Investors Behaving Badly

Posted on May 9, 2008 at 10:37 AM PST by

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.

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 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
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

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.”

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

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

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

“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

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

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

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

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

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 fact 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
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 likely to be English majors.