October 1, 2013
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We are deluged with information. Richard Saul Wurman, the godfather of information architecture, calculated that there is more information in a single issue of the New York Times than the average citizen in the 17th century would have been exposed to in his or her lifetime. And that calculation doesn’t even take into account the explosion of information available through new technology. The issue is particularly acute for investors, who can access up-to-the-minute stock quotes on their iPhones, check the value of their portfolios on an iPad and choose from a multitude of television shows, magazines and newspapers to bathe in the information stream of financial markets, economics and politics.
Shortage of information isn’t the problem: shortage of insight is.
Recent events have not provided any relief from this malady. Fiscal cliffs, debt ceilings, European crises, market volatility, political dysfunction and more have competed for investors’ attention, making it increasingly difficult to glean meaning from a cacophony of headlines. This distinctly modern challenge is known as information overload, a condition in which too much information obscures what is genuinely important. Information overload can lead to the inclination to react to each and every new data release or, at the opposite extreme, to do nothing and succumb to paralysis. Clay Shirky, a thinker and writer on the role of technology in society, claims that there is no such thing as information overload — only filter failure.
So what filters should investors have in place to enable them to hear the signal through the noise and not be distracted to their own detriment?
We offer a series of related beliefs that guide our thinking about investing at the levels of asset allocation, security selection and identification of the third-party managers we engage to help manage our clients’ assets. These investment tenets are important in any environment, but they are critical in a time characterized by heightened uncertainty.
1. Risk is not volatility
One of the cornerstones of modern portfolio theory (MPT) is that risk is defined as volatility, and that the primary objective of portfolio management is to minimize that risk for a particular level of desired return. On initial consideration, this makes sense. Exaggerated volatility of market returns is certainly unappealing to most people. Yet on second thought, most investors like upside volatility – it’s the downside volatility they can do without. So we find that the fundamental assumption of MPT is imperfect at best and one we do not share. Volatility is undesirable, but the real definition of investment risk is the possibility of permanent loss of capital: losing money and not getting it back.
Indeed, for the disciplined investor, volatility is an essential contributor to investment success. Price volatility creates the opportunity for a patient investor to acquire a security at an appropriate discount to intrinsic value1. That discount creates a margin of safety2 should unanticipated changes occur, either at the level of the company or issuer or in the broader investment environment. At the same time, upside price volatility requires the discipline to sell securities – even ones with good fundamentals – if a rally pushes the price beyond the intrinsic value of the asset.
If anything, a lack of volatility presents a serious risk, as it indicates a degree of complacency that can magnify the reaction of a market or specific security to adverse developments. As an example, consider the long stretch of price stability that characterized the equity market just before the onset of the 2008 recession. On average, the S&P 500 moves by more than 2% in either direction on about 25 days a year3. But from 2004 through 2006 – a three-year period – the market only had two such days. Complacency reigned as imbalances built up, bubbles inflated and investor sentiment implied that nothing could go wrong. Of course, a lot did go wrong, and the market’s complacency in advance of that exacerbated the severity of the bear market that followed.
Price volatility may be uncomfortable and undesirable, but it’s not the best definition of investment risk, and it can even act as a complement to a value-based approach to investing.
2. Price and value are different things
The concept of price has the advantages of availability, transparency and frequent changes. Functioning markets and rapid reporting mean that we can all agree on the price of a security. Prices change constantly, and those changes are updated instantly on a variety of pricing sources, widely available to professional and personal investors alike. The problem with prices, as outlined in the previous section, is that they can be quite volatile.
Value, on the other hand, has the opposite attributes of price. Value is opaque, unavailable and stable, but it enjoys less volatility. Whereas an investor can watch the price of a stock change throughout the course of a trading session, the value of the underlying company is only derived through patient and careful analysis and is therefore a far more robust notion than price. Benjamin Graham elegantly framed the distinction between price and value by noting that in the short run the market is a voting machine, whereas in the long run it is a weighing machine. The “votes” of countless traders determine price day-to-day and second-to-second. Weighing the underlying economic viability and free-cash flows generated by a business determines value, a far more durable concept than price. Investors primarily interested in the preservation and growth of their wealth over the long-run are better off focused on value than price for precisely these reasons.
1. Intrinsic Value: What one estimates to be the true value of a security based on analysis of both tangible and intangible factors.
2. Margin of Safety: the difference between what we believe to be the intrinsic value of a stock and its market price.
3. From the periods of January 2001 to December 2012. Sources: Bloomberg and BBH Analysis.
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