BONDS OR REMBRANDTS?

This post was inspired by the ever thought provoking Charlie Munger:

“Stocks are valued partly like bonds, based on roughly rational projections of producing future cash. But they are also valued partly like Rembrandt paintings, purchased mostly because their prices have gone up in the past."

As usual the crux of it comes down to the subtlety in phrasing used by Mr. Munger here: ‘roughly rational’. Bonds are easier to price because their cashflows are stable and the risk, mainly default risk, is easier to measure. Rarely does the reward profile fall far out of wack from the level of risk taken because in Bonds you know most of what you need to know. Of course even in bond markets strange things happen: see 2008.

Equities, however, have an information asymmetry which make them significantly more difficult to ‘roughly rationally’ project. This uncertainty and unpredictability in future cash flows leads to much higher levels of risk in Equities than in Bonds. Therefore to some extent they will always trade at least partially like Rembrandts.

This is also the reason why Modern Portfolio Theory and Efficient Market Hypothesis are robust academic insights but fail often and frequently in the real world. Just this year alone saw many names drop 50% or more only to blow past their all time highs less than a month later. That should never happen in perfectly efficient markets. And it is for this reason that market opportunities, with patience, are frequently found.