TFTF

Why Investors Fail

March 28, 2002

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 today we will look at the reasons why they fail at investing. Maybe this week's e-letter will give you some ways to help them. And as we conclude, 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.

As a corollary to investigating why investors fail, we will also look at why some investors succeed, and some do spectacularly well. I predict that much of what I am writing today will make some of you mad, and for some, it will hit too close to home. What I am trying to do today is to give you an "aha!" moment: that insight which helps you understand a part of the mysteries of the marketplace. As usual, we will look at a number of seemingly random ideas and concepts, and then see what conclusions we can draw. Let's jump in.

Why Investors Fail

The Financial Research Corporation released a study recently 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.

"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." (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.

The study also showed something I have observed anecdotally, for which there is 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 upon 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: Absolute returns cannot be guaranteed with any confidence. There is 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. 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 is extremely unlikely to repeat as #1 in an objective with more than a few funds. It is 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." (FRC)

This is in line with the study I cited a few months ago 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 chances of you picking a stock that will be in the top 25% of all companies every year for the next ten years is 50 to 1 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely they are to have an off year. Being on top for extended periods 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 over-priced? His staff 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 they will do so for the next five. The actual results for the last 50 years show the likelihood of that happening are small.

Lean Mean Reversion Machine

Let me give you the conclusions from the chapter on economic cycles from my next book (called Absolute Returns ) that I keep promising to finish and post on the web. Over time, stock market returns are basically inflation plus GDP growth plus dividends. There is always reversion to the mean, or coming back to trend. Besides being a statistical necessity, it is an investment reality. There are a number of economic, psychological and historical factors which are actually the cause of this reversion to the mean. It is worthy of note that near the end of every cycle, either bull or bear, the majority of analysts will tell you that "this time it is different" and give a parade of reasons why. They are always wrong. They are wrong because they are looking at irrelevant data or because their income depends upon a continuation of the current market trends. As an example, in the 80's and 90's, gold bugs continued to believe that gold was coming back. 20 years is a long time to be patient, and maybe this year gold will rise from the dead. Today, market analysts see (or pray for) a continued bull market forever and ever, world without end. Amen. We began a long term secular bear market in 2000, which is likely to last for at least a decade. Here the word secular means "cycle". (Secula is Latin for cycle). That does not mean we are due for a crash. It could just be a decade of sideways and broad market swings. Or we could see a steep sell-off at some point. I can make a strong case for each of the various scenarios. We can use economic data to predict trends, but specific events are in the realm of crystal balls and fortune tellers.

Tails You Lose, Heads I Win

I have recently read 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." He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he does a very thorough treatment. While I have read many of his points, he gives us several totally new (to me) concepts. 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 principals. I need to acknowledge his contribution to much of this next section.

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 7 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!

Ergodicity

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. The 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.)

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)

Don't despair yet. There is hope. I will discuss a few principles for discerning between the managers who are lucky and those who are good in a moment. But first, we need to know what we are up against in our search.

I've Got A Secret System

If you go to an investment conference or read a magazine, you are bombarded with opportunities to buy a software package which will show you how to day trade and make 1,000% a year. For $5,000 you can buy an "exclusive" letter (Just you and a thousand other readers, and their friends and clients) which will give you a hot options or stock tip. You will be shown winning trades which make 100% or more in a short time. You, too, can use this simple tested method to enrich yourself. Act Now. (Add 6.95 for shipping and handling.)

Full disclosure here: I am a manager of investment managers. I look for investment managers and funds for clients. Most of what I look at are in the private fund or hedge fund world. I get to see the track records and talk with the creme de la creme of the investment universe - the true Masters of the Universe. These are the managers available only to accredited investors ($1,000,000 or more net worth.) This world is growing leaps and bounds as more and more sophisticated investors and institutions are looking at these managers now that mutual funds and stock managers are having bad years.

None - not one - nada - zippo - zero of the best managers the world can deliver consistent results that you read about in these ads. The best offshore fund in the world for the five years ending in 2000 did about 30% a year. You can't get into it. But in 2001 they were flat.

Steve Cohen can deliver some spectacular returns and has for almost 20 years. He has been closed to new money for years. But even this legend can't put up numbers like I see in the ads.

Here's the reality. If you could make 20% a year steady, in five years - ten at the most-- you will be managing all the money you can run. Trust me, the money will find you. You will charge a 2% management fee and 20% of the profits. On $1 billion, that amounts to $60 million dollars in fees. That's every year, of course. Why would you sell a system that could do 20% a year?

Once everyone knows about a system, it won't work like it has in the past. One of the problems I wrestle with every day is trying to figure out which investment styles may be at the end of their run. Every dog has its day in the sun. The trick is to figure out when the sun is setting.

Now, saying that, there are exceptions. I get (or used to get, Rob) an email every day from a reader. Now I get weekly summaries. In it were his trades for the next day. He is uncanny. He is compounding at something like 300% year, with around 75% of his trades working. I called him and discussed his system. I was interested in starting a fund. The problem is that his style would top out (he thinks) about $1,000,000. After that, he would not be able to get enough trades. But he does nicely for himself. That means you could only have a fund for about $250,000 and let it grow, and of course there would be a thousand other problems.

Could he sell his system? You bet. But the minute he did, it would stop working.

I have looked at a manager in the Boston area. He has about the best sector rotation track record I have seen for the last five years. I called him up, wondering if I could place money with him. He said no. He will be at his maximum level, about $15 million, soon and then will have to close. I work with another manager who will soon close his fund at $250 million. That is all his style of investing can manage.

Every style has its limits, whether it is $1 million or $250 million or $1 billion. Just because you have a successful operation with 25 stores doesn't mean you can expand to 500.

