Extremely Bad Decisions

There are undoubtedly countless investors nursing losses because of a choice made in recent years to abandon value-oriented strategies to fully commit to the rapidly accelerating growth bandwagon. Although the brutal reversal in the more speculative end of the growth universe can be read as a salutary lesson on style and factor rotations, it is not. It is about the dangers of making pro-cyclical decisions when returns reach extreme levels. Rather than worry about such excesses, investors willfully and gladly embrace them. We put more chips on the table as the odds of success deteriorate. *

Whilst it is impossible to precisely define ‘extreme’, our focus should be on two measures – performance and valuations.

Any investment strategy with unusually strong performance should be a cause for concern. If a reasonable expectation for excess returns from a (highly) skillful active manager is 2% per annum and a certain fund delivers 10% annualised outperformance over five years, this is not a time for adulation of a new star manager but a potential sign of a dangerous extreme. Things that cannot go on forever won’t go on forever.

There are times when performance alone can be misleading. For example, an investment fund could deliver what look to be abnormally strong results, but this might be a recovery from a tumultuous prior period. This doesn’t mean there is no risk, but it is a different type of situation. Utilising valuations in combination with past performance is the best signal for unjustifiable extremes.

Valuations can be considered in a multitude of ways but the most effective is to observe the relative valuation of a strategy or market segment through time – how expensive does it look compared to its benchmark through history? The more richly priced, the more uncomfortable we should be.

Historically strong relative performance and elevated valuations are unlikely to be sustainable and create a perilous situation where reversion or normalisation can lead to severe losses. The more extreme these measures become, the greater the risk of bad outcomes – both in terms of magnitude and likelihood.

The added problem for investors is that as returns and valuations soar, the pressure to invest will intensify. A lack of exposure to the in-vogue area will lead to painful underperformance, which will become increasingly pronounced as the trends continue. Everyone will be asking why we are not participating.

The strength of returns won’t be treated by most as a problem or a threat, but a validation of the skill of active managers in the sweet spot or proof of some new paradigm.  The more extreme the situation, the more persuasive it becomes.

If we do invest heavily into a strategy exhibiting extreme performance and valuations, we will inevitably find ourselves in the perverse situation where we have made a bad decision with the odds stacked against us, but where everyone will be congratulating us for making it. Prices become extreme for a reason – most people will be believers, and we will be viewed as having made a smart call.

It will also make us feel better. Buying in at extremes will come as a relief as we will no longer have to discuss why we’re underperforming or don’t hold enough of the fashionable areas or funds.

What happens after we invest in a strategy exhibiting extreme valuations and performance?

Well, they will continue to work for a time.  We won’t be so unlucky as to call the peak. Prevailing trends might continue to run for months and years. There will probably be sufficient time for us to take a victory lap for our decision, but the likelihood is high that at some point there will be a painful reckoning.

We cannot predict when extremes will correct. They will go on for longer than we ever expect and reach levels, which we thought were unobtainable. It is not a viable investment approach to simply sit on the sidelines and complain about the unfairness of it all.  We should, however, exhibit great caution in the decisions we make when valuations are rich and performance is remarkably strong, as this is the time where we are most vulnerable to costly mistakes that might take years or decades to recover.

This type of post is easy to write after there has been a reversal and some prior extremes have been extinguished (or at least dampened a little). Extremes are easy to spot and bemoan after the event. Yet this is about the general, not the specific. Any investment approach can be vulnerable to extremes. So how should investors deal with them?

During the excitement of extremes everyone will obsess over the inside view and be desperate to justify the returns and valuations of the current situation (this time it’s different). We should ignore this and instead focus on the outside view – what are the lessons from history about returns following similar excesses? 

When we reach extreme heights, it probably won’t matter how skillful a fund manager is, how good our research might be or how persuasive the narrative is; this will all be overwhelmed by an erratic but inescapable gravitational pull.  

If there is a sign of an extreme, we should be asking – what is the base rate for success of investing in funds or strategies with valuations and performance at these levels? How often has investing at such a time worked out well in the long-run?

The force and salience of extremes means that they can easily dominate our behaviour. The risk of investing too much, in the wrong area, at the wrong time is never greater.

Beware of extreme decision making.

* I have focused here on the risks of making pro-cyclical decisions when valuations are historically stretched and performance has been remarkably strong. The reverse of this is that there must be opportunities in being counter-cyclical at negative extremes – this is true but difficult and dangerous. It is easier to discuss what not to do, than what to do!