Monday, April 7, 2014

When Mutual Funds Outperform Their Investors

From this MarketWatch article:

"...the typical investor booked a 4.8% annualized gain over the last decade, while the typical fund gained an average of 7.3% a year.

The same article goes on to point out the following based upon research by Morningstar:

"...investors do a good job of picking mutual funds, but a poor job in timing their moves between asset classes."

Russel Kinnel of Morningstar explained, as one recent example, that, in terms of fund flows, mutual fund investors "were going in all the wrong directions entering 2013."

Basically, they were buying mutual funds that allocate capital into bonds and selling those that are focused on U.S. stocks.* They did this at a time when doing roughly the opposite (or nothing at all) would likely have served them better. This is not an argument to get the timing right; this is an argument to not try to time such things in the first place.

This Barron's article from last month added the following:

"Individual investors have long been accused of being a lagging indicator, pouring money into areas of the market after they've seen their biggest run-ups. But that's a mistake not limited to just retail investors, but also often made by pensions and endowments managing much larger pools of money, according to insiders."

One of the major reasons for the underperformance is "that few investors sit tight in a fund" along with, once again, poorly executed attempts at timing the market.

"...the gap in returns is exacerbated by big pivot years for the market, when investors appear to have especially bad timing."

The Barron's article also notes that investors were mostly getting out of equities in 2009 while moving assets into things like bonds and commodities. Once again, not exactly the best time to be doing such things even if it probably felt like the right thing to do. The equity markets have, give or take, roughly doubled -- even if the investor didn't buy at the most opportune moments that year -- since 2009. With no doubt good intentions, investors too often do just about the opposite of what would improve returns. Influenced too much by what they've experienced recently -- what's in the rear-view mirror -- they tend to take actions that are detrimental even though, at the time, it might have felt like the right thing to do.

Benjamin Graham: Timing vs Pricing Stocks

Investors are just too often their own worst enemies. There's just no need to pick market bottoms nor is it really possible to do so consistently well. More generally, it's just not wise to make big timing calls a central aspect of the process.

"Picking bottoms is not our game. Pricing is our game. And that's not so difficult. Picking bottoms is, I think, impossible." - From this interview with Warren Buffett

The focus needs to be, or should be, on how price compares to well-judged per share intrinsic value.

Now, sometimes the right time to buy might happen to coincide with the right price, but price versus value should still be the emphasis. Good things are just more likely to happen in the long run -- even if far from a certainty -- when always buying at a plain discount to value is a central principle. There's nearly no doubt that price action might get ugly -- at the very least from time to time -- in the near and intermediate term. Expect it and, well, learn mostly ignore it. If all buying is truly at a discount to value, the price action in the early years should become increasingly irrelevant over the long haul.** Timing will inevitably end up being off; what is truly cheap becomes even cheaper due to psychological and other factors (the same, of course, can be true in the opposite direction). Yet it's easy to forget the risk of NOT owning something understandable that's become sensibly priced (in the context of long-term investment) due to fears it will temporarily get even cheaper.

In other words, attempts to get both pricing and timing right invites errors that need not be made by those who have a long-term investment horizon.

The reality is that getting the price versus value judgment right is hard enough to do consistently well without adding timing to the equation.

So it's learning to ignore price action, judging the value of what's understandable frequently well, then developing the patience and discipline to buy when there's a discount.

The most attractive discounts usually prevail when a recent or ongoing economic storm -- and the associated painful losses -- dominate the psychology of those involved.

Participants who buy when the outlook is rosy aren't likely to get great long-term results. Ditto for those who tend to sell when the outlook feels uncertain and, well, maybe even a bit scary.

In fact, the opposite behavior has a much better likelihood of being rewarded.

None of the above is necessarily easy to do well. Then again, it's also hardly impossible with the right level of energy and focus in combination with an real awareness of abilities and limits.

Overconfidence destroys results.

It's worth highlighting that, as the Barron's article notes, it's not like the investment pros -- what some might consider the "smart money" -- aren't susceptible to making the same kind of mistakes as the non-professionals.

"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." - Jack Meyer, former head of Harvard's endowment, commenting on investment managers

In other words, we might be looking at a more generalized element of human nature that, to be successful, must be tamed by the market participant no matter what the level of knowledge and expertise happens to be.


Related posts:
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
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
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
When Genius Failed...Again

* Apparently, investors were also buying lots of emerging markets funds at a rather inopportune time.
** In fact, prices that remain persistently at a discount can benefit the long-term investor, and it's not just because it allows that investor to accumulate more shares; it's because the company can use excess capital to do the same.
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