Keynes the Investor

To the extent he is known to those outside his discipline, the economist John Maynard Keynes is probably known as just that, an economist. That his ideas have come and gone and come around again, if not entirely unknown among practitioners of finance, is at least regarded as tangential to the day-to-day responsibilities of investors. However, the economist’s theories about investors and markets did not simply come from an academic observing the game from the stands but from one of the players. Indeed, Keynes himself had a somewhat long investing career, and a quite respectable one at that.

John Maynard Keynes

The British economist John Maynard Keynes is, quite rightly, more well regarded for his novel ideas about economics than his novel approach to investing. However, only his thoughts and success in the former are well-known, or at least as well-known as the ideas of economists and political philosophers can be. As it happens though, the famed economist of the early-to-mid-20th century was quite active in the financial markets he often described and derided. For twenty-five years, from 1921 to 1946, he managed the endowment of his alma mater, Kings College, Cambridge. When he took over management of the college’s portfolio, it was tilted heavily towards real estate investments, as it had been since the school was founded in the 15th century. Once in charge though, Keynes shifted the portfolio towards common stock, then a rare asset class for an endowment to be invested in.

What is more, this was hardly his only investment role. Indeed, the economist also managed money for the National Mutual Life Assurance Society, where he served as Chairman, and the Provincial Insurance Company, in which he was a director. Keynes was also a co-founder and director of the Independent Investment Company, a closed-end investment fund. However, his investment record at Kings College is the most well documented, all the better since it was there where he had the longest record and the most autonomy.

Market Psychology

Of course, one could hardly expect Keynes’s investing style to be so independent from his economic theories so as to be unrelated. Indeed, an understanding of market psychology influenced both his economic views and his investing decisions and it may very well have been the latter that came first. What the economist had to say about what he termed the ‘animal spirits’ in his most well-known work, The General Theory of Employment, Interest and Money, may have been conceived by his own experiences in financial markets, which started well before he published the book.

“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” – John Maynard Keynes in the General Theory

With respect to the animal spirits, Keynes believed market instability, and by consequence changes in economic activity, was largely driven by spontaneous optimism and pessimism. Actual changes in conditions, or even expectations of a purely quantitative sort, were only secondary drivers of the rapid turns of market cycles. This concept was briefly explained in, but critically important to, Keynes’s economic ideas as expressed in his General Theory, published in 1936, halfway through his investment career. Keynes’s theories about the animal spirits are illustrated by examples he uses to explain them, many of which come straight out of the stock market.

Investment Philosophy

Especially in the last two-thirds of Keynes’s investing career, he focused on profiting off the irrationalities of other market participants. For example, Keynes the investor believed liquidity was overrated and thus favored illiquid investments. In his General Theory, the economist noted that the market often “forgets that there is no such thing as liquidity of investment for the community as a whole”. If everyone wanted out at a certain time, even government bonds would become illiquid.

As such, believing investors charged an excessive premium for holding less liquid investments than was their due, Keynes allocated a disproportionate amount of his portfolio to stocks over bonds, which had previously been preferred by endowments. This preference did not extend to all illiquid assets though. Keynes was skeptical of real estate, for example, insisting that investors underestimated its volatility simply because they did not receive regular quotes on its value. If they did, he argued they would likely sell in fear and perhaps only then, at reduced prices, would the investment be worthwhile.

Today, Keynes is often regarded as an early follower of the school of value investing. Value investing, as the best-known practitioner Warren Buffett would explain, fundamentally consists of buying stock in companies whose intrinsic value is well above their market value. Often, this means buying the stock of companies being ignored by the mainstream investor; it requires some amount of contrarianism, something the Cambridge economist certainly possessed.

Keynes’s portfolio included many of the British equity market’s highest dividend payers. This was particularly true in the 1930s and 1940s, when the dividend yield on the portion of the Kings College endowment he managed was 1.5% and 1.8% above the overall market, respectively. Some of these companies had such high dividend yields because their share prices were depressed but the economist had no problem buying the shares others disregarded. Keynes appreciated the benefits reaped by a contrarian in the stock market and was fine with concentrated positions in companies, so long as he also believed their intrinsic value was not adequately reflected by their share price.

