Comfort is Rarely Rewarded; Maverick Risk and False Benchmarks
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“The loser is the trend-chasing, comfort-seeking investor. The market doesn’t reward comfort. It rewards discomfort.”
Conventional investment strategies, while affording the investor at least a temporary degree of comfort, are destined to produce mediocre results. Only by distancing themselves from the ordinary approach – as Jeremy Grantham and Seth Klarman have – can asset managers achieve superior performance and truly fulfill their fiduciary duties by acting as proper stewards of their clients’ capital.
In Rob Arnott’s November 2010 piece, The Glad Game he asks investors to consider “maverick risk” as an important driver of investment outcomes:
There’s conventional volatility in returns, which introduces a risk of poor investment returns. There’s the asset/liability mismatch, which leads to a risk that we cannot cover our future obligations. And, there’s maverick risk, in which investors choose a different path than their peers, exposing them to criticism, especially when performance suffers. All three risks are hugely important. Yet, we typically focus our analytics on the first of these, simple volatility, and our behavior on the last of these, maverick risk.
The idea of maverick risk is a compelling one. From a human behavioral standpoint, we are conditioned to think of being outside of the herd as risky. There is plenty of evolutionary logic behind this idea, considering that humans spent much of their existence as both predator and prey. There is safety in numbers.
So as much as we know the value of thinking outside the box or being contrarian, and as much as we value and revere those in society who are capable of going it alone, our lizard brains take over when it comes down to financial decisions and we seek the safety of crowds. This is true for amateurs and professionals alike and is well documented in the rapidly growing popular and academic literature on behavioral finance.
GMO takes the idea of career risk and argues that it can drive periods of over- and undervaluation. As Ben Inker, the head of asset allocation at GMO was quoted as saying in a recent Advisor Perspectives article:
“The market tends to be priced in a way that if you want to try to outperform, you have to take a risk of looking like an idiot,” Inker said. … Markets exhibit herd-like behavior, which in turn encourages momentum and other self-reinforcing behaviors, such as money flowing into whatever strategy has been doing well, Inker said. That merely ratchets up valuations within better-performing asset classes and sectors, he said, creating a self-fulfilling prophecy.
Of course, this cannot continue indefinitely. Eventually, the risk-return trade-off becomes so one-sided that prices get pushed back toward fair value. Consider this chart from GMO.
The Way the Investment World Goes Around: They Were Managing Their Careers, Not Their Clients' Risk