High yield credit spreads are tight. At the time of writing, the US index trades at a spread of 279 over Treasuries. This is not the tightest on record but the reward for taking additional credit risk is historically slim. Taking the view that spreads are rich is easy; however, knowing what to do about it is much more of a conundrum.

Despite high yield valuations looking optically expensive there are plenty of reasons why investors might still be comfortable holding. Let’s consider some of these arguments:

Credit spreads are ‘always’ tight: Spreads are not normally distributed – they spend a lot of the time appearing rich until the occasional bout of severe stress sees them widen substantially. In that sense tight spreads are not a useful signal. (It can be helpful to think of owning high yield credit as holding a government bond and selling an equity put option – we can happily collect the premium until things turn ugly).

Credit spread levels are a terrible timing tool: This is undoubtedly true – the level of spreads now doesn’t tell us a great deal about where they might be in 6 /12 months’ time. (I would caveat this by saying that everything is a terrible market timing tool, except maybe momentum).

Credit quality has increased: This is talked about a lot – lower spreads are justified because the quality of the underlying companies is better. What this really means is that we think that default rates and / or losses given default are lower now than has historically been the case. Is this true? Perhaps. Although at a 279 spread level, even with lower through cycle defaults and losses, the premium available is hardly plentiful.

Being underweight high yield is a ‘pain trade’: Despite tight spread levels, all in yields appear pretty attractive in this environment – sitting at about 6.5%.  Selling or moving underweight an asset with that level of carry can be a painful decision. Imagine if we replace high yield with investment grade or sovereign bonds – we are immediately short carry and are also investing in assets with a lower long-term prospective return than the one we are relinquishing. This is less of an issue for investors focused on delivering a total or absolute return, but for those where benchmark relative performance matters, being underweight high yield (much like being underweight equity) can prove very uncomfortable even when valuations are expensive.

High yield is a structurally attractive asset class: From a risk and return perspective, high yield bonds have compelling long-term characteristics – contractual returns, observable yields, pull to par, a lower volatility than equities and some duration protection. Why sell?

Corporates are more attractive than governments: This idea is something I hear increasingly, but one which I find somewhat puzzling. The central thesis is that because of the poor state of government finances in the US (and elsewhere), with high indebtedness and persistently large deficits, corporate balance sheets are more robust than most sovereigns’. This seems to ignore the fact that corporate and government balance sheets are not directly comparable, particularly if the government in question controls its own currency. The US can print the currency in which it issues debt meaning that it ‘cannot’ default unless it actively chooses to (I include debt ceilings in this definition). No corporate has that ability.

It is fair to argue that a ‘default’ in this situation comes in the form of inflation rather than a nominal failure to pay. While this is true – it seems a stretch to believe that US government bonds face an inflation risk that is not at least shared by corporates issuing debt in the same currency.

One caveat to my view here is that the current US administration does probably imbue some new form of ‘credit risk’ in US treasuries, but one that is incredibly hard to define or price in any reasonable sense.

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I haven’t written anything about the credit cycle conditions, as while they may be meaningful for spreads levels, I do not consider them to be knowable in a way that might aid investment decision making.

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Credit spreads are unequivocally tight, but there are a range of reasons as to why that might be palatable.

What could investors do?

Do nothing: This is a perfectly sensible option. High yield bonds have solid through cycle return characteristics and attempting to time them is a fool’s errand. Yes, high yield spreads will spike substantially at some unknowable point in the future, but that is simply something to weather. Furthermore, it is not just about getting out but knowing when to get back in.

For those in this camp, an interesting thought experiment is to ask what we would do if high yield spread levels dipped below a conservative estimate of default rates and expected losses? Or, in other words, is there any level of spread tightness that would compel us to act? 

Reduce exposure and increase credit quality: We can take the view that the additional return for bearing the increased risk of drawdowns and losses is not currently attractive enough, and therefore replace exposure with investment grade credit or sovereign bonds. From a pure valuation perspective this makes sense, but we need to be willing to bear the loss of carry in the near term and the long-term reduction in expected returns. (And, as above, know when to get back in).

Find a replacement asset with similar risk levels: We don’t necessarily need to replace high yield with lower risk assets, we can instead find assets that have broadly similar characteristics to high yield but without such stretched valuations. The problem is that most assets with spread are trading tight and / or bring a whole host of new risks that we must get comfortable with (see: private credit).

