How We Think

Recency Bias, Global Interest Rates, and Return Expectations

Evolution has rewarded humans (and animals in general) for recency bias.  For example, if one of our ancestors found food down a certain path one day, that was probably a good place for him to look again the next day.  If a particular type of berry made you sick last time, do not eat that type again.  This enduring mental shortcut is helpful in most areas of our lives, but in investing this shortcut is a cognitive error.  As we demonstrated in our last letter, the rate of return of an asset is inversely related to its price.  That is, as the asset’s price goes up, its future rate of return falls.  So inevitably, at the very time that recent positive returns trigger a feeling of safety because one’s expectation for future returns is growing, the opposite is actually happening.  Risk rises as actual future long-term returns decline.  The inverse is true, as well.  When recent returns have been unpleasant or negative, risk falls as future long-term returns grow.  Economic cycles and financial asset bubbles are, in part, a product of this human inadequacy.

The table above shows the nominal return an investor can earn by purchasing a 10 year sovereign bond and holding it until maturity.  Financial actors agree that U.S. Treasuries and German Bunds represent the “risk free” rate of return in dollars and euro, respectively, meaning their prices (and, by extension, their rates of return) have meaningful implications for the broader markets.  The intrinsic value of all asset classes relies on the prevailing opportunity cost, and over the next decade market participants are currently requiring a risk free rate of return of only ~2% in dollars and merely ~1% in euro.  So what rate of return should investors reasonably expect to make in stocks, real estate, private equity, venture capital, timber, etc. during this same time period?  Markets generally price opportunity cost fairly efficiently – prices of assets will be bid to levels such that returns across asset classes converge.  Accordingly, given current prices and valuation fundamentals, we would posit that rates of returns on other financial assets are unlikely to greatly exceed those of the risk free rates, at least on average.

We will continue to employ the strategy we think best for compounding capital over the decades and through market and economic cycles.  We will not put capital to work in stocks just because they are relatively less expensive than the next best option.  Instead, we will deploy capital only when we have an expectation of a satisfactory return in a particular security.  The current conundrum of very low rates of return on capital means that investors continue to have an extremely compressed opportunity set, and these factors should cause investors to be quite wary.  Fortunately, we are not compelled to be fully invested in equities at all times, which really means at any price regardless of valuation or risk.  Instead, we are continuing to scour the world for individual businesses that trade at compelling discounts to their intrinsic values.  At some point, we expect to have lots of opportunities, but in the interim we will continue to remain patient.  Risk is not something one is forced to bear; it is something one should be willing to bear only if appropriately compensated for doing so.