sa·pi·ent | ˈsāpēənt | (adjective): full of knowledge, wise, discerning; having judgment gained through experience.

John Maynard Keynes image from The Economist 

 

Keynes and the “Fail Conventionally” Syndrome

Posted by Kevin Means, CFA on Apr 25, 2019 4:22:23 PM

Keynes was a very successful investor as well as a renowned economist.  Much of his success can be attributed to his willingness to depart from conventional wisdom even in the face of intense criticism and the risk of failure.  Investors can learn something from him.      

John Maynard Keynes 

John Maynard Keynes is widely regarded as the most important economist of the 20th century.  He is best known for his magnum opus, The General Theory of Employment, Interest and Money (1936).  He departed from the classical economists of his day who believed that if left alone, markets would quickly adjust to economic shocks.  Keynes advocated a much larger role for government, including deficit spending when necessary to raise demand and employment. 

In addition to his economic writing, Keynes was also a very successful investor, ultimately.  I say “ultimately” because he was wiped out twice.  His investment philosophy evolved dramatically over the years from one of pure speculation (mostly in commodities and currencies) to one of investing in the stocks of a few companies which he believed had sound long-term intrinsic value.  

Keynes managed money not only for himself and his Bloomsbury friends, but also for King’s College, Cambridge and the National Mutual and Provincial Insurance companies.  He became the bursar of King’s College in 1924 and decided to concentrate all of the resources in his charge into a fund called the Chest.  In the face of much criticism, he invested the Chest Fund aggressively, concentrating his holdings in stocks rather than bonds and properties, which was more the norm at the time.  Starting with £30,000 in 1924, by the time of his death in 1946 the Fund had grown to £380,000, a compound growth of over 12% per year.  Over the same time period, the British stock market fell by 15%!

The “Fail Conventionally” Syndrome

Although most of his writing was focused on macroeconomics, Keynes did share some of his thoughts on investing at times, including in chapter 12 of The General Theory.  Here is one famous quote:

“It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally” (emphasis added).

The “fail conventionally” syndrome is what I call the proclivity of most investors to seek the comfort of the crowd when making key, strategic, long-term investment decisions.  For example, why is it that the vast majority of investors end up with a stock/bond asset mix that is not too far from the conventional 60/40 ratio?  Is it the end result of hours of painstaking research?  Not likely. 

Or why do most portfolios concentrate so heavily on local stocks and bonds and significantly under-weight foreign stocks and bonds?  There are good reasons for a “home market bias” but most of it has more to do with psychology than a sophisticated analysis of expected returns, risks, and costs.

And why do very few investors make meaningful allocations to alternative strategies that might diversify their stock market risk, such as global macro, managed futures, or merger arbitrage?  Might it be because those investments “sound risky” (even though they are actually low-risk), are unusual, and therefore feel uncomfortable?

Social Proofs and Maverick Risk

Humans are social animals.  Eons of evolution has ingrained in us the sense that to go it alone is to risk being eaten by the sabre tooth tiger.  We have an innate desire to belong to our group.  Intuitively, we know that it will help to conform to group norms. 

Social proof is one type of conformity.  It involves looking to the behavior of others when we are unsure of the correct behavior ourselves.  Maverick risk is the risk of being different.  We do not like that.  It is risky being different.  To paraphrase Keynes, in the eyes of the conventional crowd, being different and right makes you a screwball, not a genius, and being different and wrong makes you an idiot and a pariah.  

Principals and Agents

Maverick risk is particularly threatening to agents.  An agent is someone acting on behalf of an owner, the principal.  The owner of an investment (the principal) bears the risks and participates in the benefits of that investment.  An agent usually does not.  An agent’s incentives are often quite different than a principal’s incentives, leading to what economists call “the agency problem.”  An agent wants to keep his job, advance in his career, maximize his fee or commission income, etc.  Principals often hire agents because they are perceived as “experts.”  Agents are particularly keen to protect their reputation.  As Keynes said, they would typically rather fail conventionally than succeed unconventionally.

Unfortunately for the principals, this often leads to very sub-optimal investing.       

Successful Investing Requires Independent Thinking

In my opinion, successful investing means maximizing the probability of achieving your goals.  That may or may not involve active management or the attempt to outperform an index.  However, even an investor who implements only with index funds must make some important active decisions that require some independent thinking.  How much will I allocate to various asset classes, including stocks and bonds?  How much in domestic stocks and bonds vs. international stocks and bonds?  Should I invest only in broad index funds, or does my return outlook, risk tolerance, tax situation, or investment horizon mean that I am different enough from the average investor to require some modifications to the broad indexes I might otherwise use to invest?

For example, an investor in a high tax bracket, particularly one in a high-tax state, may want to allocate a significant portion of their domestic bonds to municipal bonds rather than simply allocate 100% to a conventional core bond fund.  An investor with a safe, stable job may be able to take more stock market risk than someone whose career is more uncertain.  The former perhaps should have more allocated to stocks than the conventional 60/40 stock/bond mix, and the latter may want to have less.  An investor concerned about rising interest rates would want to have less interest rate risk than average in their bond portfolio and may even want to consider some alternative investments (maverick risk!) as bond substitutes to diversify stock market risk.

In closing, I will return to Keynes’ own words.  Shortly after the publication of The General Theory, Keynes wrote about investing that “it is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority. When you find any one agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is the right moment for selling it.”        

 

 

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