Lessons for Building a Winning Portfolio_3

The Market Is Smarter Than You Are 85 investors getting lower and lower returns. It can be clearly seen that Mr. Sanborn had significant difficulties once his fund grew beyond a few billion dollars in size. There’s another depressing pattern that emerges from the above story: relatively few of a successful fund’s investors actually get its high early returns. The overwhelming majority hop onto the bandwagon just before it crashes off the side of the road. If we “dollar-weight” the fund’s returns, we find that the average investor in the Oakmark Fund underperformed the S&P by 7.55% annually. Jonathan Clements, of The Wall Street Journal, quips that when an investor says, “I own last year’s best-performing fund,” what he usually forgets to add is, “Unfortunately, I bought it this year.” And finally, one sad, almost comic, note. As we’ve already men-tioned, most of the above studies show evidence of performance con-sistency in one corner of the professional heap—the bottom. Money managers who are in the bottom 20% of their peer group tend to stay there far more often than can be explained by chance. This phenom-enon is largely explained by impact costs and high expenses. Those mangers that charge the highest management fees and trade the most frenetically, like Mr. Tsai and his gunslinger colleagues, incur the high-est costs, year-in and year-out. Unfortunately, it’s the shareholders who suffer most. How the Really Big Money Invests There is one pool of money that is even bigger and better-run than mutual funds: the nation’s pension accounts. In fact, the nation’s biggest investment pools are the retirement funds of the large corporations and governmental bodies, such as the California Public Employees Retirement System (CALPERS), which manages an astounding $170 bil-lion. These plans receive a level of professional management that even the nation’s wealthiest private investors can only dream of. If you are a truly skilled and capable manager, this is the playground you want to wind up in. For example, a top-tier pension manager is typically paid 0.10% of assets under management—in other words, $10 million per year on a $10 billion pool—more than most “superstar” mutual fund managers. Surely, if there is such a thing as skill in stock picking, it will be found here. Let’s see how these large retirement plans actually do. I’m indebted to Piscataqua Research for providing me with the data in Figure 3-4, which shows the performance of the nation’s largest pension plans from 1987 to 1999. The average asset allocation for almost all of these plans over the whole period was similar—about 86 The Four Pillars of Investing Figure 3-4. Performance of 243 large pension plans, 1987–1999. (Source: Dimensional Fund Advisors, Piscataqua Research.) 60% stocks and 40% bonds. So the best benchmark is a mix of 60% S&P 500 and 40% Lehman Bond Index. As you can see, more than 90% of these plans underperformed the 60/40 indexed mix. Discouraged by this failure of active management, these plans are slowly abandoning active portfolio management. Currently, about half of all pension stock holdings are passively managed, or “indexed,” including over 80% of the CALPERS stock portfolio. Small investors, though, have not “gotten it” yet; hope triumphs over experience and knowledge. If the nation’s largest mutual funds and pen-sion funds, with access to the very best information, analysts, and com-putational facilities, cannot successfully pick stocks and managers, what do you think your chances are? How likely do you think it is that your broker or financial advisor will be able to beat the market? And if there actually were money managers who could consistently beat the market, how likely do you think it would be that you would have access to them? Comic Relief from Newsletter Writers and Other Market Timers The straw that struggling investors most frequently grasp at is the hope that they can increase their returns and reduce risk by timing the mar- The Market Is Smarter Than You Are 87 ket—holding stocks when they are going up and selling them before they go down. Sadly, this is an illusion—one that is exploited by the investment industry with bald cynicism. It is said that there are only two kinds of investors: those who don’t know where the market is going and those who don’t know that they don’t know. But there is a rather pathetic third kind—the market strategist. These highly visible brokerage house executives are articu-late, highly paid, usually attractive, and invariably well-tailored. Their job is to convince the investing public that their firm can divine the market’s moves through a careful analysis of economic, political, and investment data. But at the end of the day, they know only two things: First, like everybody else, they don’t know where the market is head-ed tomorrow. And second, that their livelihood depends upon appear-ing to know. We’ve already come across Alfred Cowles’s assessment of the dismal performance of market newsletters. Some decades later, noted author, analyst, and money manager David Dreman, in Contrarian Market Strategy: The Psychology of Stock Market Success, painstakingly tracked opinions of expert market strategists back to 1929 and found that their consensus was mistaken 77% of the time. This is a recurring theme of almost all studies of “consensus” or “expert” opinion; it underperforms the market about three-fourths of the time. The sorriest corner of the investment prediction industry is occupied by market-timing newsletters. John Graham and Campbell Harvey, two finance academicians, recently performed an exhaustive review of 237 market-timing newsletters. They measured the ability of this motley crew to time the market and found that less than 25% of the recom-mendations were correct, much worse than the chimps’ score of 50%. Even worse, there were no advisors whose calls were consistently cor-rect. Once again, the only consistency was found at the bottom of the pile; there were several newsletters that were wrong with amazing reg-ularity. They cited one very well-known advisor