In his latest 2021 Year End Letter, Seth Klarman discusses why investors must maintain their bearings when others are not. Here’s an excerpt from the letter:
Of course, consistent market gains are intoxicating; if a bull market could have a brain scan, we’d see all quadrants brightly lit up. With animal spirits perpetually aroused, both investors and insiders are also loath to sell, because they fear missing out on further upside.
One paradox is that with very low interest rates and an historically elevated market multiple, the return expectations of investors seem to be going up, ignoring the mathematical tether that the higher the multiple you pay for stocks and the lower the bond yields you lock in, the lower your future returns are certain to be.
It is said that bull markets always climb a “wall of worry” as the cautious are left behind while the intrepid get ahead and the reckless lead the pack. But the opposite may also be true—bear markets must inevitably descend a mountain of overconfidence and hubris.
With the risks to investors increasingly masked by this 12-year bull market, we are resolute in maintaining our balanced approach by finding ways to achieve good returns while limiting and protecting against downside risk.
It is especially important for investors to maintain their bearings in periods when others do not. To do so in even the most challenging moments, investors must have been prepared for adversity all along. By the time you realize you were overexposed to risk, the market price of what you own may have already plummeted, and by then it’s too late to affordably arrange hedges or find mitigants.
To prepare ourselves for the possibility of a market reversal and lower business valuations, we follow our usual playbook: Avoid the incurrence of recourse leverage, limit portfolio duration by holding investments with catalysts, focus intently on the downside in the evaluation of each individual investment, and actively manage a book of hedges.
This combination of fundamental analysis conducted in fertile hunting grounds, within guardrails designed to avoid the financial distress of substantial drawdowns and the resulting psychological trauma, is intended to enhance the net worth of our clients over time. Having like-minded clients is a key element in the equation.
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