GMO Quarterly Letter | 3Q 2017

Career Risk and Stalin’s Pension Fund: Investing in a World of Overpriced Assets

With a Single Reasonably-Priced Asset

Also in this edition of the GMO Quarterly Letter

Executive Summary

Inside GMO there are three different views on whether and how rapidly the market will revert to its pre-1998 normal: James Montier feels it will be business as usual and revert within 7 years. Ben Inker also holds out for a 7 year period, but includes a 33% chance it will revert to a higher average valuation (the “Hell” scenario). I believe that the reversion on valuations will take 20 years, and that profit margins will probably only revert two-thirds of the way back to the old normal. All three outcomes are quite possible. This creates a difficult investment challenge. My proposition, though, is that there is an optimal investment for all three outcomes: a heavy emphasis on Emerging Market (EM) equities, especially relative to the US.

The next difficulty lies in deciding how much to emphasize this investment, which is perceived as riskier than most, and can of course fail. I firmly believe that asset allocation advice should not be offered unless you are willing, on rare occasions, to make major bets and accept a big dose of career and business risk. Otherwise asset allocation should be indexed. In contrast, a traditional, diversified 65% stock/35% fixed income portfolio today, designed to control typical 2-year career risk, I believe is likely to produce a return over 10 years in the 1% to 3% real range – a near disaster for pension funds. To concentrate the mind, I fantasize about managing Stalin’s pension fund where the penalty for failing to deliver 4.5% real per year over 10 years is death. I believe only a very large investment in EM equities will give an excellent chance of survival.

Be brave. It is only at extreme times like this that asset allocation can earn its keep with non-traditional behavior. I believe a conventional diversified approach is nearly certain to fail.

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Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending December 2017, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
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