Friday, June 14, 2013

Newton's Fourth Law

From this interview with Michael Mauboussin:

"...9% is what the market does over the long term. 7.5% is what mutual funds earn, and the difference is primarily fees that mutual fund managers charge."

Yet investors generally earn even less than that. According to Mauboussin, it's more like 60% or 70% of what the market returns.

What accounts for the difference between mutual funds returns and the returns of mutual fund investors?*

"...the answer is: Timing. Or I should say, bad timing. That is, most individuals tend to buy when things have done well and sell when things have done poorly. So they miss out on the subsequent rises when they sell, and of course the subsequent reversals when things have done very well in the past. They buy high and sell low instead of what you're supposed to do."

It turns out, somewhat oddly, that investors who buy load funds do better than no-load funds with the reason apparently being, because of the upfront cost, they are less likely to buy and sell as much.

That's, of course, not an argument for buying load funds.

It's an argument to stop attempting to time the buying and selling of marketable securities and/or funds.

It's an argument for less activity. A better solution, of course, would be to not pay those upfront load fees, trade a whole lot less, and resist the temptation to time the market action.

Reduced frictional costs. Fewer mistakes.

This gets back to the Fourth Law of Motion that Sir Isaac Newton, unfortunately, did not discover. 

"...Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." - From the 2005 Berkshire Hathaway (BRKaShareholder Letter

Isaac Newton, The Investor

In the same interview, Mauboussin also points out that it's not just individual investors, it is also institutions.

"So you could understand why mom and pop mutual funds maybe would do poorly, but this pervades institutions as well. And it's interesting. The American ethic, or probably Western ethic, is hard work equates to better outcomes. So doing things tends to be a good thing.

That’s not always true in the world of investing."

This Barron's article points out that 85 percent of investor sell or exchange decisions are wrong.

The Money Paradox

So that means:

"...the investor would do better by doing nothing or going the other way that 85% of the time. Simple random decision making (with no investment knowledge) would have yielded about 50% good decisions."

It's an illusion of control.

The evidence more than just suggests that trading excessively and attempting to time the market are likely to just hurt results. Productive assets -- whether partial business ownership (marketable stocks), an entire business, a farm, or some real estate -- can do the heavy lifting as far as long-term returns go.
(Especially those that possess durable advantages.)

Trading skill and clever market timing not required.

Well, at least it is for those investors who have a long enough investment time horizon and the kind of temperament that makes them not much influenced by exuberant or fearful market action. Back in 2009, Charlie Munger said this in an interview on the BBC:

"I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations."

In this BBC interview with Warren Buffett, also from back in 2009, here's what he had to say about the nature of stock markets.

"The very liquidity of stock markets causes people to focus on price action. If you buy an apartment house, if you buy a farm, if you buy a MacDonald's franchise you don't think about what it's going sell for tomorrow or next week, or next month, you think about how is this business going to do. But stocks with this huge liquidity suck people in and they turn what should be an advantage into a disadvantage."

Then, later in the interview, Buffett added this:

" can still get in trouble if you pay too much, but you are focusing on the right thing if you look at the stream of income that the asset is going to produce over time." - Warren Buffett

Invest in what you understand.

Invest with a margin of safety. 

Trade as little as possible to minimize frictional costs and mistakes.

Ignore the near-term market price action. 

Focus on underlying value and what might change it.

Remember that the quoted price of a marketable common stock can be just about anything in the near-term or even longer. 

" is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical." - Warren Buffett in The Superinvestors of Graham-and-Doddsville

Price action -- nonsensical or not -- doesn't change the underlying per share intrinsic value of the asset itself. Understanding per share intrinsic value is, in itself, difficult enough to do well. For investors, that's where the emphasis should be.

None of this applies if the time horizon is short, of course. Yet, for those with a long enough investing horizon, it's the underlying value that matters not what the quoted price might be at any point in time. Eventually the weighing machine overwhelms the voting machine.

So much for efficient markets.


Long position in BRKb established at much lower than recent market prices

Related posts:
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* In a separate study, 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. Even worse, during that same period the average fund investor, according to DALBAR, earned just 2.6% a year. 
(The average fund investor does much worse largely due to ill-timed buy/sell decisions and fund selection. In other words, a timing penalty and a selection penalty. Bogle adds why he thinks the DALBAR study might actually overstate the annual returns. See his explanation under the Is the DALBAR Study Accurate? section for more details.)
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