“It was never my thinking that made the big money for me. It was always my sitting.” - Edwin Lefèvre (Jesse Livermore).
In the history of the mutual fund industry, Fidelity’s Magellan Fund stands unique. Under its iconic manager, Peter Lynch, Magellan would become not just one of the largest mutual funds in the world, but the world’s single most successful. In history.
When Lynch took over management of Magellan in May 1977, the fund’s assets stood at a comparatively paltry $18 million. By the time Lynch concluded his tenure at the fund, in May 1990, Magellan controlled $14 billion in assets.
During Peter Lynch’s management of the Magellan fund, he delivered average annual returns of 29.2%. That is an average annual return that puts even Warren Buffett to shame. So what do you think the average investor in Magellan made ? Not more than 29.2% per annum, clearly. But 25% per annum ? Perhaps 20% ?
During the tenure of its most successful manager, the average investor in the world’s most successful ever mutual fund lost money.
You read that correctly.
How could that possibly happen ?
Our own worst enemy
A quote from another investment legend (Warren Buffett’s own mentor, Benjamin Graham, the father of ‘value’ investing) makes the point clearly:
“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
As Graham also said – the guy gave good quote – investing
“..isn’t about beating others at their game. It’s about controlling yourself at your own game.”
For most of us, one significant facet of successful investing is identifying someone with whom we can confidently invest over the longer term. Peter Lynch was clearly one of those individuals.
But the average retail investor into the Magellan Fund evidently didn’t trust Peter Lynch enough.
More likely, the average investor in Magellan ended up trading in and out of the fund on numerous occasions.
In other words, the average Magellan investor was defeated by two things:
They say that time heals all wounds. And in matters of investment there’s more than a grain of truth to that suggestion. If we choose the right manager, whether for a subset of a portfolio or for our entire portfolio, or as the capital allocator of a good listed company, all we really need is for time to do its work.
But most of us struggle to hang on for the long run.
Even when things are going well, we fall victim to the desire to be doing something.
The French ‘renaissance man’ Blaise Pascal once said that
“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”
Nowhere is that observation more valid than in the investment markets.
Enter Taleb’s dentist
The author and investor Nassim Nicholas Taleb is rightly well regarded for his book ‘Fooled by randomness’. The book is worth the cover price alone for the following analysis.
Imagine (writes Taleb) a retired dentist. This hypothetical though not entirely implausible investor is guaranteed to earn, on average, 15% returns per annum from his stock portfolio, with an associated price volatility (annualised standard deviation of return) of 10%.
Those statistics are not open to dispute.
If our retired dentist friend chooses to monitor his portfolio in real time, however, the random price oscillations he encounters are likely to trigger extreme anxiety. Depending on the frequency with which he chooses to observe his portfolio, our retired dentist will experience a huge range of outcomes between heartache, distress, and satisfaction.
The frequency of his portfolio observation – using an internet brokerage account, for example – versus the probability of his experiencing a pleasurable outcome from his monitoring efforts are shown below:
Timescale – frequency of portfolio monitoring Probability of favourable outcome
1 second 50.02%
1 minute 50.17%
1 hour 51.30%
1 day 54.00%
1 month 67.00%
1 quarter 77.00%
1 year 93.00%
(Source: ‘Fooled by randomness’ by Nassim Nicholas Taleb.)
Note that nothing has changed regardless of the frequency with which our friend checks his portfolio. If he chooses, foolishly, to track his stock holdings in real time, he will only experience the (illusory) thrill of seeing his portfolio in profit just over half the time – specifically, 50.02% of the time. In other words, 49.98% of the time he will be “out of the money”.
The same goes if he chooses to monitor his portfolio every minute. 49.83% of the time, he will be losing money.
If he exerts the monumental discipline required to limit his portfolio observations to once a day, the likelihood of him seeing a positive outcome rises to 54%. (And the likelihood of him incurring a painful outcome falls to 46%.)
But if he has the iron discipline to restrict the frequency of his observations to once a quarter, the likelihood of him experiencing the glow of a happy outcome surges to 77%. Note that nothing has changed about his portfolio here – only the frequency with which he checks it. Clearly, best of all these options is the once-a-year check, which promises a positive outcome 93% of the time. But let’s be realistic. Few investors are capable of the ‘laissez faire’ approach to limit their portfolio checking to just once, annually.
It would also not surprise us to learn that the average individual investor started experiencing dramatically poorer investment returns after about 1995, irrespective of the stock market’s direction.
