Day after day we are inundated with the apparent 'idiocy' of investors putting their hard earned money into Treasury bonds when they only earn 2% yields. Hour after hour, we hear why investors should buy stocks, 'get paid to wait', and bonds are in a bubble. So why is it that day after day, an entire generation appears to have found a new mantra of investing, preferring less risk to more, satisfied with less return as opposed to more. The simple answer comes down to two words - often misunderstood - risk and drawdown. While most consider the former to be some quantifiable measure of uncertainty (more is better because think of the upside potential); it is the latter that ends careers, crushes retirement hopes, and scars pysches for life - and is often ignored. As we discussed here previously [8] - must read, comparing (risky uncertain cashflow stream) equity dividend yields to (risk-free certain cashflow stream) Treasuries is like comparing apples to unicorns, but more importantly as Boomers retire en masse, this chart explains why there is a third leg to the investment decision - risk, reward, and regret; and equity drawdowns are the real 'risk'.
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Drawdown risk has kept equity investors at bay; bonds have appeal as a safety play - despite low yields as return OF capital still trumps return ON capital - even though bonds have provided both in recent years.
and some important lessons from Oaktree Capital's Howard Marks:
Question: Why do behaviour patterns and mistakes recur despite the plethora of information available now? Are we doomed to repeat our mistakes?
Howard Marks: It's extremely important to know history, but the trouble is that the big events in financial history occur only once every few generations. The latest global financial crisis began in 2008 and the one before that in 1929. That’s a gap of 79 years. So, while memory has the potential to restrain action and induce prudence by reminding us of tough periods, over time as memory fades the lessons fade as well.
In the investment environment, memory and the resultant prudence regularly do battle with greed, and greed tends to win out. Prudence is particularly dismissed when risky investments have paid off for a span of years. John Kenneth Galbraith wrote that the outstanding characteristics of financial markets are shortness of memory and ignorance of history. In hot times, the few who do remember the past are dismissed as relics of the old, lacking the ability to imagine the new. But it invariably turns out that there's nothing new in terms of investor behaviour. Mark Twain said that “history does not repeat itself but it does rhyme,” and what rhyme are the important themes.
The bottom line is that even though knowing financial history is important, requiring people to study it won’t make a big difference, because they'll ignore its lessons. There's a very strong tendency for people to believe in things which, if true, would make them rich. Demosthenes said, "For that a man wishes, he generally believes to be true" Just like in the movies, where they show a person in a dilemma to have an angel on one side and a devil on the other, in the case of investing, investors have prudence and memory on one shoulder and greed on the other. Most of the time greed wins. As long as human nature is part of the investment environment, which it always will be, we’ll experience bubbles and crashes.
Question: Is it volatility that’s made people scared of equity markets, particularly since 2000?
Howard Marks: Volatility goes in both directions but it’s declines that people dislike, not volatility. The equity markets of the last 50 years tell a long and meaningful story. Owning stocks wasn’t very popular back in the 1950s, until the brokerage houses popularised equity investing. People started buying equities and they went up, encouraging more people to buy them. This is the usual selffeeding spiral. So equities rose in nearly a straight line from 1960 to 1972. After this they had a bad decade, but then they did even better from 1982 to 1999. Overall, for 30 out of those 40 years, equities rose breathtakingly and people fell more and more in love with them. By the end of 1999 everyone had more equities than ever before and maybe too much of them. So, equity performance, equity prices, investor attitudes towards equities and equity allocations within portfolios all reached their acme in 2000, after which equity prices collapsed under their own weight. In 2000-02 we had the first three-year decline in equities since the Great Crash, and people started to fall out of love with them. This made them sell, driving prices down further and prompting even more selling. The same spiral, but now in reverse. And as investors fell out of love with equities, they fell in love with bonds.
The mantra in the last four decades of the 20th century was “growth” and the mantra in the last 12 years has been “safety and income.” And so, from 2000 to very recently, equity allocations have been going down, equity prices have been unchanged overall, equity returns have been close to zero, and we’ve seen people chase safety and income through bonds instead. But people often forget to look at the price they’re paying for the concept they’re buying into. In 2000, people pursued growth but forgot to ask themselves ‘at what price?’ And in recent years they've been pursuing safety and income while ignoring the same question. Today the price being paid for the safety and income of bonds is among the highest in history.
Chart: Goldman Sachs