12/7/2021 Seth Klarman's Investment Lessons From the Financial Crisis ~ market folly

market folly Tracking top hedge funds since 2008

About/Contact New Hedge Fund Quarterly Just Released search

Find Out What Top Hedge Funds Are

Friday, March 5, 2010 Buying, Selling, & Shorting
Join over 13,600 investors that receive our da
summary:

Seth Klarman's Investment Lessons From the

Get Free Email Updates

Financial Crisis
Get Free Updates via RSS

Hat tip to MyInvestingNotebook for posting this up from ValueInvestingInsight.

The following excerpt comes from Seth Klarman's annual letter to Baupost Group
investors. Needless to say, it is a must read. Without further ado, here are Seth Book of the Month

Klarman's Lessons of 2008:

In this excerpt from his annual letter, investing great Seth Klarman describes 20
lessons from the financial crisis which, he says, “were either never learned or else

The Man Who Solved the Market: How Jim S

were immediately forgotten by most market participants.”
Launched the Quant Revolution

One might have expected that the near-death experience of most investors in
2008 would generate valuable lessons for the future. We all know about the Recommended Reading Lists
“depression mentality” of our parents and grandparents who lived through the
Charlie Munger's Recommendations
Great Depression. Memories of tough times colored their behavior for more
than a generation, leading to limited risk taking and a sustainable base for Seth Klarman's Recommendations

healthy growth. Yet one year after the 2008 collapse, investors have returned Warren Buffett's Reading List
to shockingly speculative behavior. One state investment board recently Ray Dalio's Reading List
adopted a plan to leverage its portfolio – specifically its government and high- Dan Loeb's Recommendations
grade bond holdings – in an amount that could grow to 20% of its assets over
Bill Ackman's Favorite Books
the next three years. No one who was paying attention in 2008 would possibly
think this is a good idea.
David Einhorn's Picks
Blue Ridge Capital's Picks
Below, we highlight the lessons that we believe could and should have been Mohnish Pabrai's Reading List
learned from the turmoil of 2008. Some of them are unique to the 2008 melt-
Fundamentals & Valuation
down; others, which could have been drawn from general market observation
over the past several decades, were certainly reinforced last year. Shockingly, Technical Analysis & Charts
virtually all of these lessons were either never learned or else were Books We've Reviewed
immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

Follow Us On Twitter

1. Things that have never happened before are bound to occur with some
regularity. You must always be prepared for the unexpected, including
sudden, sharp downward swings in markets and the economy. Whatever
adverse scenario you can contemplate, reality can be far worse.
2. When excesses such as lax lending standards become widespread and
persist for some time, people are lulled into a false sense of security,
creating an even more dangerous situation. In some cases, excesses
migrate beyond regional or national borders, raising the ante for
investors and governments. These excesses will eventually end,
triggering a crisis at least in proportion to the degree of the excesses.

https://www.marketfolly.com/2010/03/seth-klarmans-investment-lessons-from.html 1/5
12/7/2021 Seth Klarman's Investment Lessons From the Financial Crisis ~ market folly

Correlations between asset classes may be surprisingly high when Tweets by ‎@marketfolly
leverage rapidly unwinds.
Market Folly
3. Nowhere does it say that investors should strive to make every last @marketfolly
Replying to @marketfolly
dollar of potential profit; consideration of risk must never take a Dr. Michael Burry’s Scion Asset Mgm
a ton of portfolio turnover in Q1. New
backseat to return. Conservative positioning entering a crisis is crucial: stakes: $TSLA puts, $TLT puts, calls
both $GOOG & $FB, also calls on $C
it enables one to maintain long-term oriented, clear thinking, and to & $NTAP

focus on new opportunities while others are distracted or even forced to

May 17
sell. Portfolio hedges must be in place before a crisis hits. One cannot
Market Folly
reliably or affordably increase or replace hedges that are rolling off @marketfolly
Replying to @marketfolly
during a financial crisis.
Li Lu’s Himalaya Capital cut 40% of $
4. Risk is not inherent in an investment; it is always relative to the price stake in Q1. Still owns ~$168m worth