Use more active strategies: High yield has always been a go to asset class for active investors due to the perceived limitations of passive replication; while this argument has almost certainly weakened through time, an environment of tight spreads and low dispersion may strengthen it once again. Perhaps it is a ‘credit pickers’ market!’

Create a mix of assets to replace high yield: High yield bonds are akin to sovereign debt exposure with some credit risk on top, so it is possible we could replicate that structure by combining assets to create something with similar risk characteristics but better return prospects. An obvious example might be government bonds plus exposure to some undervalued equity markets. This sounds easy but is complicated to get right, plus it is probably amplifying the risks we already hold in our portfolios.

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There is no right answer to the question of narrow high yield spreads. Our own approach will come down to a multitude of factors including our objectives, philosophy and behavioural tolerance for underperformance.

Credit spreads being tight seems obvious, what we should do about it depends on the type of investor we are.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

It seems a fair bet that in a few years’ time we will come to see the two most dangerous words in investing as “democratisation” and “innovation”. Although one might feel like something of a luddite when criticising progress, it is difficult to escape the notion that too many ‘solutions’ in investing are designed to solve the problems faced by the industry, rather than the clients it serves.

New markets, new instruments, new platforms and new structures. It is wonderful to see such a bewildering array of choice available to all. Who doesn’t want to trade single stock options at three o’clock in the morning?

The idea that providing everyone access to everything will provide clear client benefits is a dubious conceit. In most cases all it is doing is creating greater confusion, temptation and cost, while making it increasingly difficult for investors to manage their behaviour.

It is frustrating that minimal thought seems to go into answering the question: how is this development likely to impact client outcomes once we account for the behavioural impact?

There is a seemingly accepted view that opening access to ‘institutional’ assets and instruments previously unavailable to the retail market an undoubted positive. As if most private investors are being shut out from exclusive areas of the market that could transform their fortunes. This exact argument was made about hedge funds years ago, and I am not sure that it worked out too well.

For an industry perspective there are certain things that are critical from a revenue perspective – activity, complexity and differentiation. Unfortunately, these things are all too often a drag on client returns – not many investors who trade a lot, own complex products and struggle to deal with too much choice ever come out well from it.  

There is certainly nothing wrong with innovation, but we must accept that there can be an acute friction between what might be good for industry outcomes and what might be good for client outcomes.

Of course, it is possible to have industry developments that are beneficial for both clients and companies, but the more something egregiously benefits the seller, the more scrutiny we should place on the question – which client problem is this solving?

When shiny new things are brought to market (particularly the retail market) far too little effort is given to making the case as to why clients will benefit. In a world of rapid technological change and declining industry margins, investors will need to be on guard that what is presented as progress, isn’t actually likely to make them worse off.

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

As an investment theme AI has it all: the potential for transformational societal and economic change, huge capital investment and the prospect of dramatic corporate winners and losers. It would be hard to design a better setup for investors to lose a lot of money. 

I have no confident view on quite how profound the continuing developments in AI will be for our lives – but then I don’t think anybody really can. The problem is that many investors will be tempted to behave as if they do. 

All investment themes are dangerous, but a narrative as powerful as the one that currently surrounds AI requires a particular level of caution. When investors anticipate (or worry about) extreme change we find it hard to escape the feeling that our portfolios, and even our entire investment approach, needs a rethink. 

If there are to be winners and losers, then surely we must act to best exploit the opportunities and mitigate the risks? This notion sounds eminently sensible, but really isn’t. 

When we adapt our investment strategy in reaction to potentially dramatic thematic market shifts – such as AI – what we really mean is that we want to be more concentrated in our portfolio. Concentrated by idea, country, sector, stock – focused on all things seemingly related to the prevailing narrative.

Becoming more concentrated in our investment approach is simply a way of expressing that we are increasingly confident about the future. The more conviction we have in our predictions, the less diversified we need to be.

Unfortunately, taking a more concentrated approach at a time of (possibly) seismic shifts is precisely the wrong thing to be doing.

If AI is to lead to genuinely consequential change our preference should be to be more diversified not less.  Nobody can say with any confidence how it will play out, so why would our portfolio activity suggest that we can?

