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Seth Klarman: The Pressure to Perform Is What Undermines Investors

Why is the record of investing professionals so bad? By some measures, up to 95% of finance professionals fail to beat the market over time. Why is this? Some people like to explain these lopsided figures by saying the few that outperform have better data, or more complex strategies, or more computing power.

But this ignores the fact that some of the most successful investors operate strategies that are quite simple, with little reliance on technology. Warren Buffett (Trades, Portfolio) does not have a computer in his office. So perhaps there is something else at play. In a 2007 speech he gave at the Massachusetts Institute of Technology, Seth Klarman (Trades, Portfolio) discussed what that "something else" might be.

Targets cause problems

Klarman believes the pressure to produce results is what ultimately undermines many money managers. This pressure is obviously created by clients, but a lot of it comes from within the industry too, with managers being compared with their peers every day. He points out that this short-termism distracts from the focus on long-term returns. Setting specific targets can also force managers from taking on more risk than they should:

"Some investors target specific returns. A pension fund, for example, might target an 8% annual gain. But if the blend of asset classes under consideration fails to offer that expected result, they can only lower the goal--which for most is a non-starter--or invest in something riskier than they would like. Pressure to keep up with a peer group renders decision-making even more difficult. Then, there is no assurance whatsoever that the incurrence of greater risk will actually result in the achievement of higher return. The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk."

If money managers had more latitude to do their jobs without having to chase returns, perhaps their long-term returns would be better. Klarman pointed to the experience of his own Baupost Group, which he said focuses on not losing money, rather than hitting some benchmark. In a similar vein, Buffett has often said that subsidiaries of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) are not required to provide earnings forecasts, as he believes doing so encourages corner-cutting and short-term thinking.

Klarman calls the pressure to focus on the next quarter above all else "the gun to the head of everyone":

"Ironically, it is this very short-term pressure to produce--this gun to the head of everyone--that encourages excessive risk taking which manifests itself in several ways: a fully invested posture at all times; for many, the use of significant and even extreme leverage; and a market-centric orientation that makes it difficult to stand apart from the crowd and take a long-term perspective".

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.