Why Investors Fail
Consistency is hard to come by.
This week I'm in South Africa and am not as connected as I would like to be due to meetings and slow Internet, so I'm going to look at some material from my book, Bull's Eye Investing, which I think is more pertinent than ever.
Since lately there has been rather large growth in the readership, there are many for whom this material will be fresh. When I originally wrote much of this, the markets were coming out of the bear phase of 2001-2. I'm adding a few comments in [brackets]. I trust you'll find value as we look at the problems that investors face in the struggle to maximize portfolio value.
In this chapter we'll look at the reasons why people 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'll 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've 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.
"The oft-repeated legal disclosure that past performance is no guarantee of future results is true at two levels:
1. Absolute returns cannot be guaranteed with any confidence. There's too much variability for each broad asset class over multiple time periods. Stocks in general may provide 5-10% returns during one decade, 10-20% during the next decade and then return back to the 5-10% range.
2. Absolute rankings also cannot be predicted with any certainty. This is caused by too much relative variability within specific investment objectives. #1 funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking (i.e. #1 vs. top-decile [top 10%] vs. top quartile [top 25%] vs. top half), the more unlikely it is that a fund can repeat at that level. It's extremely unlikely to repeat as #1 in an objective with more than a few funds. It's very difficult to repeat in the top decile, challenging to repeat in the top quartile, and roughly a coin toss to repeat in the top half." (Financial Research Center)
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.
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 very 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 man 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'll be managing a billion dollars. They will absolutely believe they've 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 predict which one will blow up. It will be the one in which you invest!
In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something 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 dismal results, 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 most statistics are based upon only look 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're shown is a result of randomness. You're 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.)
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