Why Investors Fail

May 24, 2012

Like all 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 letter 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 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 here 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.

 

[While the research below is from a few years ago, recent studies show exactly the same, if not worse, results. Investors in general are not getting any better.]

"Many investors are purchasing funds based on past performance, usually when the fund is at or near its peak. For example, $91 billion of new cash flowed into funds just after they experienced their "best performing" quarter. In contrast, only $6.5 billion in new money flowed into funds after their worst performing quarter." (from a newsletter by Dunham and Associates)

 

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.

 

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 reaching its peak, and will soon top out. Generally that is shortly after you invest.

What do Finn and his team tell us does work? Fundamentals, fundamentals, fundamentals. 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:

"I had heard about technical analysis and chart patterns, and looking at this stuff I would say, what kind of voodoo is this? I was very, very skeptical that technical analysis had value. So I used the computers to check it out, and what I learned was that there was, in fact, no useful reality there. Statistically and mathematically all these tools -- stochastics, RSI, chart patterns, Elliot Wave, and so on -- just don't work. If you code any of these rigorously into a computer and test them they produce no statistical basis for making money; they're just wishful thinking. But I did find one thing that worked. In fact almost all technical analysis can be reduced to this one thing, though most people don't realize it: the distributions of returns are not normal; they are skewed and have "fat tails." In other words, markets do produce profitable trends. Sure, I found things that work over the short term, systems that work for five or ten years but then fail miserably. Everything you made, you gave back. Over the long term, trends are where the money is."

 

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 the average; 10% of you will do really well; and 1% will get rich through investing. You will be the lucky ones who find 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 not 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 millionaires make their money in business and/or by saving lots of money 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:

"For those who are not satisfied with simply beating the average over any given period, consider this: if an investor can consistently achieve slightly better than average returns each year over a 10-15 year period, then cumulatively over the full period they are likely to do better than roughly 80% or more of their peers. They may never have discovered a fund that ranked #1 over a subsequent one- or three-year period. That "failure," however, is more than offset by their having avoided options that dramatically underperformed. Avoiding short-term underperformance is the key to long-term outperformance."

 

For those that are looking to find a new method of discerning the top ten funds for 2002, this study will prove frustrating. There are no magic short-cut solutions, and we urge our readers to abandon the illusive and ultimately counterproductive search for them. For those who are willing to restrain their short-term passions, embrace the virtue of being only slightly better than average, and wait for the benefits of this approach to compound into something much better..."

 

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 get one of the top ten funds. 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 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 random. They had a good run or a good idea and it worked. 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.

 

1. Fear of Regret - An inability to accept that you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon.

2. Myopic loss aversion (a.k.a. as 'short-sightedness') - A fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective.

3. Cognitive dissonance - The inability to change your opinion after new evidence contradicts your baseline assumption.

4. Overconfidence - People's tendency to overestimate their abilities relative to individuals possessing greater expertise.

5. Anchoring - People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs.

6. Representativeness - The tendency of people to see patterns within random events.

 

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore

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