Sunday, June 15, 2008

Why Investors Fail

Why Investors Fail

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.

[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. 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 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.

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 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." (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.

[ Normxxx Here:  Moral: If you find a fund you really like (e.g., with a good 10 year track record and little or no turnover of top management), wait until just after that off year (or at least until after they show signs of recovery, once you figure out the reason for their bad result), and then invest!  ]

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!


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:

"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 worked for five or ten years but then failed 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 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:

"For those who are not satisfied with simply beating the average over any given period, consider this: if an investor can consistently achieve only 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 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.

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." This is part of a whole cycle of denial, anxiety, and depression. As with any difficult situation, we first deny there is a problem, and then get anxious as the problem does not go away or gets worse. Then we go into depression because we didn't take action earlier, and hope that something will come along and rescue us from the situation.

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." Basically, this means we attach too much importance to day-to-day events, rather than looking at the big picture. Behavioral psychologists have determined that the fear of loss is the most important emotional factor in investor behavior.

Like investors chasing the latest hot fund, a news story or a bad day in the market becomes enough for the investor to extrapolate the recent event as the new trend which will stretch far into the future. In reality, most events are unimportant, and have little effect on the overall economy.

3. "Cognitive dissonance— The inability to change your opinion after new evidence contradicts your baseline assumption." Dissonance, whether musical or emotional, is uncomfortable. It is often easier to ignore the event or fact producing the dissonance rather than deal with it. We tell ourselves it is not meaningful, and go on our way. This is especially easy if our view is the accepted view. "Herd mentality" is a big force in the market.

4. "Overconfidence— People's tendency to overestimate their abilities relative to individuals possessing greater expertise." Professionals beat amateurs
99% of the time. The other 1% is luck. The famous Clint Eastwood line, "Do you feel lucky, punk? Well, do you?" comes to mind.

In sports, most of us know when we are outclassed. But as investors, we somehow think we can beat the pros, will always be in the top
10%, and any time we win it is because of our skills and good judgement. It is bad luck when we lose.

Commodity brokers know that the best customers are those who strike it rich in their first few trades. They are now convinced they possess the gift or the Holy Grail of trading systems. These are the people who will spend all their money trying to duplicate their initial success, in an effort to validate their obvious abilities. They also generate large commissions for their brokers.

5. "Anchoring— People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs." If you believe that NASDAQ stocks are the place to be, that becomes your anchor. No matter what new information comes your way, you are anchored in your belief. Your experience in 1999 shows you were right.

As Lord Keynes said so eloquently when forced to acknowledge a shift in a previous position he had taken,
"Sir, the facts have changed, and when the facts change, I change. What do you do, sir?"

We expect the current trend to continue forever, and forget that all trends eventually regress to the mean. That is why investors still plunge into index funds, believing that stocks will go up over the long term. They think long term is two years. They do not understand that it will take years— maybe even a decade— for the process of reversion to the mean to complete its work.

6. "Representativeness— The tendency of people to see patterns within random events." Eric Frye did a great tongue-in-cheek article in The Daily Reckoning, a daily investment letter ( He documented that each time Sports Illustrated used a model for the cover of their swimsuit issue who came from a new country that had never been represented on the cover before, the stock market of that country had always risen over a four-year period. This year, it is time to buy Argentinian stocks. Frye evidently did not do a correlation study on the size of the swimsuit against the eventual rise in the market. However, I am sure some statistician with more time on his hands than I do will brave that analysis.

Investors assume that items with a few similar traits are likely to be associated or identical, and start to see a pattern. McQuill gives us an example. Suzy is an English and environmental studies major. Most people, when asked if it is more likely that Suzy will become a librarian or work in the financial services industry, will choose librarian.
They will be wrong. There are vastly more workers in the financial industry than there are librarians. Statistically, the probability is that she will work in the financial services industry, even though librarians are most likely to be English majors.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

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