Editor’s note: This article was first published in April 2014. Its figures are from 2014: Klarman aged 56, Baupost managing $27 billion, “more than $4 billion” in recent gains for clients and 40% of the portfolio in cash. The “current market” is the US bull market of early 2014, which kept rising for several more years.
Seth Klarman, 56, is the founder of Baupost Group, a fund that manages $27 billion in capital and recently reported more than $4 billion in gains for its clients. Klarman is already regarded as one of the best investors of recent times, and he has always stood out for his ability to stay rational when making investment decisions.
Right now, 40% of Klarman’s investment portfolio is in cash, which means he does not feel comfortable taking positions in the current market. He has explained as much in a letter to his clients, a letter that other funds will surely take note of. Klarman does not say the market is in a bubble, or that share prices are absurdly high and overvalued, but he is sure of one thing: these good times will come to an end.
For Klarman, this bull market is not real, because it rests largely on the Federal Reserve’s easy-money policies, and it is too good to last.
His advice to investors is to look for intelligent arguments that contradict our optimistic view. In other words, if you are bullish, look for investors who argue intelligently why we should be bearish, and vice versa. This is because of the well-known biases Daniel Kahneman talks about: as investors, we tend to look for information that reinforces our view and to reject any information that warns us about the decision we have made.
If you have decided to buy shares because you think the company is going to be “amazing”, do not look for arguments explaining why that company will be amazing. You already know those arguments. Look for arguments from people who reason intelligently about why investing in that company might not be such a good idea. Only in that way can we make truly intelligent investment decisions.
Klarman says that in the United States there is so much optimism among investors, and such a belief that we are probably halfway through the biggest bull market in history, that anyone who calls for caution and prudence is taken for an idiot.
Klarman is not telling you not to invest in the current market, simply to examine whether the bullish sentiment matches the real fundamentals.
Some day, he writes, financial markets will fall again. Some day the Fed’s monetary policy will come to an end, some day businesses will be allowed to fail, and some day investors will lose money. That day may be near or far off, but the odds that it arrives in the short to medium term are high, so we have to keep it in mind and act accordingly.
What phase of the cycle are we in now? Are we in the phase of investor enthusiasm, or have we already reached buying euphoria?
As a wise and experienced investor, Klarman acknowledges and admits that he does not know when the current buying euphoria will end, but he warns that when the market turns, he is sure of one thing: very few will be ready. Very few will be prepared, and many will once again lose large amounts of money.
Klarman’s advice is also in line with the analysis other investors are doing of current share prices, comparing them with average prices over the last 150 years, among other factors, and concluding that the risk of a sharp fall is enormous.
Of course, all these investors could be wrong and have a mistaken view; we could still be in the early stages of an incredible bull market, in which shares could keep rising much further.
Klarman closes with this thought: you need a strategy, because hope is not a strategy, and nobody benefits from ignoring the smart people on the other side of the trade.
Further reading
- It is not what you buy, it is what you pay for what you buy
- A brilliant strategy for investing if you expect the market to fall
Featured image: Maryland GovPics, CC BY 2.0, via Wikimedia Commons.
