{"id":81,"date":"2008-05-09T10:37:26","date_gmt":"2008-05-09T17:37:26","guid":{"rendered":"http:\/\/marketriders\/weblog\/?p=81"},"modified":"2016-12-21T07:33:05","modified_gmt":"2016-12-21T15:33:05","slug":"investors-behaving-badly","status":"publish","type":"post","link":"https:\/\/www.marketriders.com\/investing\/investors-behaving-badly\/","title":{"rendered":"Investors Behaving Badly"},"content":{"rendered":"

Investors Behaving Badly<\/span><\/h3>\n

The Financial Research Corporation released a study prior to the [2001-02]
\nbear market which showed that the average mutual fund’s three-year return was
\n10.92%, while the average investor in those same periods gained only 8.7%. The
\nreason was simple: investors were chasing the hot sectors and funds. <\/span><\/p>\n

If you study just the last three years, my guess is those numbers will be
\nworse. “The study found that the current average holding period was around 2.9
\nyears for a typical investor, which is significantly shorter than the 5.5-year
\nholding period of just five years ago. <\/span><\/p>\n

[While the research below is from a few years ago, recent studies show
\nexactly the same, if not worse, results. Investors in general are not getting
\nany better.]<\/span><\/p>\n

“Many investors are purchasing funds based on past performance, usually when
\nthe fund is at or near its peak. For example, $91 billion of new cash flowed
\ninto funds just after they experienced their “best performing” quarter. In
\ncontrast, only $6.5 billion in new money flowed into funds after their worst
\nperforming quarter.” (from a newsletter by Dunham and Associates)<\/span><\/p>\n

I have seen numerous studies similar to the one above. They all show the same
\nthing: that the average investor does not get average performance. Many studies
\nshow statistics which are much worse.<\/span><\/p>\n

The study also showed something I had observed anecdotally, for which there
\nwas no evidence. Past performance was a good predictor of future
\nrelative<\/em><\/strong> performance in the fixed-income markets and international
\nequity (stock) funds, but there was no statistically significant way to rely on
\npast performance in the domestic (US) stock equity mutual funds. I will comment
\non why I believe this is so later on.<\/span><\/p>\n

“The oft-repeated legal disclosure that past performance is no guarantee of
\nfuture results is true at two levels:<\/span><\/p>\n

1. Absolute returns <\/strong>cannot be guaranteed with any confidence. There is
\ntoo much variability for each broad asset class over multiple time periods.
\nStocks in general may provide 5-10% returns during one decade, 10-20% during the
\nnext decade, and then return back to the 5-10% range.<\/span><\/p>\n

2. Absolute rankings <\/strong>also cannot be predicted with any certainty. This
\nis caused by too much relative variability within specific investment
\nobjectives. #1 funds can regress to the average or fall far below the average
\nover subsequent periods, replaced by funds that may have had very low rankings
\nat the start. The higher the ranking and the more narrowly you define that
\nranking (i.e. #1 vs. top-decile [top 10%] vs. top quartile [top 25%] vs. top
\nhalf), the more unlikely it is that a fund can repeat at that level. It is
\nextremely unlikely to repeat as #1 in an objective with more than a few funds.
\nIt is very difficult to repeat in the top decile, challenging to repeat in the
\ntop quartile, and roughly a coin toss to repeat in the top half.” (Financial
\nResearch Center)<\/span><\/p>\n

This is in line with a study from the National Bureau of Economic Research.
\nOnly a very small percentage of companies can show merely above-average earnings
\ngrowth for 10 years in a row. The percentage is not more than you would expect
\nfrom simply random circumstances. <\/span><\/p>\n

The chances of you picking a stock today that will be in the top 25% of all
\ncompanies every year for the next ten years are 1 in 50 or worse. In fact, the
\nlonger a company shows positive earnings growth and outstanding performance, the
\nmore likely it is to have an off year. Being on top for an extended period of
\ntime is an extremely difficult feat.<\/span><\/p>\n

Yet, what is the basis for most stock analysts’ predictions? Past performance
\nand the optimistic projections of a management that gets compensated with stock
\noptions. What CEO will tell you his stock is overpriced? His staff and board
\nwill kill him, as their options will be worthless. Analysts make the fatally
\nflawed assumption that because a company has grown 25% a year for five years
\nthat it will do so for the next five. The actual results for the last 50 years
\nshow the likelihood of that happening is very small.<\/span><\/p>\n

