20

The Most Important Thing Is … Reasonable

Expectations

Return expectations must be reasonable. Anything else will get you into
trouble, usually through the acceptance of greater risk than is perceived.

I want to point out that no investment activity is likely to be successful

unless the return goal is (a) explicit and (b) reasonable in the absolute
and relative to the risk entailed. Every investment effort should begin with
a statement of what you’re trying to accomplish. The key questions are
what your return goal is, how much risk you can tolerate, and how much
liquidity you’re likely to require in the interim.

Return goals must be reasonable. What returns can we aspire to? Most
of the time—although not necessarily at any particular point in time (and
not necessarily today)—it’s reasonable to aspire to returns in single digits
or perhaps low double digits. High teens are something very special, and
anything more should be viewed as the province of experienced pros
(and only the best of those). The same is true of particularly consistent
results. Expecting too much in these regards is likely to lead to
disappointment or loss. There’s just one antidote: asking whether the
result you’re expecting is too good to be true. This requires the
application of skepticism, a quality that’s absolutely essential for
investment success.
I don’t think normal risk bearing and the normal functioning of the
capital markets should be expected to produce returns greater than those
just described. Higher returns are “unnatural,” and their achievement
requires some combination of the following:

• an extremely depressed environment in which to buy (hopefully to be
followed by a good environment in which to sell),
• extraordinary investment skill,
• extensive risk bearing,
• heavy leverage, or
• good luck.

Thus, investors should pursue such returns only if they believe some
of these elements are present and are willing to stake money on that
belief. However, each of these is problematic in some way. Great buying
opportunities don’t come along every day. Exceptional skill is rare by
definition. Risk bearing works against you when things go amiss. So does
leverage, which operates in both directions, magnifying losses as well as
gains. And certainly luck can’t be counted on. Skill is the least ephemeral
of these elements, but it’s rare (and even skill can’t be counted on to
produce high returns in a low-return environment).

There are occasional demonstrations of the importance of reasonable

expectations, and none is more dramatic than the recent Madoff scandal.
Bernard Madoff perpetrated the greatest Ponzi scheme ever to come
to light. He got away with it primarily because his investors failed to
question whether his purported accomplishment was feasible.
The returns Madoff claimed weren’t outrageously high: just 10 percent
a year or so. What was extraordinary was the way he reported them year
in and year out. Even a down month was a rarity. Yet few of his investors
asked how these returns were achieved or wondered whether they were
actually possible.
For most of the twentieth century, common stocks averaged a 10
percent return. But they did it with substantial volatility and a fair number
of down years. In fact, while 10 percent was the average, individual-year
returns were only rarely within a few percentage points of that figure.
History shows equity returns to be highly variable.
If it’s dependable returns you’re after, you can get them from Treasury
bills without subjecting yourself to price volatility, credit risk, inflation risk,
or illiquidity. But the returns on T-bills historically have been in low single
digits.
How could Madoff have produced the much higher returns of stocks
with the dependability of T-bills? Which of the five elements listed above
might he have possessed?

• He reported those returns for almost twenty years, regardless of the
investment environment.
• No one understood him to possess particular investment skill, and if
there was something exceptional about his computer model, what
kept others from discovering it and emulating it?
• He claimed not to base his efforts on predicting the direction of the
market or picking individual stocks.
• His avowed approach didn’t involve leverage.
• No one can be that lucky that long.