Because that was when the Internet started to become widely available to the public. Netscape 1.0 was released in December 1994. This correspondent started using the Internet for the first time, professionally, at some point in 1995 when working at Merrill Lynch.
And the Internet is one gigantic distraction device.
In his groundbreaking book ‘The Shallows’, Nicholas Carr develops his thesis of how “the internet is changing the way we think, read and remember”.
He could have added: “and invest”.
Carr writes how
“..I began to notice that the Net was exerting a much stronger and broader influence over me than my old stand-alone PC ever had. It wasn’t just that I was spending so much time staring into a computer screen. It wasn’t just that so many of my habits and routines were changing as I became more accustomed to and dependent on the sites and services of the Net. The very way my brain worked seemed to be changing. It was then that I began worrying about my inability to pay attention to one thing for more than a couple of minutes. At first I’d figured out that the problem was a symptom of middle-age mind rot. But my brain, I realized, wasn’t just drifting. It was hungry. It was demanding to be fed the way the Net fed it – and the more it was fed, the hungrier it became. Even when I was away from my computer, I yearned to check email, click links, do some Googling. I wanted to be connected. Just as Microsoft Word had turned me into a flesh-and-blood word processor, the Internet, I sensed, was turning me into something like a high-speed data-processing machine, a human HAL.
“I missed my old brain.”
There was once a time lost in the mists of history – perhaps 25 years ago – when it was a big deal to buy stocks. You needed to engage the services of a stockbroker, who would bundle research (of dubious value) together with the execution of trades on the exchange itself. Commissions were hefty and largely unaffected by competition.
Then along came the Internet, e*Trade and Charles Schwab.
This correspondent could tell that the writing was on the wall on the day that the market capitalization of Charles Schwab, internet broker, overtook the market cap of Merrill Lynch, full service investment bank. (This correspondent left Merrill Lynch in pursuit of better options soon afterwards.)
Perhaps the most powerful and most valuable metaphor in modern investing comes from Warren Buffett himself: the tale of the punch-card.
“I could improve your ultimate financial welfare,” wrote Buffett,
“by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do much better.”
But the investment and stock execution world of 2023 is not a punch-card. It’s a web-based service that pumps almost infinite amounts of information at your brain and offers you the opportunity to transact across an almost infinite array of investments at marginal cost, just by hitting the return key.
We would probably be better off if there were more cost and effort involved.
It has become accepted wisdom that no-load mutual funds (funds without a sales charge) are a far superior vehicle to load funds. The entire ETF industry is predicated on this belief.
But like the average investor’s experience with the Magellan Fund, it ain’t necessarily so.
Fund manager Ken Fisher points out that, on average,
“no-load fund investors do much worse than the funds themselves [c.f. Magellan] and they badly lag the S&P 500 – and even lag investors who invest in funds with heavy loads. Why ? Because no-load funds are convenient to trade, so they do it – much too often. They make moves at the wrong times, and that seriously hurts.
Solution: grow a spine
“The fee load fund investors pay upfront – sometimes as much as 5% – serves as a behavioural spine. They trade far less, hold their funds much longer – don’t in-and-out at all the wrong times, buying high and selling low – so their performance over time is much better even including those outrageous load fund fees. No-load fund investors on average hold their funds way too short a time for their own good because they trade them whenever they feel the urge, not having that behavioural “spine” the load fund investor feels.
“What no-load mutual fund investors need is an artificial “spine” as a barrier to get them to trade less and hold longer.”
Fisher advocates buying no-load funds and setting up a contract with your spouse at the same time. Every time you trade those funds you must forfeit 5% to your spouse so he or she can go out and spend it on whatever they want, frivolous or otherwise. “The threat of a spousal shopping spree can be just the discipline you need to trade less. And even over a period as short as five years, the benefit of sitting tight should easily outweigh the cost of creating your 5% artificial spine. It also motivates you to pick your funds more carefully.”
Some degree of market lag by fund managers is inevitable. Funds carry fees, and the index doesn’t. But overlay the fund investor’s overtrading with the assumed overtrading of the managers grimly tracking the index, and then add in the effect of poor market timing, and the cumulative shortfall in performance really mounts up.
Our own worst enemy II
We’ve suggested above that the typical investor’s inability to hang on to their holdings – whether of high quality stocks or of investment funds – for the long run is a key factor in most investors’ disappointing long run returns.