Tails You Lose, Heads I Win<\/span><\/h3>\n

I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb,
\ncalled Fooled by Randomness.<\/em> The sub-title is “The Hidden Role of Chance
\nin the Markets and in Life.” I consider it essential reading for all investors,
\nand would go so far as to say that you should not invest in anything without
\nreading this book. He looks at the role of chance in the marketplace. Taleb is a
\nman who is obsessed with the role of chance, and he gives us a very thorough
\ntreatment. He also has a gift for expressing complex statistical problems in a
\nvery understandable manner. I intend to read the last half of this book at least
\nonce a year to remind me of some of these principles. Let’s look at just a few
\nof his thoughts.<\/span><\/p>\n

Assume you have 10,000 people who flip a coin once a year. After five years,
\nyou will have 313 people who have come up with heads five times in a row. If you
\nput suits on them and sit them in glass offices, call them a mutual or a hedge
\nfund, they will be managing a billion dollars. They will absolutely believe they
\nhave figured out the secret to investing that all the other losers haven’t
\ndiscerned. Their seven-figure salaries prove it.<\/span><\/p>\n

The next year, 157 of them will blow up. With my power of analysis, I can
\npredict which one will blow up. It will be the one in which you invest!<\/span><\/p>\n

Ergodicity<\/span><\/h3>\n

In the mutual fund and hedge fund world, one of the continual issues of
\nreporting returns is something called “survivorship bias.” Let’s say you start
\nwith a universe of 1,000 funds. After five years, only 800 of those funds are
\nstill in business. The other 200 had dismal results, were unable to attract
\nmoney, and simply folded.<\/span><\/p>\n

If you look at the annual returns of the 800 funds, you get one average
\nnumber. But if you add in the returns of the 200 failures, the average return is
\nmuch lower. The databases most statistics are based upon only look at the
\nsurvivors. This sets up false expectations for investors, as it raises the
\naverage.<\/span><\/p>\n

Taleb gave me an insight for which I will always be grateful. He points out
\nthat because of chance and survivorship bias, investors are only likely to find
\nout about the winners. Indeed, who goes around trying to sell you the losers?
\nThe likelihood of being shown an investment or a stock which has flipped heads
\nfive times in a row are very high. But chances are, that hot investment you are
\nshown is a result of randomness. You are much more likely to have success
\nhunting on your own. The exception, of course, would be my clients. (Note to
\nregulators: that last sentence is a literary device called a weak attempt at
\nhumor. It is not meant to be taken literally.) <\/span><\/p>\n

That brings us to the principle of Ergodicity, “…namely, that time will
\neliminate the annoying effects of randomness. Looking forward, in spite of the
\nfact that these managers were profitable in the past five years, we expect them
\nto break even in any future time period. They will fare no better than those of
\nthe initial cohort who failed earlier in the exercise. Ah, the long term.”
\n(Taleb)<\/span><\/p>\n

Why Investors Fail <\/span><\/h3>\n

While the professionals typically explain their problems in very creative
\nways, the mistakes that most of us make are much more mundane. First and
\nforemost is chasing performance. Study after study shows the average investor
\ndoes much worse than the average mutual fund, as they switch from their poorly
\nperforming fund to the latest hot fund, just as it turns down. <\/span><\/p>\n

Mark Finn of Vantage Consulting has spent years analyzing trading systems. He
\nis a consultant to large pension funds and Fortune 500 companies. He is one of
\nthe more astute analysts of trading systems, managers, and funds that I know. He
\nhas put more start-up managers into business than perhaps anyone in the fund
\nmanagement world. He has a gift for finding new talent and deciding if their
\n“ideas” have investment merit.<\/span><\/p>\n

He has a team of certifiable mathematical geniuses working for him. They have
\naccess to the best pattern-recognition software available. They have run price
\ndata through every conceivable program, and come away with this conclusion: <\/span><\/p>\n

Past performance is not indicative of future results. <\/em><\/span><\/p>\n

Actually, Mark says it more bluntly: Past performance is pretty much
\nworthless when it comes to trying to figure out the future. The best use of past
\nperformance is to determine how a manager behaved in a particular set of prior
\ncircumstances. <\/span><\/p>\n

Yet investors read that past performance is not indicative of future results,
\nand then promptly ignore it. It is like reading statements at McDonalds that
\ncoffee is hot. We don’t pay attention. <\/span><\/p>\n

Chasing the latest hot fund usually means you are now in a fund that is close
\nto reaching its peak, and will soon top out. Generally that is shortly after you
\ninvest. <\/span><\/p>\n