When investors talk about AI beneficiaries and focusing their portfolios on such areas, it is worth considering the critical questions that need to be considered:

• What will be the pace and scale of development in AI technology from here?
• What will be the economic and societal impact?
• How will it impact corporate profitability across sectors?
• To what extent are AI developments already reflected in stock prices?

These questions are just the start of what is a staggeringly complex topic. We should be ensuring that our portfolios reflect the sheer level of uncertainty that exists around AI, not make investment decisions that imply that the outcomes are self-evident.

There are, of course, a range of AI-associated stocks that have already benefitted grandly from the theme’s emergence, but whether these are anything more than first order momentum trades is fiendishly difficult to decipher. 

The temptation to adopt an increasingly concentrated investment strategy in order to best capture the impact of AI exposes us to two potentially disastrous risks. First is that the consequences of AI are less significant than anticipated and ‘AI related’ stocks are materially overvalued. Second is that AI is as transformative as many anticipate, but the companies that benefit are very different to current market expectations. 

It is always important to remember that being right about some economic or technological development does not mean that we will make money from it. The internet did change the world, and China did rise to become a global economic superpower.  Knowing both of these things in advance would not have been sufficient to deliver good investment performance. In fact, knowing these things in advance would probably have increased the risk of very poor returns.

Despite constant lessons from history of the dangers of making concentrated bets on seemingly inevitable themes, the lure of repeating such mistakes will prove irresistible to many. The combination of strong performance, and compelling stories will draw us in. 

There is, however, no need to have an ‘in or out’ view on AI. Being diversified allows us to benefit from holding the areas of the market that benefit most significantly from the progress of AI, while providing some protection if its impact is underwhelming relative to expectations, or it has economic or corporate impacts that we did not foresee.

The most powerful investment themes can often make us feel as if things are becoming more certain just as they are becoming more unpredictable and risky. Our best guard against the risks that might stem from unknowable change is to remain humble and diversify. The more AI hype grips markets, however, the more likely we are to do just the opposite.

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

Perhaps the defining feature of modern corporate life is the meeting. Meetings have come to dominate how companies (and all types of groups) function. While frustrations are consistently and fruitlessly aired about what a time sink they can be, there is a bigger problem with pervasive meeting culture – it changes the way we think, and therefore the types of decisions that we make.

Let’s imagine a typical set-up for an important meeting in an organisation, one where a decision is to be made. Papers have been produced, but they are long and everybody in the meeting has been too busy in other meetings to read them. 

This situation means that the attendees are reacting to what they hear in the moment. There has been no time for slow, deliberative thought, instead everyone is thinking instinctively and that is a very different process.   

We can think of this distinction between thinking styles in terms of Daniel Kahneman’s system one and system two framing. System one is automatic, subconscious and immediate, whereas System two is slow, conscious and considered.

System one thinking is incredibly useful and effective in many situations, but typically not fantastic for most of the long-term choices that are made in business, investing or politics.

Without time to think slowly and intentionally about issues, we will shortcut to quick system one reactions which are driven by factors that can often be shallow and even entirely irrelevant. These might be our feelings about the person talking, whatever our primary incentives are, recent discussions we might have had on a similar topic, how we might want to appear to the group and whether we have had lunch yet.

Again, system one is not necessarily bad thinking. I am an advocate of using heuristics to solve complex problems, but it is best to choose a heuristic as a smart option after considered thinking, rather than because we haven’t had the chance to assess something carefully.  

Even when the process to reach a decision takes time and spans multiple meetings, it doesn’t mean that there has been space for measured thinking. It is more likely just a chain of meetings where instinctive, system one thinking has been the guiding and dominant influence.

The underlying issue is that deliberate thinking just doesn’t hold that much value in the modern corporate world. Meetings are tangible and measurable. If a decision has been made after eight meetings (all with minutes and actions) – it is considered robust, certainly more robust than someone spending the time to think long and hard about a subject.

There is nothing wrong with meetings. They can be an excellent way to debate and discuss ideas, and to benefit from diversity of experience, expertise and approach. They can also be a perfectly reasonable forum for making decisions provided careful consideration has been given to group dynamics and sufficient space is afforded for thinking deeply outside of them.

Increasingly, however, we exist in a world that assumes that if someone is not in a meeting, then they are not working. That is an extraordinarily strange perspective to take for any job where focused, considered thinking is important.

