In 2021, investors need to worry about overpaying for growth relative to value.
Stock market exuberance calls investors who are less than patient to do silly things. The issue is, there are too many of us that are programmed to opt for instant gratification and forget any and all long-term strategies. This brings to mind the marshmallow experiment that you perhaps learn in a psychology class or have seen videos of on YouTube.
Most associate marshmallows with s’mores in the summertime or hot chocolate in the winter. Psychologists, however, think of the afformentioned experiment on the question of delayed gratification and the difficulty of attaining it.
The Marshmallow Experiment
In the late 1960s, researchers at Stanford University first conducted the marshmallow experiment. In this experiment, children were given the option between:
- being give a marshmallow right then
- two marshmallows if they were willing to wait 15 minutes and not eat the marshmallow in front of them
Most children said that they would wait to be given the second marshmallow, yet out of the 600 children participants, around 2/3 gave in to the temptation of the sweet treat. Only 1/3 of the participants waited the whole 15 minutes and received their second snack.
The findings of the experiment don’t end there. 20 years after the initial experiment, the researchers reviewed the original participants and found those who wait for the second marshmallow and showed the self-control to delay gratification were more successful in nearly every measurable aspect of their lives. This wasn’t just a coincidence as the same test has been performed numerous times yielding the same results.
A World of Immediate Gratification
Delaying gratification is hard. There is overwhelming evidence that shows humans aren’t wired to de disciplined be it kids with sweets, teens setting a regular sleep schedule, or investors maintaining a long-term strategy. It is difficult to avoid instant gratification in a society of Amazon Prime, instant coffee machines, and our always-connected smartphones. We’re no longer in the days of waiting for dial-up internet to connect.
The same need for instant gratification also applies in finance. The stories of diversification or long-term investing are fun, but what’s far more exciting are the explanations of why stocks fell the other day, how this morning’s economic data is going to affect interest rates this quarter, and what oil prices are going to do over the next year. The ubiquitous explanation of these events compel activity and complicate the somewhat simple and successful process of long-term investing.
The Evidence of Discipline
A lot of investors understand the benefits of long-term discipline, but as we learned, few practice it. Take into consideration value investing, the basic concept of favoring cheap investments over more expensive ones. Historical evidence shows that value investing often yields high returns than growing investing does. The evidence to support this “value premium” is considerable and exists in almost all markets and all long-term periods.
Furthermore, along with empirical evidence, there are multiple rational explanations for the outperformance of value stocks. A noteworthy one is investors prefer good stories of fast-growing investments and tend to overestimate how long that growth will persist. This results in them overpaying for growth relative to value.
Nevertheless, some investors succumb to immediate gratification and abandon ship on value stocks during their inescapable times of underperformance. Look at the most extreme period of value stock underperformance and the best-known and arguably most successful value investor, Warren Buffet. During the late 19909s, the internet completely morphed the economic landscape, and old, boring stocks were kicked to the curb. Value investing seemed to be a thing of the past, and Buffet’s stock, Berkshire Hathaway, lost over 1/2 of its value over the course of 22 months until February 2000. While these stocks decreased, growth stocks more than doubled.
People began doubting Buffet due to his age and his ability to adapt to this new market landscape, but of course, we know that to not be true. It was just one of the inevitable periods of underperformance and long-term investors who maintained an evidence-based discipline were greatly rewarded.
Déjà vu All Over Again?
Remember the comments from David Rolfe, a longtime Berkshire Hathaway shareholder and chief investment officer at Wedgewood Partners? Mr. Rolfe told his clients he had sold the firm’s stake in Berkshire Hathaway due to frustrations with Buffet’s huge cash position:
“Warren Buffet’s cash hoard of +$125 billion continues to be a considerable impediment of growth, rather than our previous hard expectations of a valuable all option on opportunity in the hands of one of the most elite caspital allocators extant.”
Consider, Berkshire Hathaway’s cash went from nearly $23 billion in 2009 to $147 billion in 2020. Buffet increased his cash position by 6x over a decade that experienced the longest bull market on record. To quote Buffet, “The stock market is a highly efficient mechanism for the transfer of wealth from the impatient to the patient.”
Save your Marshmallows
Till the end of time, children are going to eat their marshmallows before the 15 minutes is up, and investors are inevitably going to pay too much attention to current noise. Just as the kids who exhibit stronger self-discipline end up more successful, so will the disciplined investor. To talk about your portfolio and how to stay more disciplined with it drop us a line here at NEST Financial. We’d love to talk more on the topic with you.