What do Finn and his team tell us does work? Fundamentals, fundamentals,
\nfundamentals. As they look at scores of managers each year, the common thread
\nfor success is how they incorporate some set of fundamental analysis patterns
\ninto their systems. <\/span><\/p>\n

This is consistent with work done by Dr. Gary Hirst, one of my favorite
\nanalysts and fund managers. In 1991, he began to look at technical analysis. He
\nspent huge sums on computers and programming, analyzing a variety of technical
\nanalysis systems. Let me quote him on the results of his research:<\/span><\/p>\n

“I had heard about technical analysis and chart patterns, and looking at this
\nstuff I would say, what kind of voodoo is this? I was very, very skeptical that
\ntechnical analysis had value. So I used the computers to check it out, and what
\nI learned was that there was, in fact, no useful reality there. Statistically
\nand mathematically all these tools — stochastics, RSI, chart patterns, Elliot
\nWave, and so on — just don’t work. If you code any of these rigorously into a
\ncomputer and test them they produce no statistical basis for making money;
\nthey’re just wishful thinking. But I did find one thing that worked. In fact
\nalmost all technical analysis can be reduced to this one thing, though most
\npeople don’t realize it: the distributions of returns are not normal; they are
\nskewed and have “fat tails.” In other words, markets do produce profitable
\ntrends. Sure, I found things that work over the short term, systems that work
\nfor five or ten years but then fail miserably. Everything you made, you gave
\nback. Over the long term, trends are where the money is.”<\/span><\/p>\n

Becoming a Top 20% Investor<\/span><\/h3>\n

Over very long periods of time, the average stock will grow at about 7% a
\nyear, which is GDP growth plus dividends plus inflation. This is logical when
\nyou think about it. How could all the companies in the country grow faster than
\nthe total economy? Some companies will grow faster than others, of course, but
\nthe average will be the above. There are numerous studies which demonstrate
\nthis. That means roughly 50% of the companies will outperform the average and
\n50% will lag.<\/span><\/p>\n

The same is true for investors. By definition, 50% of you will not achieve
\nthe average; 10% of you will do really well; and 1% will get rich through
\ninvesting. You will be the lucky ones who find Microsoft in 1982. You will tell
\nyourself it was your ability. Most of us assign our good fortune to native skill
\nand our losses to bad luck.<\/span><\/p>\n

But we all try to be in the top 10%. Oh, how we try. The FRC study cited at
\nthe beginning shows how most of us look for success, and then get in, only to
\nhave gotten in at the top. In fact, trying to be in the top 10% or 20% is
\nstatistically one of the ways we find ourselves getting below-average returns
\nover time. We might be successful for a while, but reversion to the mean will
\ncatch up.<\/span><\/p>\n

Here is the very sad truth. The majority of investors in the top 10-20% in
\nany given period are simply lucky. They have come up with heads five times in a
\nrow. Their ship came in. There are some good investors who actually do it with
\nsweat and work, but they are not the majority. Want to make someone angry? Tell
\na manager that his (or her) fabulous track record appears to be random luck or
\nthat they simply caught a wave and rode it. Then duck.<\/span><\/p>\n

By the way, is it luck or skill when an individual goes to work for a
\nstart-up company and is given stock in their 401k which grows at 10,000%? How
\nmany individuals work for companies where that didn’t happen, or their stock
\noptions blew up (Enron)? I happen to lean toward Grace, rather than luck or
\nskill, as an explanation; but this is not a theological treatise.<\/span><\/p>\n

Read The Millionaire Next Door.<\/em> Most millionaires make their money in
\nbusiness and\/or by saving lots of money and living frugally. Very few make it
\nsimply by investing skill alone. Odds are that you will not be that person.<\/span><\/p>\n

But I can tell you how to get in the top 20%. Or better, I will let FRC tell
\nyou, because they do it so well:<\/span><\/p>\n

“For those who are not satisfied with simply beating the average over any
\ngiven period, consider this: if an investor can consistently achieve slightly
\nbetter than average returns each year over a 10-15 year period, then
\ncumulatively over the full period they are likely to do better than roughly 80%
\nor more of their peers. <\/strong>They may never have discovered a fund that ranked #1
\nover a subsequent one- or three-year period. That “failure,” however, is more
\nthan offset by their having avoided options that dramatically underperformed.
\nAvoiding short-term underperformance is the key to long-term
\noutperformance.<\/strong><\/span><\/p>\n

