Memoirs of a Money Manager: Fearing Greed

Warren Buffett is famous for many things, not the least of which is having become one of the world’s richest men through investing. A quote often attributed to him, and I paraphrase here, is that “…one should be greedy when everyone is fearful and fearful when they are greedy.” Another famous quote in a similar vein is attributed to 18^th century British nobleman Baron Rothschild, who allegedly said “…buy when there’s blood in the streets, even if the blood is your own.”

This kind of frank advice looks obvious in hindsight but is extremely difficult to implement in real time. It has been my experience in over 40 years of providing investment advice to individuals, families and institutions that greed is an infectious disease brought on by bull markets and only cured by bear markets; the cycle repeats itself with alarming regularity in individual and institutional investment decision making.

You should fear greed. Here is why.

I believe there are not two periods, one of greed and one of fear, but rather a far more complex set of periods during which investors torture themselves with their gains, losses, hopes and fears. I think it goes like this: greed, fear, panic, forlorn hope, apathy, optimism, enthusiasm, exuberance and back to greed. “Greed” is that period when valuations are expensive by historical measures and the markets are priced for perfection, a continuous stream of good news. In the “fear” period there is a growing recognition of financial problems as prices slide and the hoped-for market rallies are sharp but short. Many times during this period the economy does not necessarily look so bad and the business and nation’s leaders assure us that “all is well” with the economy. Eventually the stock price declines become more severe and volume increases on the declines; all asset classes seem to decline together and there is no place to hide except cash and even that has unknown counterparty risk. “Panic” sets in as hopes for higher prices fade. It is somewhere here, between fear and panic that Messrs. Buffett and Rothschild start to strike their deals for big positions in attractive businesses. Then the politicians and anti-business publications step into the limelight with accusations against the evils of the “rich,” corporations, banks and “Wall Street;” new legislation is promised so this will never happen again.

Finally, investors who have not sold out during the fear-panic stage give up and sink into “forlorn hope.” In this environment the remaining investors desert the market and lose all hope that their stock portfolios will return to the high valuations they experienced in the “greed” period. Stock prices drift lower, typically even lower than those prices experienced during the fear-panic lows; volume on the exchanges is low. Investors no longer look at their on-line brokerage accounts several times a day to see what their portfolios are worth; their brokers do not call with tips and suggestions, if indeed their brokers are even still employed; the mail boxes are not stuffed with research ideas; investors are “apathetic.” Asset classes that became more highly correlated during the fear and panic stages once again become disengaged and appear to move randomly and independently of any known market force; portfolio diversification begins to work again. If investors think about their portfolios at all, they wonder quietly, “…how could I possibly have convinced myself, or permitted my advisors to convince me, to own so much equity?” In their hearts they know the answer: greed.

Investors may be apathetic about the market; at the same time many are worried about their jobs. They lost their cash cushions in the market decline because they were invested in stocks beyond what was appropriate for their circumstances. The business environment is bad. However, even as the business environment is struggling, the market for stocks begins to look more interesting. Valuations are attractive when compared to the earlier “greed” market top; dividends provide income; interest rates are low and provide for easier financing. Some are able to refinance their homes and get some cash while others aren’t so lucky. Slowly, knowledgeable investors start to purchase equities and become more “optimistic” and, as the months drag on, eventually “enthusiastic.” The Buffetts and Rothschilds of the world had to purchase their big positions during the panic, but now they are buying like the market is a candy store; market prices rise slowly and steadily. Sell offs are quickly met with new buying and volume starts to increase. Finally, there is some good economic news. The market rises further; the evening news mentions the stock prices again. Prices move up more briskly; investors who had lost all hope and were apathetic take a look at their portfolios. They still have huge losses, but values are up off the bottom; CNBC reminds them that “if you experienced the market decline of 50% you are not breaking even until the market is up 100%.” The court dockets are filling up with the government prosecution of low level corporate executives and Wall Street players; the big guys are, of course, all innocent.

Market enthusiasm turns to “exuberance.” Stock prices move up even more swiftly; valuations no longer seem “cheap” but they are still reasonable. The job market, still depressed, starts to show some life. The real estate market experiences increasing sales and prices and, with it, the construction market; car and truck sales improve markedly. People, freed from the shackles of their homes, regain mobility, quit their jobs and start to look for new ones. Corporate profit margins and earnings soar; business increases hiring. Investors that sold stocks during the fear-panic-and-forlorn-hope periods now wish they had more stock and start thinking about increasing their allocations for equities; admittedly prices are much higher than when they sold out, but greed is working its magic. The job market improves further still; business profits are soaring. Market valuations are getting excessive in the “hot” areas; market volume increases. Margin debt approaches the previous old high. Corporations increase their borrowing and, some finding little future profit in expanding their plant and equipment, start to either make acquisitions or purchase their own stock or both. Banks and investment banks are happy as mergers, acquisitions and initial public offerings gather force. The Forbes list of billionaires gains new members. Greed is back. LONG LIVE GREED!

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“To my broker and/or advisor:” “… please increase the equity percentage in my portfolio to 70% immediately; I realize now that I have been too conservative these last five years after panicking and selling out in the winter of 2009. I regret not taking your advice to stick with my old 50% equity target and rebalancing through the market cycle, but now I must make up for my earlier caution as I intend to retire at the end of the year. Nothing has changed in the health or wellbeing of either me or my family. I am now 70 and not getting any younger, but all my friends at the club are riding high with huge gains from last year’s market. Frankly, I feel left behind. Thank you.”

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“To our advisor:” “…our foundation board of directors voted last week to increase our endowment equity exposure from 50% to 80% following the recommendations of our newly established finance committee. As you know, members of our board of directors rotate off the board every three years on a staggered basis and the new members believe we have been far too conservative in the last five years. As you may recall, an equity reduction was taken following your advice in 2007; we sharply reduced our equity exposure from 75% to 50%. This decision had nothing to do with expectations about future market returns as you freely admitted you had no idea about the future. At the time you and we were concerned about our organization’s decrease in membership and the greatly reduced income that was likely from fewer members paying dues and reduced revenues from program attendance fees and publications. This loss of income combined with our scholarship commitments implied a spending rate of over 10% a year from our endowment. In addition, you pointed out that, while not wishing to forecast, the equity market was selling at a premium to historical valuations and prospects for additional gains were very likely below average. However, the primary reason for our equity reduction was the poor outlook for our business income. Our membership fees fell more than expected and we did have to dip into our endowment for operating expenses for three years. We are very grateful for your timely advice back in 2007 but those directors are no longer in charge. Now I am happy to report that membership and attendance fees are on the rise, although our income is far below the peak six years ago and our expenses are still too high, running over 8% of our endowment. In addition, despite a considerable fundraising effort, our success in this area is still lacking. We are very pleased with your services and advice, but in short, we need bigger portfolio returns. Please call our offices to arrange a meeting to discuss the board’s decision to implement a new higher equity exposure. Finally, the board wishes you to prepare a report on the best way to invest in real estate funds, leverage buy out funds, venture capital, private equity, hedge funds and commodity trading pools. Some board members have friends that have done very well in these types of investment vehicles. Thank you again so much for your help.”