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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Boutique consulting firms sprung up to advise individuals and companies on the best money managers in which to investAnother study that proves how unreliable numbers have become in evaluating a mutual fund was conducted by Burton Malkiel of Princeton University in 1996. Malkiel, a former dean of Yale Universitys graduate business school, examined the overall performance of the Forbes Honor Roll of mutual funds to determine the value of Forbess historical data as a predictor of a funds future success. This study differs from Lipper s Morningstar study in that Forbess requirement for making the honor roll is above average, but steady, long-term performance through both bull and bear markets. Short-term bursts of glory will not get a fund on the Forbes Honor Roll. Consistency of performance and toughness in tough times will. So while Forbes, too, looks at past data, it views those data for a different purpose than Morningstar does by focusing on lower volatility. But the results of the study show that even when the historical data are viewed in a different light and for a different purpose, they are still an irrelevant predictor of future performance. Malkiels findings showed that the year following a funds selection for the Forbes Honor Roll, the fund would underperform the Standard & Poor s (S&P) 500, and sometimes significantly. The following table summarizes the studys findings by comparing the Forbes Honor Roll funds to the S&P 500 the year after they appeared on the Honor Roll.5 Over the last decade, as evidence mounted that historic data were becoming increasingly useless as a predictor of future investment returns, a countervailing force encouraged the reliance on these useless statistics. This was the proliferation of eye-catching computer programs filled with data that could be easily sorted, filtered, and printed in colorful charts, graphs, and PowerPoint presentations. Boutique consulting firms sprung up to advise individuals and companies on the best money managers in which to invest. Elaborate brochures contained colorful pages decorated with reams of useless data, which we have seen presented by people who have never actually spoken to, or had any contact with, the investment managers they were claiming to have so thoroughly analyzed. Computers created the self-proclaimed expert. The do-it-yourself investor was also downloading supposed analytical tools. Lists of so-called honor-roll funds, top-performing funds, and 5-star funds were easily accessible. Between the pseudoconsultants and the individual investors, the flow of money into top-performing funds was phenomenal. Even though it did not work, past performance became the overriding criteria for selecting a portfolio manager. Financial Research Corporation, a mutual-fund consulting firm located in Chicago, analyzed the amount of cash flowing into funds ranked by Morningstar. In 1996 the study revealed that 75% of all cash flowing into stock mutual funds was being invested in funds with a four-or five-star Morningstar ranking.6 We can conclude that most of that money experienced inferior re turns almost immediately. In 1996, a survey of over 3,300 mutual fund investors performed by researchers at Columbia Universitys Graduate School of Business discovered that people overwhelmingly chose an investments published record of past performance as the single most important basis on which an investment decision is made. On a scale of 1 (lowest) to 5 (highest), those surveyed gave past performance a score of 4.62. It is extraordinary and disappointing that no other criteria even came close. Fees were judged to be the next most important criteria with a score of 2.28. Investment style scored a meager 1.68, barely beating out the importance of checking and brokerage services at 1.38. Confidentiality scored 1.35.7 How portfolio managers functioned during the old investment culture has nothing to do with how they will function in the new one. The question that needs to be asked is not, What did you do five or ten years ago? but, Where will you invest my money today? This seems obvious, but apparently it is not. What is a funds research process? Where does the research come from? How is the decision of what to invest in ultimately reached? What sorts of people are investing the money patient plodders, aggressive trading types? What is the tone of the firm or mutual fund company itself? These are the questions that should be asked. This is how Morningstar should be used because it does offer some analysis of those qualitative issues. The quantitative, or numerical, data are practically useless in comparison. Understanding the qualitative issues surrounding the portfolio manager at an investment firm or mutual fund company will lead to the superior performance that is being sought. There are many ways to get from point A to point B. Within the mutual fund and investment management industries there are hundreds of research methodologies and hundreds more ways to carry them out. There are different personalities with differing views of political and social conditions. What is needed is confirmation that the money manager under consideration has a system that digests this amalgamation of factors in a consistent way. Once the methods used by different managers are understood, a cross section of them can be selected to manage the assets in question. In this way, real diversification will be achieved, leading to less risk and superior performance. The alternative to making qualitative matters the primary concern in comparing money managers is to fall back on past performance and become vulnerable to the manipulation of numbers that we demonstrate in the following: After a difficult several months when stocks have been volatile you see an advertisement for a mutual fund that boasts an annual return of 25%. The immediate assumption is that the funds managers clearly know something other people do not. A closer look shows that it is not managing money that they are good at they are good at knowing how to play the past performance game. Investment beginning in year one:$100,000 After one great year of performance the money grows to:$200,000 Terrible returns the next year create losses. The portfolio is back to:$100,000 Your average annual return is 25%, but you have not made a dime. Explanation: $100,000 to $200,000 = 100% return year 1 $200,000 to $100,000 = -50% return year 2 Net return = 50% 50% 2 years = 25% average Market