By John Mauldin | 15 June 2008
Like the children from Lake Wobegon, I am sure all my readers are above-average investors. But I am also sure you have friends who are not, so in this chapter we will look at the reasons why they fail at investing, and how they should analyze funds and determine risk. Hopefully this will give you some ways to help them. I will show you a simple way to put yourself in the top 20% of investors. This should make it easier to go to family reunions and listen to your brother-in-law's stories.
A big part of successful Bull's Eye Investing is simply avoiding the mistakes that the large majority of investors make. I can give you all the techniques, trading tips, fund recommendations, forecasts, and so on; but you must still keep away from the patterns which are typical of failed investors.
What I want to do in this section is give you an "aha!" moment: that insight which helps you understand something about the mysteries of the marketplace. We will look at a number of seemingly random ideas and concepts, and then see what conclusions we can draw. Let's jump in.
Investors Behaving Badly
The Financial Research Corporation released a study prior to the [2001-02] bear market which showed that the average mutual fund's three-year return was 10.92%, while the average investor in those same periods gained only 8.7%. The reason was simple: investors were chasing the hot sectors and funds. If you study just the last three years, my guess is those numbers will be worse. "The study found that the current average holding period was around 2.9 years for a typical investor, which is significantly shorter than the 5.5-year holding period of just five years ago.
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I have seen numerous studies similar to the one above. They all show the same thing: that the average investor does not get average performance. Many studies show statistics which are much worse. The study also showed something I had observed anecdotally, for which there was no evidence. Past performance was a good predictor of future relative performance in the fixed-income markets and international equity (stock) funds, but there was no statistically significant way to rely on past performance in the domestic (US) stock equity mutual funds. I will comment on why I believe this is so later on.
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This is in line with a study from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances. The chances of you picking a stock today that will be in the top 25% of all companies every year for the next ten years are 1 in 50 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for an extended period of time is an extremely difficult feat.
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Yet, what is the basis for most stock analysts' predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is overpriced? His staff and board will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that it will do so for the next five. The actual results for the last 50 years show the likelihood of that happening is exceedingly small.
Tails You Lose, Heads I Win
I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb, called Fooled by Randomness. The sub-title is "The Hidden Role of Chance in the Markets and in Life." I consider it essential reading for all investors, and would go so far as to say that you should not invest in anything without reading this book. He looks at the role of chance in the marketplace. Taleb is a mathematician and stock market 'quant' who is obsessed with the role of chance, and he gives us a very thorough treatment. He also has a gift for expressing complex statistical problems in a very understandable manner. I intend to read the last half of this book at least once a year to remind me of some of these principles. Let's look at just a few of his thoughts.
Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven't discerned. Their seven-figure salaries prove it. The next year, 157 of them will blow up! With my power of analysis, I can even predict which ones will blow up. It will be the very ones in which you invest!
Ergodicity
In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something [a dirty little secret] called "survivorship bias." Let's say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had such dismal results, they were unable to attract money, and simply folded. If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases for most market statistics are based upon only looking at the survivors. This sets up false expectations for investors, as it raises the average.
Taleb gave me an insight for which I will always be grateful. He points out that because of chance and survivorship bias, investors are only likely to find out about the winners. Indeed, who goes around trying to sell you the losers? The likelihood of being shown an investment or a stock which has flipped heads five times in a row are very high. But chances are, that hot investment you are shown is a result of randomness. You are much more likely to have success hunting on your own. The exception, of course, would be my clients… (Note to regulators: that last sentence is a literary device called a weak attempt at humor. It is not meant to be taken literally.)
That brings us to the principle of Ergodicity, "...namely, that time will eliminate the annoying effects of randomness. Looking forward, in spite of the fact that these managers were profitable in the past five years, we expect them to break even in any future time period. They will fare no better than those of the initial cohort who failed earlier in the exercise. Ah, the long term." (Taleb)
Why Investors Fail
While the professionals typically explain their problems in very creative ways, the mistakes that most of us make are much more mundane. First and foremost is chasing performance. Study after study shows the average investor does much worse than the average mutual fund, as they switch from their poorly performing fund to the latest hot fund, just as it turns down. Mark Finn of Vantage Consulting has spent years analyzing trading systems. He is a consultant to large pension funds and Fortune 500 companies. He is one of the more astute analysts of trading systems, managers, and funds that I know.
He has put more start-up managers into business than perhaps anyone in the fund management world. He has a gift for finding new talent and deciding if their "ideas" have investment merit. He has a team of certifiable mathematical geniuses working for him. They have access to the best pattern-recognition software available. They have run price data through every conceivable program, and come away with this conclusion:
Past performance is not indicative of future results.
Actually, Mark says it more bluntly: Past performance is pretty much worthless when it comes to trying to figure out the future. The best use of past performance is to determine how a manager behaved in a particular set of prior circumstances. Yet investors read that past performance is not indicative of future results, and then promptly ignore it. It is like reading statements at McDonalds that coffee is hot. We don't pay attention. Chasing the latest hot fund usually means you are now in a fund that is close to its peak, and will soon top out. Generally that is shortly after you invest in it.
