Why the lauded economist’s unconventional views on active management and long term investment could unlock the potential of a modern investment strategy.
You have probably heard of John Maynard Keynes. He is widely regarded as one of the greatest economists of the past century and his legacy has been long-lasting. In 1999, Time magazine included him among its Most Important People of the Century, and more recently his investment record and views have been cited by George Soros, Warren Buffet and David Swensen, the acclaimed head of Yale University’s endowment funds.
In fact, Keynes’ success as an investor is well-established. Both as a private investor and when managing investments for King’s College, Cambridge, Keynes achieved impressive results, with the actively managed portion of his portfolio beating the British common stock index by an average of more than five per cent per year between 1921 and his death in 1946.
Dr David Chambers
But what is less well known is that this success came only after he completely changed his strategy following his disappointing performance during the late 1920s. The lessons he learned when things went wrong and the principles upon which his strategy was based could both be very useful to retail and institutional investors today, says Dr David Chambers, Reader in Finance at Cambridge Judge Business School and Academic Director of the Newton Centre for Endowment Asset Management (CEAM). He, along with his Cambridge Judge colleague Professor Elroy Dimson (Chairman of CEAM), have studied details of his trading records from the King’s College archive.
Their research shows that Keynes changed his approach in part because of a recognition that he had failed to time transactions effectively as markets rose and fell. “In the early 1930s he moved away from a top-down approach that sought to use economics and industrial statistics to predict overall market movements,” Chambers explains. “Instead he became a bottom-up stock picker, taking long term and often surprising positions in small to medium stocks that he believed possessed ‘intrinsic value’.”
Keynes was not the only investor to take this view – during the early 1920s, US economist and investor Benjamin Graham was advocating analysis of corporate financial statements to identify undervalued stocks. But Chambers and Dimson believe Keynes reached his own conclusions independently.
One important benefit of a strategy based on taking long term positions is reduced portfolio turnover. “That’s highly relevant to investors today: one way you can increase returns is to reduce trading costs, really thinking hard about whether it’s necessary to transact,” says Chambers.
Professor Elroy Dimson
He and Dimson suggest that a comparison of the way Keynes reacted to falling markets in the late 1920s and late 1930s illustrates the evolution of his approach. During the year following the 1929 Wall Street Crash, Keynes, having suffered heavy losses, sold a fifth of his UK equity holdings and switched investments into government bonds – an understandable and conventional response. But when the market declined sharply again in August 1937, he instead made some modest additions to his UK equity positions and maintained his overall equity allocation at above 90 per cent.
Keynes’ strategy was also informed to some extent by his personal network, including senior managers within some of the companies in which he invested. This has led some to suggest he may have benefitted from insider trading, which was not illegal at the time. But Chambers and Dimson argue that even if Keynes did make use of what today would be regarded as private information when monitoring his favourite stocks, he did not do so for short term gain.
Meanwhile, he also spent some of the 1920s and 1930s trying to establish if it was possible to use economic fundamentals to inform profitable currency trading – but largely trading with his own money. “Keynes believed you could forecast currencies based on economic fundamentals, but I’m not sure he still believed it by the end,” says Chambers. “What we’ve found is that most of the time, while he got the direction of the market right, he didn’t always get the timing right, so had to withstand periods of substantial losses.” This experience is consistent with Keynes’ record when trading stocks.
If Keynes were trading today, say Chambers and Dimson, his strategy would still be based on active management, perhaps using private markets, such as private equity, private debt and infrastructure, as well as equities. He would probably also favour passive investment strategies in some situations. “Keynes was a stock picker, but he also pointed out what you should do if you have no particular insight, which is to be a passive investor,” says Dimson.
Keynes was unconventional from the start when working for King’s: first by persuading the College to let him diversify some of its investments away from real estate, seeking instead to unlock the value he believed the right equity investments could deliver.
Above all, Keynes’ investment approach sought to defy convention. He stated that a long-term investor should be “eccentric, unconventional and rash in the eyes of average opinion” in his magnum opus The General Theory (1936).
“One of the things his investment behaviour clearly illustrates is that there are rewards to being unconventional and not following the crowd,” says Chambers. “However, even those investors able to take a long-term view often do not have the resolve to do so, and it is easier for them to hide in the crowd.”
As Keynes himself famously wrote of such investors: “Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.”