Rational Advisor

To be clear, firstly I consider anything less than three to five years short term.

Why do we have the recent volatility, it’s because we have just too many short term chasers and worriers. These are the people who hop around and move their money from managers who have generated the most hot performance.

These short-termers tend to be frustrated, emotional and impulsive. The only way they can see out of their predicament is to switch, and then when that falls to switch again – hop, hop, hop till they fall down the hole. All this hopping leads to underperformance, not out performance.

Why does it lead to underperformance

- Because great recent performance does not mean great investment management.

The recent hot performance is really an indicator of a past decision, and not necessarily and indication of things to come. Good investment managers make investment decisions that take time to come to fruition. It takes time for that particular investment to show its worth, whereas the hot fund has already displayed its worth and maybe planning to give it up. Strong investments often look quite average, even mediocre, during the first year or two of ownership.

- Return to normality – Reversion to the mean

One of the most overwhelming forces in the market is this – return to rationality – a reversion back to the long term average growth rates of the investment assets. This is probably one of the most ignored pieces of wisdom that investors forget, as they chase that new investment story being hyped. I believe a lot of investment managers are plain lucky because they rode a wave. And when the rationality returns, its unfortunate that the average joe investor who bought because of the great short term performance numbers gets clobbered – remember the 200% return of tech funds just before the tech wreck! When the luck turns investors who bought based on a couple of years of hot performance can get blindsided. Investors should view short term outperformance with suspicion.

- Don’t understand Risk

Many people just don’t understand risk. Consider this example: fund manager A pays $60 each for several stocks that he accurately calculates to be worth $100 each. This is a good decision. Shortly thereafter, each stock rises to $100. His rate of return is terrific, at 67 per cent.

Investors react in predictable fashion. They pour money into the fund because fund manager A has produced such a high return. But if the portfolio stays the same, risk has escalated significantly because the assets are no longer held at a big discount to value.

Another manager, fund manager B, also pays $60 each for several stocks that he accurately calculates to be worth $100 each. As with fund manager A, this is a good decision. But, shortly thereafter each stock falls to $45. The fund is down by 25 per cent.

Investors react predictably to a 25 per cent decline and flee fund manager B in droves. The investors have made a mistake. If we assume, like the example above, that the portfolio stays the same, the assets are now very low risk. That is because value now exceeds price by a wider margin that when they were originally purchased. It also follows that investors are fleeing just when their expected return is exceptionally high; eventually the $45 quote for each stock will migrate to the asset value of $100.

Short-term performance has nothing to do with the decision-making skills of fund managers A and B. The managers made equally good decisions. One was lucky because quotes quickly jumped to fair value. The other was unlucky because cheap prices got even cheaper.

- Extrapolation

Investors tend to extrapolate the short term performance out as if it could continue forever, so when a manager is under performing they think it will last forever, and when he does great he’ll carry on.

Short term performance metrics, whether positive or negative are meaningless.

What’s important is that you stick to a sound discipline and give it time to work out. Nobody can predict the markets events in the short term, but in the longer term, business and investment fundamentals rule. Even though you might be concerned about the recent volatility of your portfolio, if it is soundly structured, based on good investment principles - stay focused on your longer term objectives. What you have to determine is how much volatility you can sustain in the short term to achieve those long term objectives.

Many consider Warren Buffett one of history’s greatest investors – yet there were many periods that he underperformed his benchmark, many periods when he had a negative return in the short term. The reason he remains supreme, is because he had a discipline and he stuck to it through thick and thin.

Thanks

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