Monday, October 22, 2012

Chasing "Rearview-Mirror Performance"

In this interview, Bill Nygren, co-manager of the Oakmark Fund, says that investors are "chasing the rearview-mirror performance" of bonds.

Barron's: Why Stocks Beat the Alternatives

He also later added the following:

"...investors are looking at equities saying, 'It's not like they've returned much recently,' and everybody is telling them that the world economic outlook isn't as good as it used to be."

There is, unfortunately, a general tendency for investors to sell or avoid buying what's out of favor (and possibly more attractively valued) and, instead, own what has worked more recently.*

Of course, that leads investors too often to accumulate the asset classes that happen to now be relatively expensive (and maybe sell/avoid what's rather cheap). These days, it's bonds that are in favor. In the late 1990s, it was equities. They seem (or seemed) safe, at least in the near-term but, with a longer term risk-adjusted returns perspective, they are (were) not.
(Price action may even continue to reinforce the actions of the herd for quite some time. Well, at least it tends to do so until it doesn't. Generally speaking, just long enough to cause even more pain. Social proof can be a powerful thing.)

What seems safe is priced in a way that's unlikely to produce anything close to satisfactory enough long-term returns to compensate for the risks.

It happens all too frequently, and even, predictably.

Lou Harvey, president of DALBAR, provided a good explanation of what happens with fund investors back in 2009:

"...investor returns lag what performance reports and prospectuses would lead one to believe is achievable. While those returns are, in fact, theoretically achievable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments," he said.

One major reason so many market participants underperform long-term comes down to this reliable pattern of investor behavior. I'm guessing most don't think they are susceptible to it.

Not everyone is susceptible, no doubt, but the evidence suggests more participants are than may be obvious or expected. Chances are that means quite a few who think they immune to the pattern are, in fact, not immune at all.

As a result, the returns of fund investors suffer in a very big way.

More on that subject in just a bit. First, according to Vanguard founder John Bogle, from 1984 to 2002 the average mutual fund delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year.

So the average mutual fund performance wasn't great compared to the broader index.

Here's what Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, had to say: **

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value."

Even worse, during that same period the average fund investor, according to DALBAR, earned just 2.6% a year. This comes down to investor behavior. The reliable tendency to make poor buy/sell decisions. Less action and a focus on longer investing horizons often lead to improved returns.

What's popular isn't necessarily expensive, but chances are pretty good it's not cheap.

Similarly, what's less popular -- and likely faces near-term or longer very real headwinds -- isn't necessarily cheap, but it's not a bad place to start looking for value.

"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well." - Warren Buffett

If an investor habitually buys (sells) what's popular (unpopular), and tends to do so during bull (bear) markets, returns are likely to suffer. It certainly not tough to understand why the opposite of this behavior will generally improve long-term results. Yet, the fact is quite a few studies more than just suggest that a whole lot of fund investors, in fact, do their buying/selling at rather unfortunate times. That seems to at least imply this is less an intellectual challenge, more about temperament and discipline.

My own view is that an awareness of the tendency is just one step but an important one. Establishing, proactively, one's own simple policies or rules ("never sell if...", "only buy when...") can at least partially counteract the tendency in certain challenging market environments. In other words, better to think it through beforehand when fewer emotions are involved. Then, the policies and rules can be more routinely applied -- using objective factors to guide actions in the moment -- when the challenging and sometimes quite emotionally charged environment arises (whether a bubble/near bubble or a crash/near crash...either extreme). Even if there's no way to entirely eliminate every costly mistake, developing an effective trained response goes a long way toward reducing the cumulative adverse portfolio impact of poor buy/sell decisions made over many years.

In the long run, returns are driven by price paid and value. No matter what the near-term market environment happens to be, it's the price paid for sound investments relative to their intrinsic worth that matters.***
(Consistently buy shares of businesses with durable advantages at a discount and good things are likely to happen. The same is true for a broad-based index fund even if there are different specific risks involved. Usually the time to buy is when it feels pretty awful and the time to maybe sell some shares is when there seems to be no economic storm clouds whatsoever.)

John Bogle, in The Little Book of Common Sense Investing, also estimated that in the 25 years ending in 2005 the average mutual fund investor earned 7.3% compared to the 12.3% for the benchmark. Once again, investor ill-timed buy/sell behavior accounts for the gap in performance.

A more recent study by DALBAR reached a similar conclusion.

According to DALBAR's Quantitative Analysis of Investor Behavior (QAIB), the S&P 500 returned 8.35% over the 20 years that ended in 2008 while, on average, equity fund investors earned just 1.87% (less than the inflation rate of 2.89%).


