Insights

“Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.” – Seth Klarman

Investing, when appropriately thought of, is a long-term affair. Yet, investors are frequently too focused on the near-term outcomes. As Klarman eloquently put it, investors have become locked into a short-term, relative performance derby.

The chart below shows inflation-adjusted annualised 12-year holding period return for US equities since 1871. Over the last 150 years, US equities have generated an average annualised real return of 6.6%. The mean-reverting nature of the investment returns is clearly evident on this chart. Periods of well-above the trend returns are followed by poor returns and vice versa. When realised 12-year returns have been above the +1SD level, the subsequent 12-year returns have averaged at 3.1%.

Image Source: Data from Robert Shiller, MAEG’s calculations

Over the past twelve years, investors have earned a rather strong return. Indeed, over the 12-year holding period since March 2009, investors earned an annualised inflation-adjusted return of 14.9%. With such a strong general rise in stock prices, it’s only logical that investors will become focused on relative returns. As prices continue to rise, the myopic focus on relative returns leads to attraction towards the latest fads, a behaviour even more accentuated by passive investment vehicles. The temptation to earn large investment returns leads investors to ignore risk and be willing to accept overly optimistic projections. One can see it in the projections of the total addressable market (“TAM”) being touted by businesses that are tagged as disruptors. However, most these projections do not stand up to any rational thinking. Yet, significant capital is being allocated based on such projections.

What is ignored amidst the euphoria is that the very act of directing excessive amounts of capital to businesses thought of as the likely winners result in poor investment outcomes. For one, those over-optimistic demand projections turn out to be just that. Importantly, the supply response driven by excessive capital allocations creates oversupply. The end result, once the euphoria has subsided, usually is exposed as malinvestment.