Meetings are increasingly crowding out the type of thinking that leads to better long-term decisions. Maybe we need a meeting to discuss what to do about it.

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

The rise of private markets has been supported by the perceived existence of an ‘illiquidity premium’ – or the extra return provided to investors as compensation for holding assets that are difficult to trade. Although the concept has seemingly become commonly accepted, there is no clear definition of precisely what it is or how it comes about. At times it can feel as if it is simply some magic dust sprinkled on private assets to boost performance. Given the growing importance of this area, it feels worthwhile being a little more specific – so just what is the illiquidity premium?

Let’s return to the basic definition – investors demand a higher return for an asset that is hard to buy and sell. This makes sense – if I am going to lock my money away, I want some reward for the inflexibility. *

While this idea may seem reasonable, investors demanding an additional return does not make it so, and the above framing is still a little vague.  A better one might be:

The illiquidity premium is the additional return for holding an illiquid asset relative to a more liquid asset, other things being equal.

The ‘other things being equal’ part is important here. To isolate the illiquidity premium we need to say that if we had two identical assets but one was illiquid (private) and the other liquid (public), we should anticipate a higher return from the private asset.

The next question is – how do we get a higher return from the illiquid asset? It must be because it is cheaper than its liquid counterpart. If there is no difference in fundamentals, then there has to be a valuation discount to enhance my prospective return. How else could it come about?

There are, of course, other ways that additional performance may be garnered from illiquid, private market exposure – the opportunity set might be wider, there may be a benefit to private equity firms having control of a business and a private market manager may have a greater ability to add ‘alpha’. While all these elements may be valid, they are simply potential features of private market investing not an illiquidity premium.

If we define the illiquidity premium as being derived from a valuation gap between private and public assets, it tells us two things:

1) The premium should be in some way observable: Although we will never be able to observe the valuation of a private asset in a parallel universe where it is publicly listed , it should be possible to compare the valuations of similar assets in the public and private sphere, and ascertain whether there is a discount. (This is probably easier to analyse in private credit than private equity). If private assets of similar quality are priced more expensively – where is the illiquidity premium coming from?

2) The premium will be time varying: If the illiquidity premium is about the valuation gap between public and private assets then it will not be static, but will wax and wane based upon the prevailing environment. If private assets are in high demand, the illiquidity premium will be (at best) lower. We should not treat it as a permanent, structural advantage.

One of the primary drivers for the burgeoning demand for private assets has been the long-run return advantage relative to public markets (let’s leave the validity of this argument for another day). Part of this apparent edge is widely believed to have come from the illiquidity premium. We need to be careful, however, that what is being identified as an inevitable premium is not simply a significant valuation re-rating in private assets from a period where demand was far lower and access much more difficult.

There is a not insignificant risk that the clamour to capture an illiquidity premium acts to extinguish it.

The broader use of private assets will inevitably be a critical investment theme over the coming years. Given how consequential this area may be for investors, if we are to use coverall terms like ‘the illiquidity premium’ we need to be clear about precisely what we mean.

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* From a behavioural perspective, there is a strong case that illiquidity improves ‘behaviour-adjusted’ returns by forcing us to be long-term investors and preventing us from following our worse impulses. Perhaps this is the real illiquidity premium.

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

When you disagree with someone about an investing issue, is it because you have distinct interpretations of a specific topic or because your starting beliefs and aims are entirely incompatible? It is almost certainly the latter. Most financial market debate and discussion amounts to people shouting at each other in different languages.

We can think about our investing language as being founded upon two things – our investment principles and our objectives. What we believe about how investing works and what we are trying to achieve. These two aspects shape how we think about a given subject and the position we will take on it.

Let’s take two investors – a short-term trader looking to realise day to day profits, and a fundamentally driven, long-term stock picker – they have significant disagreement on the impact of US tariff policy. Are they likely to have a productive conversation where they exchange views and potentially learn from each other’s perspective? Absolutely not, because they are not speaking the same language. It is doubtful that they will even understand what the other person is saying. 

What might sound like a disagreement between investors is often just a proxy war that is really about conflicting investment beliefs. A conflict that is unlikely to be resolved.  

