The annals of investor behavior make for some pretty scary reading. Yet this story from the Wall Street Journal may take the cake. It is an article about the top-performing mutual fund of the decade and it shows with remarkable clarity how badly investors butcher their long-term returns. The article hits the premise right up front:
Meet the decade’s best-performing U.S. diversified stock mutual fund: Ken Heebner’s $3.7 billion CGM Focus Fund, which rose more than 18% annually and outpaced its closest rival by more than three percentage points.
Too bad investors weren’t around to enjoy much of those gains. The typical CGM Focus shareholder lost 11% annually in the 10 years ending Nov. 30, according to investment research firm Morningstar Inc.
It’s hard to know whether to laugh or cry. In a brutal decade, Mr. Heebner did a remarkable job, gaining 18% per year for his investors. The only investment acumen required to reap this 18% return was leaving the fund alone. Yet in the single best stock fund of the decade investors managed to misbehave and actually lose substantial amounts of money—11% annually.
Even Morningstar is not sure what to do with Mr. Heebner:
The fund, a highly concentrated portfolio typically holding fewer than 25 large-company stocks, offers “a really potent investment style, but it’s really hard for investors to use well,” says Christopher Davis, senior fund analyst at Morningstar.
I beg to differ. It’s really hard to use well?? What does that even mean? If it is, it’s only in the sense that a pet rock is really hard to care for.
Investor note: actively managed or adaptive products need to be left alone! The whole idea of an active or adaptive product is that the manager will handle things for you, instead of you having to do it yourself.
Unfortunately, there is an implicit belief among investors—and their advisors—that they can do a better job than the professionals running the funds, but every single study shows that belief to be false. There is not one study of which I am aware that shows retail investors (or retail investors assisted by advisors) outperforming professional investors. So where does that widespread belief come from?
From the biggest bogeyman in behavioral finance: overconfidence. Confidence is a wonderful trait in human beings. It gets us to attempt new things and to grow. From an evolutionary point of view, it is probably quite adaptive. In the financial arena, it’s a killer. Like high blood pressure, it’s a silent killer too, because no one ever believes they are overconfident.
At a Harvard conference on behavioral finance, I heard Nobel Prize winner Daniel Kahneman talk about the best way to combat overconfidence. He suggested intentionally taking what he called an “outside view.” Instead of placing yourself—with all of your incredible and unique talents and abilities—in the midst of the situation, he proposed using an outside individual, like your neighbor, for instance. Instead of asking, “What are the odds that I can quit my day job and open a top-performing hedge fund or play in the NBA?” ask instead, “What are the odds that my neighbor (the plumber, or the realtor, or the unemployed MBA) can quit his day job and open a top performing hedge fund or play in the NBA?” When you put things in an outside context like that, they always seem a lot less likely according to Kahneman. We all think of ourselves as special; in reality, we’re pretty much like everyone else.
Why, then, are investors so quick to bail out on everyone else? Overconfidence again. Our generally mistaken belief that we are special makes everyone else not quite as special as us. Overconfidence and belief in our own specialness makes us frame things completely differently: when we have a bad quarter, it was probably bad luck on a couple of stock picks; if Bill Miller (to choose a recent example) has a bad quarter, it’s probably because he’s lost his marbles and his investment process is irretriveably broken. We’d better bail out, fast. (A lot of people came to that conclusion over the past couple of years. In 2009, Legg Mason Value Trust was +40.6%, more than 14% ahead of its category peers.)
Think about an adaptive Dorsey, Wright Research model like DALI. As conditions change, it attempts to adapt by changing its holdings. Does it make sense to jump in and out of DALI depending on what happened last quarter or last year? Of course not. You either buy into the tactical approach or you don’t. Once you decide to buy into—presumably because you agree with the general premise—a managed mutual fund, a managed account, or an active index, for goodness sakes, leave it alone.
In financial markets, overconfidence is the enemy of patience. Overconfidence is expensive; patience with managed products can be quite rewarding. In the example of the CGM Focus Fund, Mr. Heebner grew $10,000 into $61,444 over the course of the last ten years. Investors in the fund, compounding at -11% annually, turned $10,000 into $3,118. The difference of $58,326 is the dollar value of patience in black and white.