There simply was no rational explanation for Madoff’s returns. His
investors could say either “I checked it out” or “I think it makes sense,”
but it was impossible to say “I checked it out, and it makes sense.” His
method and results were simply unsupportable: there weren’t enough
options outstanding to accommodate the capital he managed, and even if
there were, the strategy he described couldn’t produce the virtual
absence of losing months he claimed. But people regularly suspend
disbelief and accept unreasonable expectations when they’re told free
money is available. The Madoff scandal is an exceptional example of the
importance of saying “too good to be true” to return expectations that are
unreasonable. But few people seem capable of doing so.
While on the subject of Madoff, I want to mention a good way to sort
out the reasonable from the unreasonable. In addition to “Is it too good to
be true,” just ask “Why me?” When the salesman on the phone offers you
a guaranteed route to profit, you should wonder what made him offer it to
you rather than hog it for himself. Likewise, but a little more subtly, if an
economist or strategist offers a sure-to-be-right view of the future, you
should wonder why he or she is still working for a living, since derivatives
can be used to turn correct forecasts into vast profits without requiring
much capital.
Everyone wants to know how to make the correct judgments that can
lead to investment success, and lately people have been asking me,
“How can you be sure you’re investing at the bottom rather than too
soon?” Finding the bottom is one of the things about which our
expectations have to be reasonable. My answer is simple: “You can’t.”
“The bottom” is the point at which the price of an asset stops going
down and gets ready to start going up. It can be identified only in
retrospect.
If markets were rational, such that nothing would sell for less than its
“fair value,” we could say the bottom has been reached when the price
arrives at that point. But since markets overshoot all the time—and price
declines continue long after they should have stopped at fair value—
there’s no way to know when the price has reached a level below which it
won’t go. It’s essential to understand that “cheap” is far from synonymous
with “not going to fall further.”
I try to look at it logically. There are three times to buy an asset that
has been declining: on the way down, at the bottom, or on the way up. I
don’t believe we ever know when the bottom has been reached, and
even if we did, there might not be much for sale there.
If we wait until the bottom has been passed and the price has started
to rise, the rising price often causes others to buy, just as it emboldens
holders and discourages them from selling. Supply dries up and it
becomes hard to buy in size. The would-be buyer finds it’s too late.
That leaves buying on the way down, which we should be glad to do.
The good news is that if we buy while the price is collapsing, that fact
alone often causes others to hide behind the excuse that “it’s not our job
to catch falling knives.” After all, it’s when knives are falling that the
greatest bargains are available.
There’s an important saying attributed to Voltaire: “The perfect is the
enemy of the good.” This is especially applicable to investing, where
insisting on participating only when conditions are perfect—for example,
buying only at the bottom—can cause you to miss out on a lot. Perfection
in investing is generally unobtainable; the best we can hope for is to
make a lot of good investments and exclude most of the bad ones.
How does Oaktree resolve the question of knowing when to buy? We
give up on trying to attain perfection or ascertain when the bottom has
been reached. Rather, if we think something is cheap, we buy. If it gets
cheaper, we buy more. And if we commit all our capital, we assume we’ll
be able to raise more.
One of the six tenets of our investment philosophy calls for “disavowal
of market timing.” Yet we expend a lot of effort to diagnose the market
environment, and we certainly don’t invest regardless of what we think
the environment implies for risk and return. Rather, our disinterest in
market timing means—above all else—that if we find something
attractive, we never say, “It’s cheap today, but we think it’ll be cheaper in
six months, so we’ll wait.” It’s just not realistic to expect to be able to buy
at the bottom.

In addition to an excess of trust and shortage of risk consciousness, I

think unrealistic expectations played a leading role in creating the recent
financial crisis and the ensuing market crash.
Here’s how I imagine the attitude toward return of a typical investor—
both individual and institutional—in 2005 through 2007:

I need 8 percent. I’d be glad to earn 10 percent instead. Twelve

percent would be even better. Fifteen percent would be great.
Twenty percent would be terrific. And 30 percent would be out of
this world.

Most people see nothing wrong in this imaginary monologue. But

something is very wrong … because the investor has failed to ask (a)
whether a given goal is reasonable and (b) what would have to be done
to achieve it. The truth is that trying for higher returns in a given
environment usually requires some increase in risk taking: riskier stocks
or bonds, greater portfolio concentration, or increased leverage.
What that typical investor should have said is something like this:

I need 8 percent. I’d be glad to earn 10 percent instead. Twelve

percent would be even better. But I won’t try for more than that,
 because doing so would entail risks I’m just not willing to bear. I
don’t need 20 percent.

I encourage you to think about “good-enough returns.” It’s essential to

realize that there are returns so high that they aren’t worth going for and
risks that aren’t worth taking.

Investment expectations must be reasonable. Anything else will get you

into trouble, usually through the acceptance of greater risk than is
perceived. Before you swallow the promise of sky-high returns without
risk or of steady “absolute returns” at levels much higher than T-bills, you
should wonder skeptically whether they’re really achievable and not
simply alluring; how an investor with your skill can reasonably expect to
achieve them; and why an opportunity so potentially lucrative is available
to you, ostensibly cheaply. In other words, are they too good to be true?