One of the (many) unusual features of the investment world is that it brings people together who are engaged in entirely distinct endeavours and assumes that they are (pretty much) doing the same thing. Much of the heat and noise that comes from financial markets is caused by these fractious interactions.  

This dynamic is a critical one for individual investors to understand, otherwise we are at risk of having our head turned by every opinion that we hear. When someone voices an investment perspective, we should always ask ourselves what it is that this person believes and what are they trying to achieve? If the answer is wildly misaligned with our own principles and goals then we should treat it with caution.

That doesn’t mean that we should never challenge our own investment beliefs, but there is a big difference between taking the time to deliberately reflect on the merits of our own approach, and listening to the day to day cacophony of individuals whose activities – under the surface – bear very little relation to our own.

These language problems are also a major issue for investment teams. Although diversity within teams across expertise, experience, temperament and background can be highly beneficial, this does not stretch to investment beliefs and objectives. Teams with conflicting incentives and principles are inevitably beset by constant friction, frustration and disharmony.

If we are trying to build a successful football team, we want individuals with unique (complementary) skills, but shared goals and consistent, overarching principles about how to be effective. If, instead, we have a group of talented people all striving to achieve different things in different ways, the team is almost inevitably destined for failure, no matter how strong the component parts.

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Having shared principles and goals does not mean just listening only to people who agree with us – individuals can share foundational beliefs and disagree a lot. This is an essential feature of a healthy decision-making dynamic. We must, however, be on guard against being overly distracted by the views and actions of people who exist in the same universe as us but are speaking an entirely different language.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

There are three types of investors: momentum, valuation and noise. Momentum investors care about price movements, valuation investors care about fundamentals and noise investors care about a random assortment of stuff. Many of us are noise investors, even though we won’t realise it.

Of course, investment approaches do not all neatly fit into such discrete categories. Most are a combination of momentum and valuation, and every investor lets some noise into their world. The critical question is – how much is market noise impacting our behaviour?

The more influential noise is, the more inconsistent and unpredictable our decisions will be. When observing the choices made by a noisy investor it will be difficult to discern any recognisable pattern.

This is not a path to good investment outcomes.

Why is noise such an overwhelming issue for most investors? There are two factors at play. First is the sheer amount of ‘information’ available to us, which means that we face a constant struggle to understand what is important and what is immaterial. Second is our reaction to this torrent of stimulus. If we don’t define what is consequential, we will act like everything is. Is that GDP print important? What about that conflict in the Middle East? What about that technological change?

Noisy information leads to noisy behaviour.

The key differentiator between a noise-influenced investor and a momentum or valuation-led investor is that the latter group will have a far more clearly defined idea of what information matters and how they are likely to react to it.

That doesn’t mean that valuation and momentum approaches are inherently good, it is just that they are less noisy. An investor with a process that involves buying the best performing mutual funds of the past three years is momentum-focused but not noisy. It is still a very bad idea, just not one beholden to market noise.

Noise-driven investment behaviour is incredibly destructive, but it is almost certainly how most of us act. Why is it so hard for investors to avoid being captured by noise?

1) We are surrounded by it: It is close to impossible to switch off from the slew of financial market news and information. It is all-encompassing and overwhelming.

2) It is heavily incentivised: While noise may be bad for us it is fantastically lucrative for many in the industry – noise means clicks, trading, turnover, spreads and commissions.

3) Everything feels important in the moment: We tend to judge the importance of something by how available or prominent it is. Even if an issue has no real relevance for our objectives or over our time horizon, it will feel very much like it does.

4) Other people think it is important: It is incredibly hard to ignore subjects that everyone else is treating with the utmost significance. We will either look naïve or negligent, perhaps both.

5) Noise is exciting: Financial market noise is fascinating and, at times, exciting – engaging with it is stimulating and enjoyable. The trick is to be interested in it, without letting impact our investment decision making.

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It is vital to acknowledge that our default state is to succumb to the allure of financial market noise. Once we have done this, is there anything we can do about it?

The starting point is to define the things that we care about. What matters most given our investment approach and objectives? Anything that is not in this list we can categorise as unhelpful noise.

(There is no objective list of what constitutes ‘noise’. One investor’s noise will be another’s essential information – it depends on what we believe and what we are trying to achieve).

We also need to take an active approach to blocking out market noise. All investors should be thinking carefully about how we can disregard things that are not likely to be influential, even when we know that at times they will feel crucial.