Averages Become Immaterial Even without the inception of a new dominant investment system, the use of market averages as a guide to whether stocks are over- or underpriced is a dicey exercise. But this has not been the majority view. The generally accepted notion holds that because large-company U.S. stocks, adjusted for inflation, grew at 7.43% annually between 1925 and 2001, this must be their inherently normal growth rate. In support of this theory many statisticians believe that this average is arrived at through the markets ability to account fully for all available information at a given point in time, in an objective fashion. This means that one year s events have no effect on the next; each year is an independent random realization (the random walk theory). According to this view, there are no fundamental shifts that can occur that are not already fully discounted in the markets price. Yet the statisticians seem to contradict themselves by believing that the markets are shaped by an inexplicable equilibrium force that will always cause the stocks of large companies to revert to an average annual return of 7.43%. Frank Schmid, writing in Monetary Trends, a publication of the Federal Reserve Bank of St. Louis, compares the logic of market averages to that used in predicting the flip of a coin.8 By flipping a coin an infinite number of times, the long-run average of heads will be 50%. This is not because, as some believe, a law of nature mandates a reversion to the mean. It is that an infinite number of coin flips eventually smoothes out any deviations. Those who believe some natural phenomenon will cause Dow-type stocks or the old dominant investment system to revert to its 7.43% average annual return are no different from those who apply cryptic notions to coin tossing. The erroneous belief in reversion to the mean in coin tossing is called the gambler s fallacy. Those who peg themarkets return at 7.43% will say it is cheap when its performance falls below 7.43% and that therefore stocks should be purchased. Themarket is expensive when the performance average rises above 7.43%, and therefore stocks should be sold. Perhaps after the Dow ended its discovery, formulation, and acceleration phases and found its rhythm, the 7.43% number could have been an accurate indicator of the markets normal and expected rate of return. But at least one authority will not even concede that much ground any longer to the old reliance on market averages. Economists theorize that in a capitalistic system the laws of supply and demand inevitably create a state of equilibrium. (Recall that the economic view of the equilibrium state developed in the 1800s.) Fundamental stock analysis grows out of this equilibrium theory. Stocks are also supposed to have a true fundamental value, so their market price will eventually move toward equilibrium and reflect that value. Taken collectively, all stocks of the market will do the same. The equilibrium state of the market will be its average. George Soros disagrees: There is little empirical evidence of an equilibrium or even a tendency for prices to move toward an equilibrium. The concept of an equilibrium seems irrelevant at best and misleading at worst.9 In Part I we quoted experts who explained why big-cap stocks can no longer be counted on to maintain an average growth rate of 7.43% per year. This is a problem not only for the change-averse investor, but also for many insurance and mutual fund companies and to a much greater extent. They have created popular investment products that allow participation in the growth of the S&P 500 while guaranteeing investors principle. The guarantees are based on the kinds of market averages we have been discussing. In asking an insurance company representative what would happen if the S&P 500 did not perform as expected and his company was forced to have to make good on all the guarantees, he told us: Not only will I not be around to talk to you anymore, the whole company will disappear. He said this with a haughty condescension, as if a commandment of biblical proportion has precluded this from ever happening. It is nonsense to expect the market to average a return that is independent of the growth rate of the stocks that comprise it. It follows that because we have a new investment culture that defines the kinds of stocks that represent the market differently, we should be wondering what new sorts of average returns we can expect. To do this we will need to find ways to differentiate the expectations of the companies of the old dominant investment system from those of the present system. This will not be easy because current protocol requires all companies to report the same kinds of data, regardless of whether it bears any relevance to the type of business in question. One corrective measure would be to free companies using new business models from the encumbrances of the quarterly earnings report. Rituals like the preannouncement of quarterly corporate earnings, followed by the announcement of what is put forth as actual earnings, should be eliminated. Gimmicks like this serve only to put a positive spin on weakened old companies while being a shortsighted and inhibiting way of judging the progress of companies working hard at adapting to, and prospering in, the twenty-first century. If it is frightening to picture a world with no quarterly earnings reports, if it evokes suspicious feelings because these vital gems of data are being withheld, we counter that for 20 years now, successful portfolio managers have told us that they have developed their own data-collecting methods because they view things like earnings reports and balance sheets with a jaundiced eye. Another way of getting the new investment culture out of the shadow of the old is to delineate analysts specializing in the new dominant investment system from those who focus on the companies of the previous (Dow Jones) dominant system. Just as the community of bond (the first dominant investment system) analysts separated themselves in the twentieth century from stock analysts because their perspective differs the new, third group would be free to develop their own analytical tools. This would make it more likely that twenty-first century companies would be viewed in their proper perspective. The three groups of analysts, just like the two groups (bond and stock) we have now, would be equally important to investors who will always need to have portfolios diversified across all three groups. |
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