“For those that are looking to find a new method of discerning the top ten
\nfunds for 2002, this study will prove frustrating. There are no magic short-cut
\nsolutions, and we urge our readers to abandon the illusive and ultimately
\ncounterproductive search for them. For those who are willing to restrain their
\nshort-term passions, embrace the virtue of being only slightly better than
\naverage, and wait for the benefits of this approach to compound into something
\nmuch better…”<\/span><\/p>\n

That’s it. You simply have to be only slightly better than average each year
\nto be in the top 20% at the end of the race. It is a whole lot easier to figure
\nout how to do that than chase the top ten funds.<\/span><\/p>\n

Of course, you could get lucky (or Blessed) and get one of the top ten funds.
\nBut recognize it for what it is and thank God (or your luck if you are agnostic)
\nfor His blessings.<\/span><\/p>\n

I should point out that it takes a lot of work to be in the top 50%
\nconsistently. But it can be done. I don’t see it as much as I would like, but I
\ndo see it. <\/span><\/p>\n

Investing in a stock or a fund should not be like going to Vegas. When you
\nput money with a manager or a fund, you should think as if you are investing in
\ntheir management company. Ask yourself, “Is this someone I want to be in
\nbusiness with? Do I want him running my company? Does this company have a
\nreasonable business objective? What is their edge that makes me think they will
\nbe above average? What is the reason I would think they could discern the
\ndifference between randomness and good management?”<\/span><\/p>\n

When I meet a manager, and all he wants to do is talk about his track record,
\nI find a way to quickly close the conversation. When they tell me they are
\ntrying to make the most they can, I head for the door. Maybe they are the real
\ndeal, but my experience says the odds are against it.<\/span><\/p>\n

It’s about not settling for being mediocre. Statistics and experience tell us
\nthat simply being consistently above average is damn hard work. When a fund is
\nthe number one fund, that is random. They had a good run or a good idea and it
\nworked. Are they likely to repeat? No.<\/span><\/p>\n

But being in the top 50% every year for ten years? That is NOT random. That
\nis skill. That type of consistent solid management is what you should be looking
\nfor.<\/span><\/p>\n

By the way, I mentioned at the beginning that past performance was
\nstatistically useful for ascertaining relative performance of certain types of
\nfunds like bond funds and international funds. In the fixed-income markets
\n(bonds) everyone is dealing with the same instruments. Funds with lower overhead
\nand skilled traders who aggressively watch their trading costs have an edge.
\nThat management skill shows up in consistently above-average relative
\nreturns.<\/span><\/p>\n

Likewise, funds which do well in international investments tend to stay in
\nthe top brackets. That is because the skill set for international fund
\nmanagement is rare and the learning cost is high. In that world, local knowledge
\nof the markets clearly adds value.<\/span><\/p>\n

But in the US stock market, everybody knows everything everybody else does.
\nPast performance is a very bad predictor of future results. If a fund does well
\nin one year, it is possibly because they took some extra risks to do so, and
\neventually those risks will bite them and their investors. Maybe they were lucky
\nand had two of their biggest holdings really go through the roof. Finding those
\nmonster winners is a hard thing to do for several years in a row. Plus, the US
\nstock market is very cyclical, so that what goes up one year or even longer in a
\nbubble market will not do well the next.<\/span><\/p>\n

Investors Behaving Badly<\/span><\/h3>\n

Gavin McQuill of the Financial Research Center sent me his rather brilliant
\n$5,000 report called “Investors Behaving Badly.” He was the author and he did a
\ngreat job. I read it over one weekend, and refer to it again from time to
\ntime.<\/span><\/p>\n

Earlier we looked at a report which showed that over the last decade
\ninvestors chased the hot mutual funds. The higher the markets went, the less
\nlikely it was that they would buy and hold. Investors consistently bought high
\nand sold low. Investors made significantly less than the average mutual fund
\ndid.<\/span><\/p>\n

McQuill focused on six emotions that cause investors to make these mistakes.
\nYou should read these and see whether some of them are familiar.<\/span><\/p>\n

1. “Fear of Regret – An inability to accept that you’ve made a wrong
\ndecision, which leads to holding onto losers too long or selling winners too
\nsoon.” This is part of a whole cycle of denial, anxiety, and depression. As with
\nany difficult situation, we first deny there is a problem, and then get anxious
\nas the problem does not go away or gets worse. Then we go into depression
\nbecause we didn’t take action earlier, and hope that something will come along
\nand rescue us from the situation.<\/span><\/p>\n

