Changing His Mind
David Chambers and Elroy Dimson have published a wonderful paper on Keynes the Stock Market Investor, which analyses John Maynard Keynes’ remarkable investment record as the effective Chief Investment Officer of Kings College Cambridge over a period of a quarter of a century. It’s a fascinating insight into the evolution of one individual from underperforming, overconfident, macro-based and behaviorally biased to an outperforming, realistic, stockpicking rationalist.
That this journey happens to have been made by one the last century’s most famous economists, and that it flies in the face of much of his own macroeconomic theory merely adds piquancy. The lessons, though, are applicable for any investor, whether genius or not.
Perhaps the key point about Keynes’ investing style was his selection of equities as his preferred asset class: a very unusual decision for the time when most institutions were focussed on bonds. His particular insight was that equities offered a way of riding industrial growth, that they offered both return and income premiums over bonds and that the equity risk premium of shares over bonds would ensure a profitable, if volatile ride. This was by no means a no-brainer; as the paper points out, between 1900 and 1920, before Keynes moved into equities, the equity risk premium was 0.3%, but rose to 4.9% over the next twenty five, covering the remainder of his life.
Yet, despite his correct analysis of the landscape of asset classes Keynes failed to make significant returns over is first decade as an investment manager, as he persisted with an investment approach based on top-down analysis using something called the ‘credit cycle theory of investment’: utilizing monetary and economic indicators to determine when and whether to move between the different major asset classes of cash, bonds and equities. The results of this approach was poor, as Keynes himself admitted:
“Credit cycling means in practice selling market leaders on a falling market and buying them on a rising one and, allowing for expenses and loss of interest, it needs phenomenal skill to make much out of it”
Patience is a Virtue
In fact over that first decade or so Keynes managed to underperform the market by an average of 5.3% a year. Any normal institution would have fired any normal investment manager but Keynes was no ordinary man and Oxbridge colleges are no ordinary institutions: Keynes stayed on, adjusted his approach and afterwards handsomely beat the market by 5.4% a year.
It seems that in the early 1930s Keynes abandoned his top-down approach in favor of a method of investing we’ve seen many time before, and frequently amongst the very best investors: he went bottom-up and started focusing on stocks that he knew something about and which were cheap on the basis of intrinsic value. With one of those ironies that history so often throws up, across the Atlantic his exact contemporary, one Ben Graham, was undergoing almost exactly the same transformation, yet there’s no evidence they ever corresponded.
Keynes’ approach was idiosyncratic and aggressive in the extreme:
“It is clear that Keynes took considerable risks in constructing his UK portfolio. He aggressively allocated to equities, adopted very active sector weightings, selected smallcap and mid-cap stocks, and rotated between high dividend yield and low dividend yield stocks relative to the market.”
In the words of the authors the early 1930s represent a “structural break” in the way Keynes invested, as he moved from his macroeconomic led, top-down approach to a focused, bottom-up value led method. Underlying this appears to be a change in psychology because the analysis suggests that the younger, supremely confident Keynes suffered from the bugbear of so many investors – rampant overconfidence in his own ability to time the market.
In fact the evidence indicates that he was never really very good at market timing, even in his successful years: it was just that his returns were so good that it didn’t matter. So, despite his success over the latter part of his investing career the authors also show that he demonstrated the disposition effect over all periods. By and large, like the rest of us, he sold his winners too early and held on to his losers in the hope he would make back his losses.
Nevertheless, it seems that experience did help him overcome his overconfidence, a finding backed up by other research (e.g. Career Concerns of Mutual Fund Managers) which suggests that older investors and asset managers tend to suffer less from this type of problem, and that they also tend to create more idiosyncratic portfolios: which seems to fit Keynes’ behaviour to a tee. His post break stock selection was highly concentrated, focused on stocks and sectors he understood well:
“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes”
Which sounds more like Warren Buffett than John Maynard Keynes, you’d have thought.
He also tended to favour mid to small capitalisation stocks, was generally contrarian in nature and, unusually, invested internationally, mainly in the US. Indeed it seems that it was his experience of equities tracking US industrial growth that led to his decision to move into the new asset class. And, notwithstanding his preference for non-dividend paying mining stocks, particularly gold, his portfolio also tended to provide a relatively higher yield than government bonds. In fact, in many ways this looks like a modern, value focused, internationally diversified portfolio: difficult enough to manage now, but completely unheard of in the pre-war investing universe.
Moreover, as time went on, his holding period increased and his portfolio turnover dropped. In the 1920s he turned over his UK equity portfolio once every two years, but by the 1930s this was happening less than once every three years. This, again, seems to be a common behavioral change in older fund managers and investors; the benefits of experience, presumably.
This type of unconventional, high risk idiosyncratic portfolio seems to be typical of many highly effective investors and is very difficult to replicate. Few fund managers are allowed the freedom that Keynes had in managing the funds of a Cambridge college whose investment horizons were essentially infinite and who were willing to defer to his judgement. In fact when he attempted to implement his ideas in other organisations he struggled to get his way, and later resigned those positions.
Long Horizons, Clear Views
Of course, in managing the investment portfolio of a Cambridge college Keynes had huge advantages over your normal investment manager; in fact his position is more analogous to that of a private investor, albeit one with inordinately long horizons. The lessons of his transformation are pretty simple really: experience does help, a bit, to remove behavioral biases, but simply finding a better method of investing is the major trick.
The lessons of Keynes the investor are straightforward really: don’t worry about macroeconomic trends but, instead, focus on individual stocks and their opportunities. And, of course, if the facts change be prepared to change your mind.