whose strategy pro-duced an astounding 5.4% loss during a 13-year period when the S&P 500 produced an annualized 15.9% gain. More amazing, there is a newsletter that ranks the performance of other newsletters; its publisher believes that he can identify top-per-forming advisors. The work of Graham and Harvey suggests that, in reality, he is actually the judge at a coin flipping contest. (Although the work of Graham, Harvey, Cowles, and others does suggest one prom-ising strategy: pick the very worst newsletter you can find. Then do the opposite of what it recommends.) When it comes to newsletter writers, remember Malcolm Forbes’s famous dictum: the only money made in that arena is through sub- 88 The Four Pillars of Investing scriptions, not from taking the advice. The late John Brooks, dean of the last generation of financial journalists, had an even more cynical interpretation: when a famous investor publishes a newsletter, it’s a sure tip-off that his techniques have stopped working. Eugene Fama Cries “Eureka!” If Irving Fisher towered over financial economics in the first half of the twentieth century, there’s no question about who did so in the second half: Eugene Fama. His story is typical of almost all of the recent great financial economists—he was not born to wealth, and his initial aca-demic plans did not include finance. He majored in French in college and was a gifted athlete. To make ends meet, he worked for a finance professor who published—you guessed it—a stock market newsletter. His job was to analyze market trading rules. In other words, to come up with strategies that would produce market-beating returns. Looking at historical data, he found plenty that worked—in the past. But a funny thing happened. Each time he identified a strategy that had done beautifully in the past, it fell flat on its face in the future. Although he didn’t realize it at the time, he had joined a growing army of talented finance specialists, starting with Cowles, who had found that although it is easy to uncover successful past stock-picking and market-timing strategies, none of them worked going forward. This is a concept that even many professionals seem unable to grasp. How many times have you read or heard a well-known market strategist say that since event X had just occurred, the market would rise or fall, because it had done so eight out of the last ten times event X had previously occurred? The classic, if somewhat hackneyed, exam-ple of this is the “Super Bowl Indicator”: when a team from the old NFL wins, the market does well, and when a team from the old AFL wins, it does poorly. In fact, if one analyzes a lot of random data, it is not too difficult to find some things that seem to correlate closely with market returns. For example, on a lark, David Leinweber of First Quadrant sifted through a United Nations database and discovered that movements in the stock market were almost perfectly correlated with butter production in Bangladesh. This is not one I’d want to test going forward with my own money. Fama’s timing, though, was perfect. He came to the University of Chicago for graduate work not long after Merrill Lynch had funded the Center for Research in Security Prices (CRSP) in Chicago. This remark-able organization, with the availability of the electronic computer, The Market Is Smarter Than You Are 89 made possible the storage and analysis of a mass and quality of stock data that Cowles could only dream of. Any time you hear an invest-ment professional mention the year 1926, he’s telling you that he’s got-ten his data from the CRSP. Fama had already begun to suspect that stock prices were random and unpredictable, and his statistically rigorous study of the CRSP data confirmed it. But why should stock prices behave randomly? Because all publicly available information, and most privately available infor-mation, is already factored into their prices. Sure, if your company’s treasurer has been recently observed to be acting peculiarly and hurriedly obtaining a Brazilian visa, you may be able to profit greatly (and illegally) from this information. But the odds that you will be able to repeat this feat with a large number of com-pany stocks on a regular basis are zero. And with the increasing sophistication of Securities and Exchange Commission (SEC) surveil-lance apparatus, the chances of pulling this off even once without winding up a guest of the state grow dimmer each year. Put another way, the simple fact that there are so many talented ana-lysts examining stocks guarantees that none of them will have any kind of advantage, since the stock price will nearly instantaneously reflect their collective judgment. In fact, it may be worse than that: there is good data to suggest that the collective judgment of experts in many fields is actually more accurate than their separate individual judgments. A vivid, if nonfinancial, example of extremely accurate collective judgment occurred in 1968 with the sinking of the submarine Scorpion. No one had a precise idea of where the sub was lost, and the best esti-mates of its position from dozens of experts were scattered over thou-sands of square miles of seabed. But when their estimates were aver-aged together, its position was pinpointed to within 220 yards. In other words, the market’s estimate of the proper price of a stock, or of the entire market, is usually much more accurate than that of even the most skilled stock picker. Put yet another way, the best estimate of tomorrow’s price is . . . today’s price. There’s a joke among financial economists about a professor and student strolling across campus. The student stops to pick up a ten-dollar bill he has noticed on the ground but is stopped by the profes-sor. “Don’t bother,” he says, “if that were really a ten-dollar bill, some-one would have picked it up already.” The market behaves exactly the same way. Let’s say that XYZ company is selling at a price of 40 and a clever analyst realizes that it is actually worth 50. His company or fund will quickly buy as much of the stock as it can get its hands on, and the ... - tailieumienphi.vn