“When you find any one agreeing with you, change your mind. When I can persuade the Board of my Insurance Company to buy a share, that, I am learning from experience, is the right moment for selling it.” – John Maynard Keynes on the stock market, 1937

The economist was not only interested in long-term stock investing. In his early days managing the endowment, he traded frequently and he was also involved in currency and commodities speculation. But in doing so, he still focused more on fundamentals than technical indicators. In his currency bets, Keynes favored spotting misalignments between a currency’s value and the issuing country’s macroeconomic and political situation. Even when it came to gold, Keynes, ever the skeptic of monetary standards based on gold, was nonetheless bullish on the metal as nations like South Africa, France, and Holland devalued their currencies in the 1930s as the global economy weakened.

Returns

According to Elroy Dimson of London Business School and now co-director for the Centre for Endowment Asset Management at Cambridge, Keynes’s investment returns were quite good. His Kings College portfolio earned an annual return of 16% over the period from 1922 to 1946, the year of his death. This was not bad for a period that included Britain’s economic stagnation of the 1920s, the Great Depression, and the Second World War. Indeed, the market return during this period would have been closer to 10%. While Keynes’s portfolio was more concentrated, Dimson concludes that even on a risk-adjusted basis, his investment returns were impressive.

It was not always like this though. Keynes’s early performance, namely during the 1920s, was much weaker, and the economist was often too early on some trades. For example, his bets against the German mark in 1920 moved substantially against him before turning profitable. The same was true for later short positions against the French franc and Dutch guilder when he anticipated their abandonment of the gold standard in 1934, two years too soon.

Essentially, Keynes’s early top-down ‘macro’ driven analysis had its shortfalls. True to his strengths, the economist initially used monetary and economic indicators to make investment decisions. However, these signals often coincided with market movements in the direction expected given the news. In other words, by buying stocks when the economy seemed to turn for the better, Keynes would have been buying them on the way up, and then selling when conditions deteriorated, which occurred alongside market contractions. Keynes was trying to time the market but had access to no special information. It was not as though the approach was not sensible but it was one hardly built for outperformance. In fact, in his early years at the head of the Kings College fund, he underperformed greatly.

To say his early returns were disappointing would be to put it generously. By 1930, his portfolio at King College had lagged the broad British stock market by a cumulative 13% since inception and by 40% over just the previous five years. This was mostly owed to low-single-digit returns during an otherwise booming market in 1927 and 1928. It was not out of inactivity that he underperformed so greatly. During the 1920s, annual portfolio turnover, the ratio of securities traded over the size of the fund, regularly exceeded 50%. This high turnover, in an era of meaningful trading expenses, no doubt helped reduce Keynes’s returns during that decade.

The economist’s initial top-down approach to investing consisted of digesting macroeconomic forces and making investment decisions on their basis, as he had with the currency trades mentioned earlier. This proved difficult though because it relied on market timing and anticipating the animal spirits, something Keynes was no better at than anyone else. After his first decade though, he changed his strategy, rather than master predicting the animal spirits, he would disregard them.

“… professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors …” – John Maynard Keynes in the General Theory

As Keynes’s approach changed, annual portfolio turnover, which was over 50% on average in the 1920s, fell below 15% in the 1940s. The economist-investor’s gradual shift towards contrarian longer-term investing and away from market timing coincided with vastly improved returns. Even compared to the British stock market as a whole, Keynes’s investment performance had improved after the 1920s and was strongest in the mid-1930s and mid-1940s, periods of already strong market performance.

It might be argued that Keynes’s portfolio was simply a ‘high-beta’ portfolio, one more sensitive to market movements, and so simply magnified the market’s strength without adding ‘alpha’, out-performance due to skill at picking investments. However, the risk-adjusted interpretations of Keynes’s returns by Dimson et. al. dispute this view. It is also worth noting that some of Keynes’s best years came during periods of negative market performance, specifically 1932 and 1934. At the same time, the industry distribution of his investments seemed significantly at odds with the broader market composition. Therefore, it would be hard to argue that his investing strategy at all mimicked the broader market.

Lesson

Whatever his success in it, Keynes had much to say about investing. It isn’t his returns that warrant the most interest perhaps, but rather how his own participation in financial markets may have shaped his economic ideas. It is worth noting that his most famous work and magnum opus, the General Theory, was written after he had amassed years of experience investing. What he has to say about investors and speculators was not therefore coming from a recluse academic but from an active participant in the very markets he scrutinized.

In some other ways, he was also well ahead of his time. Recall that being so active in equity markets, or in currencies and commodities for that matter, was quite unusual for university endowments. Today, however, such an approach has become more common as foundations and endowments invest heavily in common stock and alternative investments. Many became famous decades later for ‘pioneering’ this shift, but the strategy was already decades old at Kings College, all due to its most famous economic thinker.

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