Another common, related problem – common amongst the so-called professionals as much as in supposed ‘amateur’ investors – is to be lured away from a solid investment strategy by shorter term price volatility, a.k.a. noise. More specifically, it’s the tendency to treat the market price as all-important, when it really just reflects the mood of fellow investors on any given day, at any given time. Benjamin Graham coined the personage of “Mr. Market” to account for these constant mood swings between market participants, ranging from giddy euphoria to abject depression and back again.
Take a stock we know quite well: Fairfax Financial Holdings.
The table below, extracted from the company’s 2021 annual report, shows the growth in the company’s intrinsic value, or book value per share, since 1985 (column 1).
Column 2 shows the company’s year-end share price.
Source: Fairfax Financial Holdings Ltd.
Over a period of more than 35 years, Fairfax, under the inspiring leadership of its CEO, Prem Watsa, “Canada’s Warren Buffett”, has grown its book value per share, on average, by 18.2% per annum. That is a hugely impressive, Warren Buffett-, Berkshire Hathaway-style return.
And over a period of the same 35+ years, Fairfax’s share price has grown, on average, by 15.7% per annum.
And for any other business operating along similar lines, with similar profitability, we can expect the share price, over the longer run, to more or less exactly match the increase in the company’s intrinsic value. It makes absolute sense.
Whatever happens to the share price in the short run (short run being defined here as perhaps anything less than two to three years) is not really terribly significant.
Except inasmuch as – just like Benjamin Graham advised in ‘The Intelligent Investor’ – the disciplined investor can take advantage of other people’s impatience and mood swings, leading to a temporary fall in the share price, to load up the truck.
This is a subtlety that is all too often ignored by the vast majority of market commentators and investors. Growth in intrinsic value is what everybody wants to see in their stock portfolio – but just about everybody gets sidetracked by what the share price happens to be doing from one day to the next.
The reality, of course, is that as long as management is doing its job to the best of its ability, and the company continues to be run well, we should have every expectation that the company’s growth in intrinsic value and the company’s share price will move in lockstep with each other. Any day to day fluctuations in the share price, provided that the business itself is not impaired, should merely be regarded as an opportunity to buy more, or to lighten up, holdings in the stock – or simply to leave well alone and do something fundamentally more constructive with one’s time.
“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”
Here’s a great example of what we mean – and the investment media are fully complicit. A US newspaper (names have been withheld to protect the guilty) published the following article on February 17th, 2016. The headline blared:
“Could Fairfax Financial Holdings Ltd Crash Even More? The Stock Had Another Big Decline Today”
And the article in question went on to add,
“The stock of Fairfax Financial Holdings Ltd (TSE:FFH) is a huge mover today! The stock is down 0.22% or $1.68 after the news, hitting $777.15 per share. About 27,286 shares traded hands..”
When a share price movement of 0.22% amounts to a “crash”, all bets are clearly off.
In the very next sentence the article points out,
“Fairfax Financial Holdings Ltd (TSE:FFH) has risen 21.61% since July 10, 2015 and is uptrending. It has outperformed by 31.32% the S&P500.”
Either the journalist in question never went to journalism school (likely), or the computer that wrote this garbage didn’t get programmed correctly (just as likely). ChatGPT at least solves the latter problem.
Having cited an egregious example of financial media entirely missing the plot, we feel duty bound to reiterate an observation made by the academic Thomas Schuster in a research note entitled ‘Meta-Communication and Market Dynamics’:
“The media select, they interpret, they emotionalize and they create facts.. The media not only reduce reality by lowering information density. They focus reality by accumulating information where “actually” none exists.. A typical stock market report looks like this: Stock X increased because.. Index Y crashed due to.. Prices Z continue to rise after.. Most of these explanations are post-hoc rationalizations.. An artificial logic is created, based on a simplistic understanding of the markets, which implies that there are simple explanations for most price movements; that price movements follow rules which then lead to systematic patterns; and of course that the news disseminated by the media decisively contribute to the emergence of price movements.”
And, needless to say, as the Fairfax story cited above makes clear in spades, they exaggerate, in the cause of making a story and attracting attention.
The best advice we can offer to any reader is simply to choose your investment commentary with extreme care. Rather than sup freely from the mixed waters of the financial media, only consume content from sources you know can be trusted. And if in doubt, trust no-one. Or rather, put your trust in the price – and in the simple but compelling mathematics of value investing and compound returns.
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you, too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio -with no obligation at all:
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: email@example.com
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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