Investors have Lousy Timing

The June/July issue of Morningstar Advisor (a trade publication for independent advisors) contains an article about how poorly investors time their purchases of mutual funds.

The article points out that, through most of 2009 and 2010, investors moved money from equity funds to bonds. The problem is that the stock market hit a low in March of 2009 and then proceeded to mount a rather aggressive recovery.

Investors who were moving from stocks to bond were heading in the wrong direction. They sold stocks when the market was low and moved into bonds after the bond market's very long rally.

Why do investors do this? Because they are driven by emotion. In the depths of the economic crisis, investors were panicked and fearful. What do people do when they feel this way? They run away. This reaction is instinctual. Taking flight is a helpful and appropriate reaction if you are being chased by a saber tooth tiger. In fact, it could save your life. It is not helpful if you are a long term investor trying to grow your wealth.

Stock Pickers Beaten Badly

Three of the most highly regarded fund managers have recently lagged behind their peers and the market itself.

Investment News reports (Berkowitz, Heebner and Miller in tight battle — for last place) that Bruce Berkowitz, Kenneth Heebner and Bill Miller have posted results are all well behind the Standard & Poor's Index through June 9, 2011.

Mr. Berkowitz was Morningstar's fun manager of the decade. Mr. Miller beat the S&P 500 index 15 straight years through 2005. Mr. Heebner was manager of the best-performing diversified US stock fund over a 10-year period.

Here's the scorecard:

Manager - Fund - Return

Bruce Berkowitz - Fairholme Fund - 12%

Kenneth Heebner - CGM Focus Fund - 12%

Bill Miller - Legg Mason Capital Opportunity Fund - 11%

S&P 500 Index + 3.4%

Data source: Morningstar

What can we learn from the fall of these stock picking stars? We have more information that suggests that stock pickers are unable to beat the market indefinitely. Certainly some managers beat the market. We would expect some to beat the market and others to underperform the market. The problem is differentiating one from the other.

Moreover, we do not know whether managers who beat the market do so because of skill or luck. Certainly successful fund managers claim that their superior investing skills underlie their performance. But we also routinely hear from underperforming managers that bad luck has derailed their funds. So, is it skill or luck?

Some might suggest that the savvy investors should ride the stars as long as possible and then jump off when they start to falter. There are three challenges that must the investor must overcome to pull this off. First, the investor must be able to identify and invest with the stock picking star BEFORE he starts his winning streak. Second, the investor must have the conviction to stay invested with the star if/when a more compelling investing opportunity appears. Third, the investor must know when to fold 'em and move out of the fund BEFORE it becomes a losing fund.

We know that investors are rarely able to move in and out of mutual funds successfully. Dalbar's research shows that shareholders in mutual funds earn returns that are consistently lower than those of the funds in which they invest.

The lesson for intelligent investors: Waste no time searching for the next hot fund manager. Instead invest across asset classes and capture the returns of those asset classes using low cost, passive funds.

Investors Hunkered Down

Prudential Financial recently conducted an online survey of investors, "The Next Chapter: Meeting Investment & Retirement Challenges."

http://news.prudential.com/images/20026/2011TLConsumerStudyFINAL.pdf

The study yielded some interesting data.

• 44% of the participants said they are not likely to ever put money in the stock market.

This is rather alarming, because it means a substantial portion of Americans are forsaking the asset class (stocks) with the greatest long term returns when compared to bonds, real estate and cash instruments (CDs, bank accounts, money market accounts).

• 61% believe the principles of investment diversification and asset allocation have changed.

The principles of successful investing have not changed. We know that markets are fickle. Asset allocation and diversification cannot and do not provide a shield from extreme market volatility. However, over long periods, no other strategy provides better results.

• 66% are concerned that they will miss out on the stock market recover based on their current portfolio mix.

Many investors bailed out of equities at or near the bottom of the recent stock market swoon. Since March of 2009, the low point, the stock market is up well over 100%. Investors who were not properly invested in equities lost out on this opportunity. Moreover, the opportunity will not present itself again until we have yet another economic crisis.

• 72% of Americans agree that they need to think differently about saving and planning for retirement.

The economic crisis, stock market crash and housing collapse may yield some long term benefit, if Americans actually begin reducing personal debt and saving more. Very few Americans are on track for a financially secure retirement.

• 69% believe few financial service firms are trustworthy.

The banks, wire houses, insurance companies, and credit unions have largely failed investors. In general, they have not served their customers in a fiduciary capacity. They have not engaged their customers in comprehensive planning. Instead they have offered complex and confusing products that have essentially transferred billions of savings from investors to large financial institutions.

Many Americans need to make a major change in their approach to retirement. If they do not, they run the risk of finding that the last decades of their lives will be something far less than golden. Among other findings, the Prudential survey suggests that the need for greater financial and investment literacy is great.

The Erosive Effect of Fees

I often wonder if investors realize how important fees are to their long term investing results. My sense is that they really don't get it. If they did, they would embrace low cost, passive investing and avoid active management and high priced investment advisors.

The Department of Labor reports that for every 1% increase in fees, an investor's portfolio erodes by 28% over 35 years. So, if an investor would have had $1 million at the end of 35 years, instead she would have $650,000. This is an enormous difference.

Investors have no control over the performance of their market based investments. However, they do have the ability to work with advisors who charge low fees and invest in funds that have low internal costs. Intelligent investors realize that low cost, passive investing is the most reliable path to successful investing.