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I RECENTLY HAD the opportunity to attend a panel discussion that included the prominent investment manager Seth Klarman.
Not familiar with Klarman? The simplistic version of his biography has him as a hedge fund billionaire. While that’s true, it doesn’t do him justice. Klarman is more like a cult hero, at least in the investment world. Some call him the “Oracle of Boston.”
Google his name, and you’ll see him described as “the next Warren Buffett.” Search YouTube, and you’ll find a grainy, 10-year-old interview with thousands of views. And if you look up Klarman on Amazon, you’ll find used copies of his nearly 30-year-old, out-of-print book selling for $1,000 or more. In short, Klarman is full of wisdom and commonsense advice that, I think, could benefit any investor. Here are four observations he shared:
1. When building a portfolio, you have to “pick your poison.”
In today’s world, with the availability of index funds, it’s not difficult to build a portfolio. The question is, what kind of portfolio do you want to build? Or, to put it another way, what are you trying to accomplish? Here’s how Klarman summed it up: “Do you want to trail the market when it’s going up or when it’s going down?”
In other words, you can structure your portfolio to be more aggressive than the overall stock market. That will help you when the market is going up, but hurt you in down markets. Alternatively, you can structure things to be more conservative than the market, in which case you’ll trail in up markets but lose less when the market is going down. But you can’t have it both ways.
While this seems like commonsense, Klarman is making an important point: To a great extent, investment returns are within our control. Many people—myself included—worry about the stock market. Klarman’s point: It doesn’t need to be that way. If you don’t want to lose sleep worrying about the market, you don’t have to. It’s all about the asset allocation choices you make. This is good advice, especially when the market is still near all-time highs. If you’re feeling any amount of angst about a potential market drop, that tells you it’s probably time to revisit your asset allocation.
2. When it comes to investments, “there’s no such thing as a perfect 10.”
In other words, no investment is ever going to be perfect, and we shouldn’t expect it to be. In traditional finance textbooks, investment decisions are presented as a tradeoff between risk and return. If you want more return, you have to take more risk. But if you want less risk, you have to be satisfied with lower returns.
Klarman views this traditional risk-return framework as overly simplistic. (He also views it as wrong, but that’s a topic for another day.) In evaluating investments, investors should think things through much more carefully. In addition to risk and return, consider an investment’s fees, complexity, liquidity, tax treatment and the overall level of certainty or uncertainty.
3. Be willing to pay more when warranted.
In making this statement, Klarman was referring to the management fee embedded in an investment fund. His view: It’s worth paying more if it you’re getting extra value. Most investors are sensitive to fees and taxes—and they should be—but Klarman’s comment is a good reminder not to take this too far.
Similarly, if you’re suffering with an overpriced, underperforming fund, should you hang on forever just because you would have to pay some taxes if you sold? Klarman’s view: Of course not. Don’t be afraid to incur a cost if you think it will pay off in the long run.
4. “Don’t fall in love with an investment.”
This statement is a corollary to Klarman’s “pick your poison” and “perfect 10” ideas. Just as there’s no perfect investment on the day you buy it, there is no investment that you should expect to remain perfect for all time. I see this as particularly applicable to thinking about index funds—an investment that appears awfully close to perfect right now.
Like many people, I believe that index funds are the best way to invest—and there’s plenty of supporting data. But we should never be too comfortable. Right now, I believe indexing works exceptionally well. But I also accept that it may not work forever. Markets are dynamic. Indexing might begin to work less well or other forms of investing might begin to work better. Klarman’s advice: Anything can happen, so be careful. When it comes to your investments, you don’t want to be blinded by love.
Adam M. Grossman’s previous articles include When in Doubt, Rolling the Dice and Get a Life. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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“In making this statement, Klarman was referring to the management fee embedded in an investment fund. His view: It’s worth paying more if it you’re getting extra value…a good reminder not to take this too far. ”
Feels a little like asking a barber if you need a haircut. Study after study shows that index funds outperform the vast majority of actively managed funds, and even actively managed funds that beat an index have a hard time doing it for an extended period of time. Add to that the risk that if you find a fund that outperforms, the manager may leave at any time, and the capital gains tax issues with actively traded funds, and I don’t see a case for anyone to step outside of indexes.
His other points are all ones to consider, but I’m skeptical of this one.