We are in a momentum-driven market. In 2014, assets that were expensive became more expensive while assets that were cheap became even cheaper. Consequently, active managers (including hedge funds) who care about risk have underperformed a simple, capitalization-weighted, momentum-driven U.S.-biased S&P 500 index fund in which you own more and more of the stocks that have become the most expensive.
These are the times when, increasingly, the risk of actually losing money seems to become “less important” than keeping up with the short-term performance of peers. That sentiment was captured perfectly in the “Whine of 1999” Newsweek cover published shortly before the crash of the dot-com market in 2000.
Strong momentum markets and their keeping-up-with-the-Joneses mentality can lead to bubbles. Bubbles begin with sound logic, but as rising prices lead to excess, that logic is perverted into absurdity. “What the wise man does first, the fool does last.” Think “the Internet is going to change the world” (dot-com bubble, 1997-2000) or “mortgages almost never default” (mortgage bubble and subsequent financial crisis, 2006-2008). This time it's “interest rates are so low and we are so strong that the U.S. stock market is the only place to invest.”
Great, serious investors are not interested in low-risk low-return or high-risk high-return; what they insist on is low-risk high-return. They achieve it by an unwavering commitment to managing downside risk — the risk of actually losing money — which is largely determined by going in price.
With that in mind, here are our Hirtle Callaghan investment resolutions for 2015.
We will:
1. Never forget that real investing is, first and always, about managing risk. Superior returns are achieved by making superior judgments regarding risk. The risk of losing money is largely a function of price. There is no asset that is a good investment at any price.
2. Remember the difference between investing and speculating. Buying an already overpriced asset and hoping it will become more overpriced is speculating, not investing. Buying an asset without having some reasonable sense of its worth is just as bad.
3. Be wary of following the crowd. The risk of losing money is far more important than the risk of not “keeping up with the Joneses.” Following peers who are acting irresponsibly by not considering downside is foolish.
4. Always seek to broaden our opportunity set. With the U.S. stock market priced to perfection, this is the year to seriously consider out-of-favor investments to reduce downside risk and enhance long-term results, even if it means underperforming in the short term.
5. Extend investment horizons. It is widely accepted that stock market investors should have a three-to-five year horizon at the minimum, yet they frequently focus on short-term results. Those short-term results are random and trying to predict or plan for randomness is nonsense. Serious investors can use their longer horizons to exploit the day-to-day, week-to-week, month-to-month focus of Wall Street.
6. Adhere to our discipline. Our investment discipline was carefully developed and is powerfully logical. We will avoid letting pressure from Wall Street, peers or the media compromise that discipline.
7. Evaluate each investment opportunity net of all costs. Our clients can only “eat” net returns; gross returns are meaningless. We will evaluate each investment opportunity in terms of risk and return – net of all costs (including taxes).
8. Price the style of each money manager and index. Great money managers have a disciplined process and that process can be “priced.” We will assign more assets to managers and indexes whose styles and implied styles are underpriced and, consequently, lower the risk of losing money while increasing long-term results.
9. Dare to be different. Differentiated results cannot be achieved by following the crowd. Warren Buffett was one of the few high-profile investors who did not own dot-com stocks during their 1997-2000 bubble. He significantly underperformed for three years before being dramatically vindicated when those dot-com stocks crashed in 2000. He dared to be different, and so will we.
Jonathan J. Hirtle is the CEO of Hirtle, Callaghan & Co.