What do Finn and his team tell us does work? Fundamentals, fundamentals, fundamentals [[this enables you to identify those (frequently stodgy) stocks that will do well over the long run— you can then use TA to determine entry points (and exit points, if you also want to use a small percentage for (play) 'trading'): normxxx]]. As they look at scores of managers each year, the common thread for success is how they incorporate some set of fundamental analysis patterns into their systems. This is consistent with work done by Dr. Gary Hirst, one of my favorite analysts and fund managers. In 1991, he began to look at technical analysis. He spent huge sums on computers and programming, analyzing a variety of technical analysis systems. Let me quote him on the results of his research:
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Becoming A Top 20% Investor
Over very long periods of time, the average stock will grow at about 7% a year, which is GDP growth plus dividends plus inflation. This is logical when you think about it. How could all the companies in the country grow faster than the total economy? Some companies will grow faster than others, of course, but the average will be the above. There are numerous studies which demonstrate this. That means roughly 50% of the companies will outperform the average and 50% will lag. The same is true for investors. By definition, 50% of you will not achieve even the average, which is pretty abysmal as noted; 10% of you will do really well; and 1% will get rich through investing. You will be the lucky ones who found Microsoft in 1982. You will tell yourself it was your ability. Most of us assign our good fortune to native skill and our losses to bad luck.
But we all try to be in the top 10%. Oh, how we try. The FRC study cited at the beginning shows how most of us look for success, and then get in, only to have gotten in at the top. In fact, trying to be in the top 10% or 20% is statistically one of the ways we find ourselves getting below-average returns over time. We might be successful for a while, but reversion to the mean will catch up. Here is the very sad truth. The majority of investors in the top 10-20% in any given period are simply lucky. They have come up with heads five times in a row. Their ship came in. There are some good investors who actually do it with sweat and work, but they are [far less than] the majority. Want to make someone angry? Tell a manager that his (or her) fabulous track record appears to be random luck or that they simply caught a wave and rode it. Then duck.
By the way, is it luck or skill when an individual goes to work for a start-up company and is given stock in their 401k which grows at 10,000%? How many individuals work for companies where that didn't happen, or their stock options blew up (Enron)? I happen to lean toward Grace, rather than luck or skill, as an explanation; but this is not a theological treatise. Read The Millionaire Next Door. Most [the vast majority of] millionaires make their money in business and/or by saving lots of money [[rather slowly, in usually stodgy (but reliable) investments: normxxx]] and living frugally. Very few make it simply by investing skill alone. Odds are that you will not be that person.
But I can tell you how to get in the top 20%. Or better, I will let FRC tell you, because they do it so well:
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That's it. You simply have to be only slightly better than average each year to be in the top 20% at the end of the race. It is a whole lot easier to figure out how to do that than chase the top ten funds. Of course, you could get lucky (or Blessed) and actually get one of the top ten funds [[but then give it all back and then some in some subsequent year— such funds are NOT likely to prove very consistent in the long run…: normxxx]]. But recognize it for what it is and thank God (or your luck if you are agnostic) for His blessings.
I should point out that it takes a lot of work just to be in the top 50% consistently. But it can be done. I don't see it as much as I would like, but I do see it.
Investing in a stock or a fund should not be like going to Vegas. When you put money with a manager or a fund, you should think as if you are investing in their management company. Ask yourself, "Is this someone I want to be in business with? Do I want him running my company? Does this company have a reasonable business objective? What is their edge that makes me think they will be above average? What is the reason I would think they could discern the difference between randomness and good management?"
When I meet a manager, and all he wants to do is talk about his track record, I find a way to quickly close the conversation. When they tell me they are trying to make the most they can, I head for the door. Maybe they are the real deal, but my experience says the odds are against it. It's about not settling for being mediocre. Statistics and experience tell us that simply being consistently above average is damn hard work. When a fund is the number one fund, that is [always] random. They had a good run or a good idea and it worked [[i.e., everything fell into place! : normxxx]]. Are they likely to repeat? No.
But being in the top 50% every year for ten years? That is NOT random. That is skill. That type of consistent solid management is what you should be looking for.
By the way, I mentioned at the beginning that past performance was statistically useful for ascertaining relative performance of certain types of funds like bond funds and international funds. In the fixed-income markets (bonds) everyone is dealing with the same instruments. Funds with lower overhead and skilled traders who aggressively watch their trading costs have an edge. That management skill shows up in consistently above-average relative returns. Likewise, funds which do well in international investments tend to stay in the top brackets. That is because the skill set for international fund management is rare and the learning cost is high. In that world, local knowledge of the markets clearly adds value.
But in the US stock market, everybody knows everything everybody else does. Past performance is a very bad predictor of future results. If a fund does well in one year, it is possibly because they took some extra risks to do so, and eventually those risks will bite them and their investors. Maybe they were lucky and had two of their biggest holdings really go through the roof. Finding those monster winners is a hard thing to do for several years in a row. Plus, the US stock market is very cyclical, so that what goes up one year or even longer in a bubble market will not do well the next.
Investors Behaving Badly
Gavin McQuill of the Financial Research Center sent me his rather brilliant $5,000 report called "Investors Behaving Badly." He was the author and he did a great job. I read it over one weekend, and refer to it again from time to time. Earlier we looked at a report which showed that over the last decade investors chased the hot mutual funds. The higher the markets went, the less likely it was that they would buy and hold. Investors consistently bought high and sold low. Investors made significantly less than the average mutual fund did.
McQuill focused on six emotions that cause investors to make these mistakes. You should read these and see whether some of them are familiar.
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Normxxx
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