paid. Uncertainty is not the same as risk. Indeed, when great May 17

uncertainty – such as in the fall of 2008 – drives securities prices to

Market Folly
especially low levels, they often become less risky investments. @marketfolly
Sir Chris Hohn’s TCI Fund boosted st
5. Do not trust financial market risk models. Reality is always too complex in $MSFT 43% and $SPGI 147% duri
Q1. Also started small new positions
to be accurately modeled. Attention to risk must be a 24/7/365 $LRCX $KLAC

obsession, with people – not computers – assessing and reassessing the

Embed View o
risk environment in real time. Despite the predilection of some analysts
to model the financial markets using sophisticated mathematics, the
Archive
markets are governed by behavioral science, not physical science.
6. Do not accept principal risk while investing short-term cash: the greedy ► 
2021
(2)
► 
2020
(6)
effort to earn a few extra basis points of yield inevitably leads to the
► 
2019
(101)
incurrence of greater risk, which increases the likelihood of losses and ► 
2018
(178)

severe illiquidity at precisely the moment when cash is needed to cover ► 

2017
(334)
► 
2016
(312)
expenses, to meet commitments, or to make compelling long-term
► 
2015
(416)
investments.
► 
2014
(477)
7. The latest trade of a security creates a dangerous illusion that its ► 
2013
(527)

market price approximates its true value. This mirage is especially ► 

2012
(556)
► 
2011
(373)
dangerous during periods of market exuberance. The concept of "private
▼ 
2010
(735)
market value" as an anchor to the proper valuation of a business can ► 
12/19 - 12/26
(9)

also be greatly skewed during ebullient times and should always be ► 

12/12 - 12/19
(13)
► 
12/05 - 12/12
(5)
considered with a healthy degree of skepticism.
► 
11/28 - 12/05
(14)
8. A broad and flexible investment approach is essential during a crisis.
► 
11/21 - 11/28
(4)
Opportunities can be vast, ephemeral, and dispersed through various ► 
11/14 - 11/21
(3)

sectors and markets. Rigid silos can be an enormous disadvantage at ► 

11/07 - 11/14
(8)
► 
10/31 - 11/07
(9)
such times.
► 
10/24 - 10/31
(13)
9. You must buy on the way down. There is far more volume on the way
► 
10/17 - 10/24
(17)
down than on the way back up, and far less competition among buyers. ► 
10/10 - 10/17
(16)

It is almost always better to be too early than too late, but you must be ► 
10/03 - 10/10
(12)
► 
09/26 - 10/03
(16)
prepared for price markdowns on what you buy.
► 
09/19 - 09/26
(16)
10. Financial innovation can be highly dangerous, though almost no one ► 
09/12 - 09/19
(7)
will tell you this. New financial products are typically created for sunny ► 
09/05 - 09/12
(14)

days and are almost never stress-tested for stormy weather. ► 

08/29 - 09/05
(8)
► 
08/22 - 08/29
(3)
Securitization is an area that almost perfectly fits this description;
► 
08/15 - 08/22
(6)
markets for securitized assets such as subprime mortgages completely ► 
08/08 - 08/15
(10)
collapsed in 2008 and have not fully recovered. Ironically, the ► 
08/01 - 08/08
(17)

https://www.marketfolly.com/2010/03/seth-klarmans-investment-lessons-from.html 2/5
12/7/2021 Seth Klarman's Investment Lessons From the Financial Crisis ~ market folly

government is eager to restore the securitization markets back to their ► 

07/25 - 08/01
(11)
► 
07/18 - 07/25
(18)
pre-collapse stature.
► 
07/11 - 07/18
(11)
11. Ratings agencies are highly conflicted, unimaginative dupes. They are ► 
07/04 - 07/11
(12)
blissfully unaware of adverse selection and moral hazard. Investors ► 
06/27 - 07/04
(15)

