Jeremy Grantham on Betting Against Bull Market Irrationality ~ market folly

Friday, April 20, 2012

Jeremy Grantham on Betting Against Bull Market Irrationality

GMO's Jeremy Grantham is out with his latest quarterly letter. In it, he talks about how to bet against bull market irrationality. He also touches on the tension between protecting your job or your clients' money. He also says that investment managers, in order to not lose their jobs, must "never, ever be wrong on your own."

On how most investors prevent this, Grantham goes on to write:

"Professional investors pay ruth­less atten­tion to what other investors in gen­eral are doing. The great major­ity 'go with the flow,' either com­pletely or par­tially. This cre­ates herd­ing, or momen­tum, which dri­ves prices far above or far below fair price."

Herding in the markets is by no means a new phenomenon. Legendary investor Michael Steinhardt last year said that there's more herding in hedge funds than ever.

Grantham then goes on to re-phrase the oft-quoted Keynes reference of "the market can stay irrational longer than the investor can stay solvent" to an amended version that ends with "longer than the client can stay patient."

How to Survive Betting Against Bull Market Irrationality

Grantham lays out 3 main ways to do so:

1. Invest with a margin of safety: This, of course, is one of the principles by which Seth Klarman and many other value investors invest. The last two days we've highlighted notes from Seth Klarman's Margin of Safety.

2. Stay reasonably diversified: For a retail investor, this can make sense. However, we'd imagine that numerous hedge funds would disagree with this statement.

Many long/short managers often run portfolios of around 20 long positions and 30-40 short positions. Their argument would be that in lieu of diversification as a means to protect from downside, they've outright hedged by shorting. But then again, it all comes down to Grantham's definition of just how diversified 'reasonably diversified' is.

3. Never use leverage: Leverage has been the demise of many investors, so this is prudent advice. While some hedge funds employ leverage, the ones who do so successfully seemingly keep it to low levels. It's when you're leveraged 30:1 (or whatever Lehman Brothers was at) that problems arise.

Embedded below is Jeremy Grantham's latest investment outlook:

For further wisdom from the strategist, head to Grantham's 10 investment lessons.

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