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Since the birth of the modern stock market in 1602, the pendulum of the investment culture has moved from a return focus to a risk focus and back. One way to tame the ‘animal spirits’ of professional investors is the Prudent Man Rule from 1830, which can serve as a useful anchor for investors.
As portfolio managers of Robeco Conservative Equities, we are not only passionate about research-based investing, but also about financial history. We therefore want to place our role as money managers in a deep historical perspective.
The first IPO in history was the issue of shares of the Dutch East India Company (Vereenigde Oost-Indische Compagnie or VOC) in 1602. A few years later, VOC stocks started being actively traded on the Amsterdam exchange.
The first real stock market crash occurred in 1672 when the Dutch Republic was at war with England and France. Half a century later, the market was in bubble territory. In 1720, the Dutch Republic experienced a wave of IPOs of companies with highly speculative business models. Investors participating in this ‘Windhandel’ or ‘thin air trading’ lost most of their investment when the bubble burst later that year. Only one company of the Dutch 1720 IPO bubble survived until today, the Rotterdam-based insurance company ASR.
In the same year, Europe experienced its first wave of simultaneous stock market crashes. In England, the South Sea stock bubble burst, while in France, the overvalued stocks of the Mississippi Company crashed, leaving many newly-made millionaires disillusioned. Both state-owned companies had creatively converted government debt into tradable shares. After the 1720 bubble, speculators and brokers were mocked in poems and theater plays, in which their greediness and losses were ridiculed.
We skip the stock market crises of 1772, 1792 and many 19th century crashes with 1873 being the biggest. The 20th century saw markets crashing in 1901 and 1907, followed by the famous 1929 crash. But at this point it is fair to conclude that boom and bust cycles are as old as stock markets themselves.
Today, after the Global Financial Crises, we witness similar responses from society. For example, ‘The economics of good and evil’, a book by Sedláček, is translated into a popular theater play in Prague. It is a strong plea for economics being a moral science, with an important ethical responsibility for society. Today, in popular books and on social media ‘banksters’ and speculators are ridiculed as they were in the 18th century.
A more modern boom-bust cycle is the period of the ‘Go-Go years’ of the 1960s. It marks the rise of the performance culture with a new generation of star mutual fund managers. The old, experienced and conservative fund managers who had experienced the 1930s and war time period were overshadowed by a new breed of younger fund managers that only had one goal: short-term outperformance. The traditional virtues of conservatism, diversification and stewardship were replaced by return chasing, speculation and salesmanship. 1 Capital preservation went out of fashion, beating the market became the new name of the game.
The risky growth funds kept on delivering high performance, riding on the back of a strong general bull market, until sentiment decidedly turned around in 1969. Markets plummeted, liquidity dried up and more than 100 brokerage firms were near bankruptcy. The Dow Jones Index, which was composed of industrial blue chip companies, fell 35% from peak to through in the 1968-1970 period. For the popular risky growth stocks, the decline was far more dramatic with losses up to 86%. High-performance funds turned out to be high-beta funds after all.
This Go-Go years episode marks the beginning of a change in our investment industry. At the beginning of the 20th century most money was managed by asset owners themselves, but at the beginning of the 21st century, most money is managed by professional investors that are focused and incentivized on relative performance. When investing becomes a relative game, the incentives change and might not be aligned anymore between asset managers and their clients.
Bubbles, bursts and high stock market turnover are caused by what Keynes described as ‘animal spirits’ in his book “The General Theory of Employment, Interest and Money”. Related to this, in the popular book “Thinking Fast and Slow” Daniel Kahneman distinguishes two neuro systems. System 1 is our intuitive instinct (animal spirits), and System 2 is the rational side of decision-making. Our instincts are related to overconfidence, high turnover and poorer investment results.
An important lesson from investment history is that investors’ animal spirits are hard to tame, especially in stock markets. This is why we like a rules-based approach to harvest the low-risk anomaly, as it both profits from market behavior and tames our own animal spirits.
In 1830, the Massachusetts judge Samuel Putnam composed a list of prudent investments for trustees. It has come to be known as the ‘Prudent Man Rule’. The court stated that:
“All that can be required of a trustee is that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of the capital to be invested…”
With all the wisdom of four centuries of investing, we can conclude that not much has changed in financial markets. It seems animal spirits are still hard to tame, just as they were in 1720.
We do not believe that our human nature will change quickly. What is constant over time is the cycle in the investment culture, driven by human behavior. The market still highly rewards funds with recent 3-year strong performance, which is a clear incentive for asset gatherers to increase risk, like in the Go-Go years. Also regulators have not created incentives for fund managers to decrease risk. For example, the Dutch regulatory framework for pension funds considers defensive stocks to be more risky than a market-weighted index and Solvency II does not differentiate between low-risk and high-risk stocks.
This brings us to our daily jobs as fund managers. In today’s benchmark-focused investment industry, we cherish the Prudent Man Rule of 1830. The three virtues mentioned in the original Prudent Man Rule of 1830 serve us as a useful benchmark in our Conservative Equity strategies: ‘Considering the probable safety of capital’, ’Considering the probable income of capital’ and ‘Not in regard to speculation’.
We are happy to see that over the past years we have witnessed a shift in preferences by some asset owners: more focus on capital protection, income and little trading. This shift has contributed to the growth in assets in Conservative Equities from less than EUR 50 million in 2006 to over EUR 10 billion as of 2016. Still, we are aware that animal spirits and agency problems are driving markets. Capital preservation is now more fashionable, but aiming for the highest returns will become the name of the game again somewhere in the future. We therefore continue to write research papers and manage expectations of our clients. We believe that if client philosophy and our philosophy match, this helps to build trust and patience. This alignment is crucial for long-term success. We look forward to see whether we have succeeded in achieving this goal, say in 2026.
1 See for example Fox (2009)
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