should never trust them. ► 

06/20 - 06/27
(10)
► 
06/13 - 06/20
(12)
12. Be sure that you are well compensated for illiquidity – especially
► 
06/06 - 06/13
(15)
illiquidity without control – because it can create particularly high ► 
05/30 - 06/06
(6)
opportunity costs. ► 
05/23 - 05/30
(18)
► 
05/16 - 05/23
(21)
13. At equal returns, public investments are generally superior to private
► 
05/09 - 05/16
(14)
investments not only because they are more liquid but also because
► 
05/02 - 05/09
(22)
amidst distress, public markets are more likely than private ones to ► 
04/25 - 05/02
(13)

offer attractive opportunities to average down. ► 

04/18 - 04/25
(23)
► 
04/11 - 04/18
(22)
14. Beware leverage in all its forms. Borrowers – individual, corporate, or
► 
04/04 - 04/11
(19)
government – should always match fund their liabilities against the
► 
03/28 - 04/04
(20)
duration of their assets. Borrowers must always remember that capital ► 
03/21 - 03/28
(23)

markets can be extremely fickle, and that it is never safe to assume a ► 

03/14 - 03/21
(14)
► 
03/07 - 03/14
(24)
maturing loan can be rolled over. Even if you are unleveraged, the
▼ 
02/28 - 03/07
(20)
leverage employed by others can drive dramatic price and valuation David Stemerman's Conatus Capital Bo
Technolog...
swings; sudden unavailability of leverage in the economy may trigger an
Goldman Sachs' VIP List: Most Importan
economic downturn. For...

15. Many LBOs are man-made disasters. When the price paid is excessive, Seth Klarman's Investment Lessons Fro
Financi...
the equity portion of an LBO is really an out-of-the-money call option. What We're Reading ~ 3/5/10
Many fiduciaries placed large amounts of the capital under their Lee Hobson's Highside Capital Bullish O
Internati...
stewardship into such options in 2006 and 2007.
Jonathan Auerbach's Hound Partners B
16. Financial stocks are particularly risky. Banking, in particular, is a Transdi...

highly leveraged, extremely competitive, and challenging business. A Dan Loeb's Hedge Fund Third Point: Ne
Distre...
major European bank recently announced the goal of achieving a 20% Hedge Fund Woodbine Says Global Re
Is Mos...
return on equity (ROE) within several years. Unfortunately, ROE is
Whitney Tilson's T2 Partners Letter: Feb
highly dependent on absolute yields, yield spreads, maintaining 2010

adequate loan loss reserves, and the amount of leverage used. What is Pershing Square's Economic Exposure
General Gro...
the bank's management to do if it cannot readily get to 20%? Leverage Warren Buffett On Succession Planning
Investments
up? Hold riskier assets? Ignore the risk of loss? In some ways, for a
Charles Anderson's Hedge Fund Fox Po
major financial institution even to have a ROE goal is to court disaster. Capital: P...

17. Having clients with a long-term orientation is crucial. Nothing else is as Philippe Laffont's Coatue Management
On Te...
important to the success of an investment firm. PIMCO's Bill Gross On Corporate Versu
Sovereign B...
18. When a government official says a problem has been "contained," pay no
Soros Fund Management's Portfolio: Ad
attention. Citigroup ...

19. The government – the ultimate short-term-oriented player – cannot Brett Barakett's Tremblant Capital Bets
Res...
withstand much pain in the economy or the financial markets. Bailouts Steven Cohen's Hedge Fund SAC Capit
Updates Posi...
and rescues are likely to occur, though not with sufficient predictability
John Burbank's Passport Capital Hedge
for investors to comfortably take advantage. The government will take ETFs, ...

enormous risks in such interventions, especially if the expenses can be Thomas Steyer's Farallon Capital Focus
Risk A...
conveniently deferred to the future. Some of the price-tag is in the form Warren Buffett & Berkshire Hathaway's
Letter
of back- stops and guarantees, whose cost is almost impossible to
► 
02/21 - 02/28
(18)
determine.
► 
02/14 - 02/21
(20)
► 
02/07 - 02/14
(27)
https://www.marketfolly.com/2010/03/seth-klarmans-investment-lessons-from.html 3/5
12/7/2021 Seth Klarman's Investment Lessons From the Financial Crisis ~ market folly