Being complacent about the amount of superfluous noise in financial markets is not a viable option, if we don’t find a way to guard against it, it will quickly come to define our investment approach.

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

One of my favourite Daniel Kahneman quotes is: “Nothing in life is as important as you think it is while you are thinking about it”.  It beautifully encapsulates our tendency to significantly exaggerate the importance of whatever is on our minds at any given moment. This is an issue that is particularly troublesome for investors. There is just one problem – the quote gets it wrong.

I am asleep in my bedroom one night when I am awoken by the sound of an alarm going off. I then see smoke creeping underneath the door. I quickly realise that there is a fire in the house and need to work out what to do next.

Sometimes, just sometimes, events might be as crucial as we think they are when we are thinking about them.  

We have a tendency to overstate the significance of whatever has our attention because – on rare occasions – it will be profoundly consequential.

From an evolutionary perspective this makes perfect sense. Worrying a lot about things that might be a threat to our survival is a highly effective adaption. We can’t reproduce if we cannot survive.

Kahneman’s quote might instead have been: “The vast majority of things in life are not as important as we think they are while we are thinking about them”. Not as catchy, I grant you.

If nothing was ever as important, then we wouldn’t act as if a lot of things were.   

This gets at a core issue of why investing is so difficult. Many of the behaviours that have made humans such a successful species, also make it difficult to be good, long-term investors.

Our overreaction to short-term, visible, in-the-moment risks, is just one of them. There are plenty of others – including herding, aversion to losses, and our susceptibility to stories.

Discussion around investor behaviour often seems focused on creating a long list of detrimental biases that humans suffer from as if we are just a poorly wired species, ill-equipped to make good decisions. This is not the case – it is simply that certain ingrained behaviours that are incredibly effective in some contexts, can be detrimental in others.

That investment issue that you are currently worrying about is very unlikely to be as vital as you believe it to be, but it is very human to act as if it is.

The key to good investment decision making is to understand what makes us human, and then to adapt those elements which might also make us bad investors.  

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Other things equal, a higher valuation for an asset should make it less attractive. Returns are being pulled from the future to the present. So why does the reverse often seem to be true? Why do investors often behave as if their return expectations are increasing alongside valuations? *  

It is easy to characterise this phenomenon as simply characteristic performance chasing behaviour. Many investors don’t really care about the valuation of an asset; they are focused on recent returns – either attempting to capture momentum or crudely extrapolating the past into the future. Yet while these types of investors are not valuation-driven, changes in valuation are exerting a significant influence on their decisions.

Changes in the valuation of an asset can create self-reinforcing valuation loops – where a rising (falling) valuation directly leads to an increase (decrease) in investor confidence. It looks something like this:

A rising valuation boosts performance, stories are created to justify the strength of performance and this in turn increases investor appetite for the asset thereby increasing the valuation. And so it can continue.

Let’s take the example of US equities over the past decade. A substantial portion of its outperformance has been due to this market becoming more expensive (alongside good fundamental growth). This rise in valuation inevitably played a role in the emergence and persistence of the ‘US exceptionalism’ argument. As the market became more expensive it became more exceptional.

Ultimately, investors care more about performance and less about what is causing it.  

But there must be a limit to these valuation loops, surely the value of an asset can’t keep going in one direction? While there usually is a limit, the strength of it depends on how much of a valuation anchor an asset class possesses.

A valuation anchor is simply some fundamental features of an asset that exert a form of gravitational pull on how cheap or expensive it can become. There are three key factors that dictate how much of a valuation anchor might be apparent:

– Does it have cash flows or any other fundamental means of valuation?

– Are cash flows contractual / constrained?

– Is there a maturity point or is it perpetual?

For example, a ‘AA’ rated corporate bond with two years to maturity has a very strong valuation anchor. Its cash flows are contractual, and it will mature in twenty-four months. There is only so far its valuation is likely to move in that period.  

Conversely, an asset like gold has no anchor and is perfect for sustained valuation loops. It doesn’t have cash flows and is a perpetual instrument. Its price is its value, and its value is perceived to increase the more it rises. Does gold become more attractive if it falls 50%? Probably not for the vast majority of investors.

