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Useless Investing Variables: We Are Our Own Worst Enemy

April 21, 2010
guruek

Daily Reckoning

3 followers
04/21/10 Gaithersburg, Maryland – Ken Heebner’s CGM Focus Fund was the best US stock fund of the past decade. It rose 18% a year, beating its nearest rival by more than three percentage points. Yet according to research by Morningstar, the typical investor in the fund lost 11% annually! How can that happen?

It happened because investors tended to take money out after a bad stretch and put it back in after a strong run. They sold low and bought high. Stories like this blow me away. Incredibly, these investors owned the best fund you could own over the last 10 years – and still managed to lose money.

Psychologically, it’s hard to do the right thing in investing, which often requires you to buy what has not done well of late so that you will do well in the future. We’re hard-wired to do the opposite.

I recently read James Montier’s Value Investing: Tools and Techniques for Intelligent Investment. It’s a meaty book that compiles a lot of research. Much of it shows how we are our own worst enemy.

One of my favorite chapters is called “Confused Contrarians and Dark Days for Deep Value.” Put simply, the main idea is that you can’t expect to outperform as an investor allthe time. In fact, the best investors often underperform over short periods of time. Montier cites research by the Brandes Institute that shows how, in any three-year period, the best investors find themselves among the worst performers about 40% of the time!

It seems strange. Great chefs don’t cook bad meals, but the best investors routinely make a hash of things. Shocking as it may seem at first, it makes sense in the context of markets. “If everyone else is dashing around trying to guess next quarter’s earnings numbers,” Montier writes, “and you are exploiting a long-term time frame, then you may well find yourself staring at the wrong end of a bout of underperformance.”

The point being you can’t worry too much about short-term performance. Investing is a game won by determined turtles, not hares. That means you have to stick with solid ideas, instead of trying to catch what the hottest thing is.

Another chapter I like is “Keep It Simple, Stupid.” It illustrates another key point about the nature of investing: It pays to focus on a handful of essential details and ignore the rest. Montier shows us experiments in which people made worse decisions when given more information. For example, in one instance, researchers asked people to choose the best of four cars given only four pieces of information on each car. (In the examples, one car is noticeably and objectively better than the others.) People picked the best car 75% of the time. When given 12 pieces of information, their accuracy dropped to only 25%. The added information was more than just extraneous; it made their choices worse.

In the context of investing in stocks, it’s better to focus in on key variables that clearly matter and ignore the rest. My investment process aims to do that by boiling down the many details of investing in a company into four major areas. Too many details spoil the broth, but most investors haven’t learned this. “Our industry is obsessed with the minutia of detail,” Montier writes.

I certainly would agree. I read quite a bit of investment research in any given year and I am always amused at the detailed modeling (and forecasting) that goes on. If an idea depends on such finely tuned analysis, then odds are it is not such a great deal.

Throughout the book, Montier reveals and validates many ideas essential to smart investing. He also quotes liberally from scores of investing luminaries from Benjamin Graham to Sir John Templeton. There is a lot of wisdom here. Though repetitive at times, digesting these ideas is like eating your vegetables.

They keep your portfolio healthy.


Chris Mayer

for The Daily Reckoning


Rating: 3.9/5 (14 votes)

Comments

Dr. Paul Price
Dr. Paul Price premium member - 4 years ago


Just a look at the equity mutual fund inflow/outflow numbers show that the average investor was cashing out of his equity funds as things got cheaper and cheaper in 2008 through early 2009 and continued to pull money out for many months more even as stocks picked up dramatically.

Only recently have equity mutual funds shown net inflows and, even then, bond funds (with interest rates at record lows) still are drawing much more money than stocks funds.
guruek
Guruek - 4 years ago
The phenomena of investor entering and leaving the mutual funds at the wrong times is by-definition-ly unavoidable. Asset managers, however, show navigate the perilous times and protect the less-educated clients. This is the topic of Investment Guru, Robert Rodriguez's speech last year.
expectingrain
Expectingrain - 4 years ago
This also defines the reason why mutual funds are by nature poor investments- the managers get notices of outflows when stock prices are depressed forcing their hand by selling stock at the lows. They also get too many inflows at market peaks which again forces the manager to buy stocks at their highs. Put that together with the high fee structure and you get a subpar investment idea.

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