Letter To The FT: The Journey Matters
The Financial Times recently published our (very short) response to an article by the columnist, John Authers. The article, which you can read here, addresses something we give tremendous weight to at Monmouth Capital: the fact that how a portfolio performs along the way to a particular target return is as important as the return itself.
I will go further: the ability or not to endure the path determines the end result. As the FT paraphrases, the journey matters to every investor:
Intuitively, the journey should matter less to institutions. Aside from institutions with specific funding requirements (1), they ought to be able to withstand year-to-year fluctuations far better than individual humans, since they can put in place robust governance and controls to mitigate the potential for costly, emotional reactions to market fluctuations along the way. This dispassionate approach is more difficult for individuals dealing with their own personal retirement money.
But this is not always the case. Institutions, even those with seemingly endless time horizons, can be as uncomfortable with fluctuations in market prices as ordinary individuals. Why?
My best guess is that this is because of career risk. The human beings who make decisions on behalf of the institution may not have their personal retirement money at stake but nonetheless respond as if they do. A sharp fall in value over one year may jeopardise their job, their bonus – or perhaps just their reputation. Any of these factors may prove to be enough of an incentive for the individual to go to great lengths to minimise the chances of this happening.
The performance, or more significantly, the governance, of the Californian state pension fund, CalPERS, before and during the financial crisis of 2007 to 2009 is well-documented (2). The story provides a useful case study of how personal, human-level incentives are powerful enough to overcome what might be in the institution’s best interests in the long run.
CalPERS should have benefited from the financial crisis. With an indefinite time horizon, it ought to have had the ability not only to endure short-term losses but to use the opportunity to restore its equity allocation at ever cheaper prices. Instead, scarred by losses, its managers made drastic reductions in its equity allocation as markets fell and then kept it low in the aftermath, missing out on the spectacular gains from 2009 onwards.
Our concern is with our private (human, not institutional) clients. Among other things, the CalPERS experience highlights the emptiness of a question I am sometimes asked, which is “What returns can you get?” Without consideration of time horizon, capacity for loss, requirement for risk and psychological response to losses, the question is not just meaningless but potentially dangerous – even to an institution.
The zigs and zags of the “random walk” taken by the stock market are clearly not for everyone. In our view, it cannot be overstated how important it is to find out what kind of journey clients need to meet their goals and what they can stomach. Only after establishing these important financial and psychological boundaries can we engage in the finer arts of portfolio construction and fund selection.
Some institutions have liability-matching (such as pension funds with members in drawdown) or other annual funding requirements (such as charitable endowments mandated to distribute certain sums each year) and that could explain an aversion to fluctuations in portfolio values. Clearly this aversion would not be for the emotional and psychological reasons that most often drive individual to a similar position.
See https://www.shiftto.org/investing-for-the-long-run/ for a thorough analysis of how CalPERS was governed before, during and after the financial crisis.