Seth Klarman: Investors Should Not Target A Desired Rate Of Return

Johnny HopkinsSeth KlarmanLeave a Comment

In his book, Margin of Safety, Seth Klarman provides some great insights into the reasons why investors should not target desired rates of return, saying:

Choosing to avoid loss is not a complete investment strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in U.S. Treasury bills or own sizable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.

Many investors mistakenly establish an investment goal of achieving a specific rate of return. Setting a goal, unfortunately, does not make that return achievable. Indeed, no matter what the goal, it may be out of reach. Stating that you want to earn, say, 15 percent a year, does not tell you a thing about how to achieve it. Investment returns are not a direct function of how long or hard you work or how much you wish to earn. A ditch digger can work an hour of overtime for extra pay, and a piece worker earns more the more he or she produces. An investor cannot decide to think harder or put in overtime in order to achieve a higher return. All an investor can do is follow a consistently disciplined and rigorous approach; over time the returns will come.

Targeting investment returns leads investors to focus on upside potential rather than on downside risk. Depending on the level of security prices, investors may have to incur considerable downside risk to have a chance of meeting predetermined return objectives. If Treasury bills yield 6 percent, more cannot be achieved from owning them. If thirty-year government bonds yield 8 percent, it is possible, for a while, to achieve a 15 percent annual return through capital appreciation resulting from a decline in interest rates. If the bonds are held to maturity, however, the return will be 8 percent. Stocks do not have the firm mathematical tether afforded by the contractual nature of the cash flows of a high-grade bond.

Stocks, for example, have no maturity date or price. Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price. Investors thus tend to predict their returns from investing in equities by predicting future stock prices.

Since stock prices do not appreciate in a predictable fashion but fluctuate unevenly over time, almost any forecast can be made and justified. It is thus possible to predict the achievement of any desired level of return simply by fiddling with one’s estimate of future share prices.

In the long run, however, stock prices are also tethered, albeit more loosely than bonds, to the performance of the underlying businesses. If the prevailing stock price is not warranted by underlying value, it will eventually fall. Those who bought in at a price that itself reflected overly optimistic assumptions will incur losses.

Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate.

Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.

Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.

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