20. Almost no one will accept responsibility for his or her role in ► 
01/31 - 02/07
(21)
► 
01/24 - 01/31
(21)
precipitating a crisis: not leveraged speculators, not willfully blind
► 
01/17 - 01/24
(19)
leaders of financial institutions, and certainly not regulators,
► 
01/10 - 01/17
(16)
government officials, ratings agencies or politicians. ► 
01/03 - 01/10
(10)
Below, we itemize some of the quite different lessons investors seem to have
► 
2009
(849)
learned as of late 2009 – false lessons, we believe. To not only learn but also
effectively implement investment lessons requires a disciplined, often ► 
2008
(336)

contrary, and long-term-oriented investment approach. It requires a resolute

focus on risk aversion rather than maximizing immediate returns, as well as
.
an understanding of history, a sense of financial market cycles, and, at times,
extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.

2. Bad things happen, but really bad things do not. Do buy the dips,
especially the lowest quality securities when they come under pressure,
because declines will quickly be reversed.
3. There is no amount of bad news that the markets cannot see past.
4. If you’ve just stared into the abyss, quickly forget it: the lessons of
history can only hold you back.
5. Excess capacity in people, machines, or property will be quickly
absorbed.
6. Markets need not be in sync with one another. Simultaneously, the bond
market can be priced for sustained tough times, the equity market for a
strong recovery, and gold for high inflation. Such an apparent
disconnect is indefinitely sustainable.
7. In a crisis, stocks of financial companies are great investments, because
the tide is bound to turn. Massive losses on bad loans and soured
investments are irrelevant to value; improving trends and future
prospects are what matter, regardless of whether profits will have to be
used to cover loan losses and equity shortfalls for years to come.
8. The government can reasonably rely on debt ratings when it forms
programs to lend money to buyers of otherwise unattractive debt
instruments.
9. The government can indefinitely control both short-term and long-term
interest rates.
10. The government can always rescue the markets or interfere with
contract law whenever it deems convenient with little or no apparent
cost. (Investors believe this now and, worse still, the government
believes it as well. We are probably doomed to a lasting legacy of
government tampering with financial markets and the economy, which
is likely to create the mother of all moral hazards. The government is
blissfully unaware of the wisdom of Friedrich Hayek: “The curious task
of economics is to demonstrate to men how little they really know about
what they imagine they can design.”)

Took the words right out of your mouth, didn't he? And this is exactly why he is

https://www.marketfolly.com/2010/03/seth-klarmans-investment-lessons-from.html 4/5
12/7/2021 Seth Klarman's Investment Lessons From the Financial Crisis ~ market folly

considered one of the greatest investors out there. For more resources on Klarman's
hedge fund, we've previously posted up Baupost Group's portfolio, a past interview
with Klarman, as well as some of his prior investment insight.

Posted by
market folly
at
6:55 AM

Labels:
baupost group,
hedge fund,
investor letters,
seth klarman

blog comments powered by Disqus

Newer Post Home Older Post

Disclaimer

The content provided within this website is property of MarketFolly.com and any views or opinions expressed herein are tho
solely of MarketFolly.com and do not represent that of any firm or institution. This website is for educational and/or enterta
purposes only. Use this information at your own risk. MarketFolly.com is not an investment advisor of any kind, so do not co
anything on this page to be legal, tax, or investment advice. MarketFolly.com is not responsible for any third party links or c
MarketFolly.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designe
provide a means for sites to earn advertising fees by advertising and linking to amazon.com. As an Amazon Associate I earn
qualifying purchases.
Copyright (c) 2020 market folly

https://www.marketfolly.com/2010/03/seth-klarmans-investment-lessons-from.html 5/5