Investors in bond funds revealed a similar pattern and, of course, results. The bond fund investors earned 0.77% compared to 7.43% for the index.

So it's not difficult to find evidence that investors can be their own worst enemy. In the long run, an awareness of the damage this pattern of behavior does to portfolio returns is only useful if wise steps are taken to counteract the tendency.

Not seriously considering the implications of this in the context of one's own investing approach seems a bit foolish and certainly, well, expensive.

It's worth keeping the following front of mind:

- Investors have a reliable tendency to buy and avoid/sell at the wrong times; it's an expensive pattern.

- Index funds have a not insignificant likelihood of outperforming a large number of market participants especially if trading is minimized and they're held long-term. It's a relatively simple approach. When a simple approach produces the same or better results than the more complex one, the simpler approach obviously wins. The added complexity needs to be worth the trouble. In other words, there's a cost to complexity and the benefits of a less straightforward approach should be apparent and easy to justify.

- More investors, due to overconfidence in (or overestimation of) their own abilities, seem to believe they can outperform an index than appears to be justified based upon available evidence.

- Investors who buy marketable stocks need to realistically assess their own ability outperform an index long-term and on a risk-adjusted basis. Similarly, investors who buy an actively managed fund need to realistically assess whether they can identify the particular fund (or funds) that will outperform in the future. I mean, knowing who did well after the fact doesn't really help a whole lot. Studies seem to more than suggest too many investors overestimate their own ability to either pick stocks or active managers.

I've used this quote recently but it bears repeating:

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

Buffett goes on to say, in effect, the
"know-something investor" who's able to identify "five to ten sensibly-priced" enterprises with sound business economics that possess long-term competitive advantages need much less diversification than what is offered by an index fund. As I said in this recent post, there's a big difference between it being not possible and it being not likely to achieve attractive results buying individual stocks. So it's not likely that many equity investors will do better than an index fund. Yet, as I said in this recent post, there's a big difference between not possible and not likely. Attractive results can be achieved buying individual stocks but some seem to think long-term outperformance is easier than it actually is.

Still, if the results of these studies are any indication, a rather daunting number of market participants will end up doing worse by buying individual stocks. It'd be folly to ignore the results from the studies noted above and others.

The added risk and complexity of owning individual stocks works against long-term returns unless the investor: 1) truly knows business economics, 2) is able to identify those with sustainable advantages, 3) judges value well, then 4) buys with an appropriate margin of safety. The right temperament and no small amount of discipline is necessary.

The evidence supporting the idea that index funds are often the way to go is not insignificant. Yet, that doesn't mean no one should invest in individual stocks. Some are really very good at it but, as always, it's about knowing one's own limits.

Check out the full Barron's interview.

Adam

Related posts:
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Halo Effect & Rear-View Mirror Investing
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Rear-View Mirror Investing
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
Recent Study on Investor Returns
When Genius Failed...Again
Best Performing Mutual Funds - 20 Years

* Certain bonds may be generally expensive but that doesn't mean, near current levels, the major equity indexes are at extraordinarily low valuations. Best case, the major indexes seem to be annoyingly neither cheap nor expensive, though certain individual stocks appear rather attractively priced.
(In general, my own approach is to buy shares of businesses with durable economics below what their worth then ideally "never" but, at least, rarely sell once I own part of a quality enterprise at a fair or better price.)
** Index funds don't just outperform the average mutual fund. It's much worse than that: "The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - The Motley Fool
John Bogle makes a similar point here. There are some very good actively managed funds. The problem is it's difficult to pick those that will outperform a broad-based market index over a long time frame into the future.
*** And how much intrinsic worth will change, for better or worse, over time. Investing in individual stocks starts and ends with knowing how to judge value and paying an appropriate discount. Those that don't feel they can judge value certainly shouldn't be buying individual stocks (even if you are a buyer of index funds, having a good sense of price versus value is hugely useful). Naturally, a lousy market environment often produces attractively priced assets while a euphoric market produces the opposite. What's more important, at least for those building an equity portfolio with long-term results in mind, is whether shares can be bought (via an index fund or well understood, ideally higher quality individual stocks) at a plain discount to value no matter what the market environment is. For long-term investors, it's first and foremost about consistently buying shares at a discount to value not the near-term (or even somewhat longer term) price action or mood of the equity markets. Very bullish/bearish market environments just usually (though not always) provide a larger number of mispriced assets and more extreme individual mispricings. Understandably, a trader looks at this in an altogether different manner if for no other reason that his/her time horizon is vastly shorter.
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