“Many shall be restored that now are fallen, and many shall fall that now are in honor.” – Horace, Ars Poetica
Benjamin Graham, the father of value investing and mentor to Warren Buffett, opened with this quote in his 1934 classic on investing, Security Analysis. Graham knew that the key to investing was to take advantage of – and not fall prey to – the market’s fluctuations. “Individuals who cannot master their emotions,” stated Graham, “are ill-suited to profit from the investment process.”
Being trained in understanding human psychology as it relates to markets is an integral component of successful long-term investing. The typical individual’s tendency is to jump into the market at the top and flee at the bottom. (This holds true for all markets, be they stocks, bonds, real estate, art, antiques, etc.) Pursuing what has already performed well and avoiding what has performed poorly is called “performance chasing.” Succumbing to this causes the long-term returns of most individuals to suffer horribly.
Performance chasing occurs when people lose patience and abandon their investments, their strategy, or their investment managers at just the wrong time. Joel Greenblatt, one of the greatest investors of the past 30 years, cites the following:
“If you look at the top performers over the last decade, the top 25% of managers that have outperformed, that came out with the best record over the past ten years, 97% of those top managers spent at least three years in the bottom half of performance. 79% spent at least three years in the bottom quartile of performance. Almost half, 47%, spent at least three years in the bottom ten percent of performance. These are the ones who ended up with the best long-term record. Yet most people leave them – most people don’t stick around long enough. If [an investment manager] underperformed in the last six months, year, or two years, people chase performance and they take money away…and give it to someone else.”
Greenblatt notes, “The best performing mutual fund during the decade of the 2000s was up 18% annualized but the average investor in that fund lost an average of 11% per year. Why is that? Because every time the fund underperformed, people left.”
Louis Harvey, president of stock market research firm Dalbar, says too many investors “get excited or they panic, and they hurt themselves.” Dalbar’s studies demonstrate how costly it is for the multitude of investors who leave what seems will be forever cold to move into what is currently hot. By measuring all flows of funds into and out of stock mutual funds, Dalbar proves that investors earn far less than the market over time. During the past 20 years, investors earned 4% annualized compared with 8% for the U.S. stock market. Since the beginning of 2000 and through 2012 (the last year for which data is currently available), investors earned a total return of 11% over 13 years. (This compares to an average return of +90% for Cheviot clients during the same time.)
Too many investors “get excited or they panic, and they hurt themselves.”
nature has not adapted well to the cyclicality of markets: most people rush in at high prices only to bail out at low prices. The best investors are able to suppress their emotions and use crowd psychology to their advantage. Morningstar, the mutual fund research company, advises its readers to “adopt a contrarian mind-set.” Commenting on what recent investment returns may mean for the future, its research states: “Just as very strong recent performance often doesn’t foretell strong returns ahead, the opposite is also true: The fund with very weak recent returns can end up on top. A spell of weak returns can signal a buying opportunity because the securities in the portfolio could be relatively inexpensive.”
Legendary investor John Templeton knew that the crowd is usually wrong and he proved that the contrarian approach works quite well. The masses pulled money out of stocks a few years ago when they were reasonably priced and is pouring money into stocks now at elevated levels. Said Templeton, “People are always asking me where is the outlook good, but that’s the wrong question. The right question is: Where is the outlook the most miserable?” This is because the herd-like stampede of investors away from one area of the market often leaves it undervalued and attractive. Templeton continued, “Focus on value because most investors focus on outlooks and trends. You must be a fundamentalist [one who understands underlying businesses and the economy] to be really successful in the market.”
“Focus on value because most investors focus on outlooks and trends.” – Sir John Templeton
Behavioral finance teaches us that most people follow trends. And their long-term investment returns are much worse because of it. This is applied to all types of investing, including the selection of individual stocks, mutual funds, and investment advisors. Michael Mauboussin, author of numerous books on behavioral finance, states that after a couple of years of underperformance investment managers are typically fired and, “to wit, of course, over the next 24 months, the folks that they fired did better than the folks that they hired. So had they simply sat on their hands, they would have been better off!” Mauboussin continues: “So that is the message of the ‘hot hand.’ When they [the investment manager] have done poorly, the next move is likely up.”
The psychological barriers to successful long-term investing are difficult for individuals to overcome. Warren Buffett advises investors to, “be fearful when others are greedy and greedy when others are fearful.” Less eloquently, some simply say, “Zig when others zag.” Bernard Baruch, master investor and financier of the early 20th century, may have summed it up best: “Never follow the crowd.”