I think there are three broad groupings that frame an asset’s susceptibility to self-reinforcing valuation loops:

Strong valuation anchor: Most fixed income securities qualify for this group as they have contractual returns and a fixed maturity. Although when discussing quasi-perpetual assets like a ten-year US treasury the anchor is far weaker.

Weak valuation anchor: Equities reside here. Although they do have cash flows and a ‘fair value’ can be estimated, they are perpetual and have no (hard) limits on the theoretical future cash flows that can be generated. There is not much to prevent fantastical stories being used to justify either very high or low valuations. There are, however, certain extremes where valuations start to bite – US equities might trade at 30x earnings and the rest of the world at 15x, but it is hard to imagine the US reaching 100x.

Many commodities would probably fit into this category also, not because of cash flows but because of competitive market dynamics.  

No valuation anchor:  Gold and crypto are the obvious examples and what I would call belief assets.** They are perpetual with no cash flow and no reasonable means of valuation. It is not that stories are used to justify a rising price / valuation, it is that the price is the story. This creates the potential for prolonged trends where a rising price serves to increase the validity of the asset, and it does so without any obvious anchor to a valuation level. This can be extremely attractive, but it is critical to remember that this exact phenomenon can also operate in reverse.

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Antti Ilmanen of AQR recently wrote a piece suggesting that equity investors extrapolate while bond investors look for mean reversion. I think one of the reasons for this contrasting behaviour is the strength of the valuation anchor for each asset class. The weaker it is, the greater the likelihood of investors acting as if higher valuations are making an asset class more attractive (and vice-versa). There is nothing to get in the way of the stories.

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* By the valuation becoming more expensive, I mean paying more for the same expected cash flows, not a situation where a higher valuation is due to improving fundamentals.

** This doesn’t mean you should not own these assets – some may have useful characteristics (gold has Lindy properties) – but they are inevitably high risk and come with a wide range of outcomes.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Is Warren Buffett attempting to ‘time the market’ by holding over $300bn in cash?

In a word, no.

I have written regularly about the folly of attempting to skilfully predict and time the movements of financial markets. It is an incredibly difficult, probably impossible, activity to perform consistently well and most investors should avoid it. One challenge I often receive when expressing this view, however, is that as all active positions require us to take on some form of market risk, most of us are market timers – whether we like it or not. We either engage in market timing or do nothing.

I don’t buy this argument – I think it falls into the trap of confusing process and outcome.  

Market timing is a very distinct investment activity that has two characteristic features – it is a decision that specifies both why something will happen and when it will occur.

It includes both the identification of a catalyst (or catalysts) and a moment. Let’s take a simple example:

‘I believe that US equities will outperform over the next 3 months as tariff concerns abate.’

This is clearly an attempt at market timing. We are predicting the cause of a price movement in an asset and when it will occur.

Let’s contrast this with another scenario. A value-orientated equity fund manager is holding 20% in cash because, after applying their investment process, they are unable to identify enough attractive opportunities.

This is not market timing. The fund manager is saying nothing about what will cause prices to move nor when that may happen. It is perfectly reasonable to be uncomfortable with an equity fund holding a high cash weighting and the risks that stem from it (outcome), but it doesn’t mean that the decision that led to it is an effort to time the market (process).

Although the fund manager is not seeking to time the market, they are exposing themselves to the same risks as if they were. We can have two identical investment positions where one is the result of market timing and the other is not – investors can carry equivalent risks but for entirely different reasons.

Take two multi-asset portfolios:

– Investor A is 5% underweight US equities because they believe the next jobs report will cause an equity market sell-off.

– Investor B is 5% underweight US equities because they believe that, on the balance of probabilities, rich valuations are likely to lead to lower future returns.

The critical point is that intent matters. We don’t simply need to be comfortable with the risk being taken, we need to be comfortable with the reason that the risk is being taken. Investor A is attempting to time the market by forecasting its movements; Investor B is taking the same position but is agnostic on when and why something might occur.

Just because something isn’t market timing (as I would define it), does not mean that it is a good idea. We might be uncomfortable being subject to significant market risk, or we might believe that a process being adopted is weak or unconvincing. There are lots of ways to make bad investment decisions – market timing is just one of them.   

All active investment views are subject to the chaotic fluctuations of financial markets, but only in some are we explicitly trying to predict them. Given how hard it is to get right, it is important to know market timing when we see it.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).