There are physical limits to everything and every system. Knowing your limits, and the limits of your investment managers, is critical. Many of the spectacular blow-ups have been from managers who do not understand the limits of their style.

Take the Janus 20 fund. This is a fund that focuses on the 20 "best" companies, mostly tech. They had an incredible record, and grew to manage tens of billions of dollars. This was good for the managers, as annual bonuses grew each year as well. They told their investors the secret to their success was doing their homework and being expert on analyzing companies. They were bottom's up value investors, looking for growth potential, and boy were you lucky to have found them.

They were a bus load of investors on their way to a train wreck. No one seemed to think the party would end. But when it did, they had no exit strategy or even the ability to exit. If you own $5 billion in Cisco, you are not a shareholder. You are a partner. You are stuck. If you try to get out, the market will soon get the word that Janus is bailing, and the shorts will eat your lunch.

In hindsight, their incredible track record was less brilliant investing and more simply was participation in the largest investment bubble in history, with no exit strategy. They got heads 8 times in a row.

Smaller investors and funds could have taken the exact same approach, but because they were smaller would have the ability to exit.

Analyzing a Fund

OK, here is a confession. There are thousands of funds and managers for me to investigate. When I go to my databases, I do a sort for high Sharpe ratios, low standard deviation, low betas and yes, good returns. Returns do matter. Then I begin to analyze.

There are lots of questions to ask. First, I want to know "Why do you make money?" Then I ask, "How do you make money?" Then I want to know how much risk they are taking and the last question is, "How much money do you make?" (Besides the normal few score due diligence questions. For a list of those, see the

/pdf/amg.pdf
Accredited Investor's Membership Guide.

Janus 20, to pick on them again, made money because they were in a bull market. Period. They lost money because they were in a bear market and they were a long only fund. Some "market timers" made good money in the last bull market, but lost their touch as we went into more volatile bear markets. The irony is that their systems need bull markets to be successful, but it was not until we were in a bear market that we knew that. Unfortunately, this was at precisely the time you wanted a market timer to work for you. So you have to find out what market they are trading in and look at their performance in light of that. That simple process will often tell you whether you are dealing with good managers or lucky traders.

Of course, if you understand "Why?" they made money in the past, you have to ask yourself are the conditions likely to remain in place for them to continue to make money in the future?

If they can give you a good reason for why they make money in their niche, then you start to look at how they do it. What is their system? Do they really have one or are they flying by the seat of their pants? Every manager has a proprietary trading system. You start with that as a given. There are lots of questions and analysis that is crucial at this point.

As an aside, if a manager tells me about his unique trend-following program, I end the interview. To me, a trend-following system is just a system that hasn't blown up yet. In my experience, the percentage of trend-following systems which have experienced train wrecks after spectacular ten year track records is way too high. I simply do not have the skills to figure out which ones are going to still be flipping heads in ten years, and which ones are going to crash, so I just leave that arena to smarter managers than myself.

I am consumed with wanting to know how a manager controls risk. I understand that you can't make above market returns without risk. But not all risk is apparent from past performance. (The blow-up by Long Term Capital comes to mind. Right up until the end, they were as steady as you could find. Then: Ka-Boom.) All styles will lose money from time to time. I want my risk to reward to be reasonable and controlled.

After you understand the above, looking at a track record can make sense. Did the manager add value in the markets they are in? Did he give us "Alpha," that bit of profit over what we could expect blind dogs to make in his market trading style? (That is not the technical definition for Alpha, but it is more understandable.)

There are a lot of manages and funds who do deliver "Alpha". Mostly, they are managers who have found a niche to work in, and stick to their knitting. They manage their risks well. They have good operational staff and administration. It takes a lot of work (and some luck) to find them.

Becoming a Top 20% Investor

Over 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 out-perform 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 study above 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 awhile, but reversion to the mean will catch up.

Here is the very sad truth. The majority of successful investors in any given period are simply lucky. They have come up with heads five times in a row. 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 their401k 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 by simply 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 yet, 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 under-performed. Avoiding short-term under-performance is the key to long-term out-performance.

"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 is 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 of this e-letter that past performance was statistically useful for 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 returns.

Likewise, funds which do well in international investments tend to stay in the top brackets. That is because the skill set and learning cost for international fund management is rare. 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 so cyclical, so that what goes up one year or even longer in a bubble market will not do well the next.

My true belief is that investors who look for absolute returns in this decade will be the winners. Steady as she goes, mate.

That's enough for today. It is time to go if I am going to catch my plane.

A quick plug for my Accredited Investor E-letter. I write a monthly letter on private offerings and hedge funds. Since under the SEC rules, I can only write or talk to accredited investors about these funds, I have to limit the circulation to those whose net worth is $1,000,000 or more, or who have made $200,000 per year for the past two years. If you are in that category, and would like to receive that letter, simply hit reply and email me a note and I will send you a simple form for you to fax or mail back to me.

Lastly, it is Easter. Many of you will be going to church this Sunday. As you do, if you think of it remember my friend Teri Griffis. She is a mother of seven who has just been diagnosed with liver cancer. She and her husband David (with whom I grew up) are missionaries with Youth With A Mission and could use your prayers. Roughly 500,000 people will get this e-letter this week, so that could be a lot of prayers. They work.

I will be in Southern California in late April, speaking at an investment conference. I will be glad to meet with clients and prospective clients. If you are interested, please drop me a note. And I do read all your comments, criticisms and suggestions, even if I can't answer them every time.

And now, I will hit the send button and rush to the airport (with my bride) for a long weekend in Sedona. I wish you a great weekend as well.

Your more grateful than ever for His Blessings analyst,

John Mauldin

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