2. “Myopic loss aversion (a.k.a. as ‘short-sightedness’) – A fear of losing
\nmoney and the subsequent inability to withstand short-term events and maintain a
\nlong-term perspective.” Basically, this means we attach too much importance to
\nday-to-day events, rather than looking at the big picture. Behavioral
\npsychologists have determined that the fear of loss is the most important
\nemotional factor in investor behavior.<\/span><\/p>\n

Like investors chasing the latest hot fund, a news story or a bad day in the
\nmarket becomes enough for the investor to extrapolate the recent event as the
\nnew trend which will stretch far into the future. In reality, most events are
\nunimportant, and have little effect on the overall economy.<\/span><\/p>\n

3. “Cognitive dissonance – The inability to change your opinion after new
\nevidence contradicts your baseline assumption.” Dissonance, whether musical or
\nemotional, is uncomfortable. It is often easier to ignore the event or fact
\nproducing the dissonance rather than deal with it. We tell ourselves it is not
\nmeaningful, and go on our way. This is especially easy if our view is the
\naccepted view. “Herd mentality” is a big force in the market.<\/span><\/p>\n

4. “Overconfidence – People’s tendency to overestimate their abilities
\nrelative to individuals possessing greater expertise.” Professionals beat
\namateurs 99% of the time. The other 1% is luck. The famous Clint Eastwood line,
\n“Do you feel lucky, punk? Well, do you?” comes to mind.<\/span><\/p>\n

In sports, most of us know when we are outclassed. But as investors, we
\nsomehow think we can beat the pros, will always be in the top 10%, and any time
\nwe win it is because of our skills and good judgement. It is bad luck when we
\nlose.<\/span><\/p>\n

Commodity brokers know that the best customers are those who strike it rich
\nin their first few trades. They are now convinced they possess the gift or the
\nHoly Grail of trading systems. These are the people who will spend all their
\nmoney trying to duplicate their initial success, in an effort to validate their
\nobvious abilities. They also generate large commissions for their brokers.<\/span><\/p>\n

5. “Anchoring – People’s tendency to give too much credence to their most
\nrecent experience and to show reluctance to adjust their current beliefs.” If
\nyou believe that NASDAQ stocks are the place to be, that becomes your anchor. No
\nmatter what new information comes your way, you are anchored in your belief.
\nYour experience in 1999 shows you were right. <\/span><\/p>\n

As Lord Keynes said so eloquently when forced to acknowledge a shift in a
\nprevious position he had taken, “Sir, the fact have changed, and when the facts
\nchange, I change. What do you do, sir?”<\/span><\/p>\n

We expect the current trend to continue forever, and forget that all trends
\neventually regress to the mean. That is why investors still plunge into index
\nfunds, believing that stocks will go up over the long term. They think long term
\nis two years. They do not understand that it will take years – maybe even a
\ndecade – for the process of reversion to the mean to complete its work.<\/span><\/p>\n

6. “Representativeness – The tendency of people to see patterns within random
\nevents.” Eric Frye did a great tongue-in-cheek article in The Daily
\nReckoning,<\/em> a daily investment letter (www.dailyreckoning.com). He documented
\nthat each time Sports Illustrated<\/em> used a model for the cover of their
\nswimsuit issue who came from a new country that had never been represented on
\nthe cover before, the stock market of that country had always risen over a
\nfour-year period. This year, it is time to buy Argentinian stocks. Frye
\nevidently did not do a correlation study on the size of the swimsuit against the
\neventual rise in the market. However, I am sure some statistician with more time
\non his hands than I do will brave that analysis.<\/span><\/p>\n

Investors assume that items with a few similar traits are likely to be
\nassociated or identical, and start to see a pattern. McQuill gives us an
\nexample. Suzy is an English and environmental studies major. Most people, when
\nasked if it is more likely that Suzy will become a librarian or work in the
\nfinancial services industry, will choose librarian. They will be wrong. There
\nare vastly more workers in the financial industry than there are librarians.
\nStatistically, the probability is that she will work in the financial services
\nindustry, even though librarians are likely to be English majors.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"

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 … Read more →<\/span><\/a><\/p>\n","protected":false},"author":8,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_wp_rev_ctl_limit":""},"categories":[12,20],"tags":[],"yoast_head":"\nInvestors Behaving Badly | MarketRiders<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/www.marketriders.com\/investing\/investors-behaving-badly\/\" \/>\n<meta name=\"twitter:card\" content=\"summary_large_image\" \/>\n<meta name=\"twitter:title\" content=\"Investors Behaving Badly | MarketRiders\" \/>\n<meta name=\"twitter:description\" content=\"Investors Behaving Badly The Financial Research Corporation 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