven by career risk,” he writes in the lastest GMO Quarterly Commentary. “In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes  knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially.”

The problem, is, however, that this creates “herding”, or momentum. And this results in prices deviating from “fair value” by a considerable margin.

“There are many other inefficiencies in market pricing, but this is by far the largest,” he continues. “It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market.  

“This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1 percent of its long-term trend. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19 percent two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!”  

Market prices tend to revert back to their mean, however, a phenomenon that underpins Mr Grantham’s - and GMO’s investment management philosophy. Unfortunately, as he is the first to admit, this is not always a comfortable position to take. Market prices can take a very long time to revert back to the mean even if they appear very expensive or very cheap.  

“Ridiculous as our market volatility might seem to an intelligent Martian, it is our reality and everyone loves to trot out the “quote” attributed to Keynes (but never documented): “The market can stay irrational longer than the investor can stay solvent.” For us agents, he might better have said “The market can stay irrational longer than the client can stay patient.””

But how long can a typical client remain patient before demanding action or taking his business elsewhere?

“Over the years, our estimate of “standard client patience time,” to coin a phrase, has been 3.0 years in normal conditions,” says Mr Grantham. “Patience can be up to a year shorter than that in extreme cases where relationships and the timing of their start-ups have proven to be unfortunate.

“For example, 2.5 years of bad performance after 5 good ones is usually tolerable, but 2.5 bad years from start-up, even though your previous 5 good years are well known but helped someone else, is absolutely not the same thing! With good luck on starting time, good personal relationships, and decent relative performance, a client’s patience can be a year longer than 3.0 years, or even 2 years longer in exceptional cases. I like to say that good client management is about earning your firm an incremental year of patience. The extra year is very important with any investment product, but in asset allocation, where mistakes are obvious, it is absolutely huge and usually enough.”

As Keynes pointed out in The General Theory of Employment, Money and Interest funds overseen by investment committees and boards tend to be the most critical of fundamental value, driven investors.

“What Keynes definitely did say in the famous chapter 12 of his General Theory is that “the long-term investor, he who most promotes the public interest … will in practice come in for the most criticism whenever investment funds are managed by committees or boards,” “ continues Mr Grantham. “He, the long-term investor, will be perceived as “eccentric, unconventional and rash in the eyes of average opinion … and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.”

Mr Grantham and GMO have certainly experienced considerable criticism from investors, not least for calling the collapse of the technology bubble of the late 1990s two to three years early, (although GMO’s performance during the deep bear market of 2000 to 2003 more than made up for the opportunities apparently foregone)..

“Reviewing our experiences of being early in several extreme outlying events makes Keynes’s actual quote look painfully accurate in that “mercy” sometimes was as limited as it was at a bad day at the Coliseum, with a sea of thumbs down,” he concludes. “But his attribution, in contrast, has proven too severe: we appear to have survived.”