Why Investors Fail...

verfasst von Rossi, 12.10.2002, 11:45

-->How to Know When the Next Bear Market Rally Begins
It's a Cruel, Cruel Investment World
Why Investors Fail
Where are the Bull Market Geniuses?
Tails You Lose, Heads I Win
Ergodicity
I've Got A Secret System for You
Baggage Claim Blues


By John Mauldin

Exactly what use is past performance? How can you spot a trend
before it starts, and determine when it will stop? And when will the
next big bear market rally start? This week we examine why so many
investors fail, and why a few succeed over and over again. While I
am sure that none of my regular readers make these mistakes, this
will be a useful column to send to your friends who have not been as
successful as you. Oh, yes, and I tell you how to know when the next
big rally starts. Let's keep that detail to ourselves. No use
tipping your friends on this one.

But first, I must admit a BIG mistake. Last week, after several
pages of detailing why deflation is a big problem in our near
future, I ended by writing that the Fed must begin NOW to fight
inflation. I meant the Fed must begin NOW to fight deflation. Many
of you wrote, asking me to explain. As my friend Mac Ross wrote:
'John, there are now 1 million plus readers taking Excedrin trying
to figure out what you meant.' I do apologize. Since Alan Greenspan
did not abandon his easy money policy, as a result (other than
reader confusion) there has been no material damage.

It's a Cruel, Cruel Investment World

It's been a very busy week. I have been continually reminded at
every stop in my travels how difficult it is to make money in the
stock market. I have spent the last few days speaking at and
attending the Fund of Hedge Funds Forum in New York, and then a
private meeting in DC of investment newsletter publishers from
around the world. I was privileged to have dinner in La Jolla with
Richard Russell of Dow Theory fame, and one of the hottest hands in
the investment world of late. I have had the privilege of
interviewing a number of managers and analysts, and have been
reviewing Nassim Taleb's must read book, Fooled by Randomness. I
will pass on a few of the more noteworthy ideas, especially from Mr.
Russell, that I have gleaned from this investment elite to you.

If you have been having trouble making money in the stock market
this year, you are not alone. Hennessee reports that the average
hedge fund was down 1.3% for September, and is now down 5.5% for the
year! The hedge fund industry is on track for its first losing year
ever.

Think about that for a second. In the bear markets of 2000 and 2001,
the average hedge fund managed to make a profit. Some did quite
well, thank you. So, it is not just the bear market that is the
problem. This market environment is proving to be the toughest
conditions that most of us have ever seen.

One would think that because high net worth investors and huge
pension funds are willing to pay high fees for their expertise, they
believe these hedge managers are at the top of the investment
management world. These funds have some of the best research and
brightest minds and they are having problems.

To be sure, they have out-performed their peers in the mutual fund
world, but that is small comfort if your returns are negative.
Charging high management fees does not necessarily mean you are a
good investment manager. However, if you don't produce results, you
will soon be out of business. While investors are often more patient
than they should be, negative returns soon wear thin.

Why Investors Fail

While the professionals typically explain their problems in very
creative ways, the mistakes that most of us make are much more
mundane. First and foremost is chasing performance. Study after
study shows the average investor does much worse than the average
mutual fund, as they switch from their poor performing fund to the
latest hot fund, just as it turns down.

Mark Finn of Vantage Consulting has spent years analyzing trading
systems. He is a consultant to large pension funds and Fortune 500
companies. He has a team of certifiable mathematical geniuses
working for him. They have access to the best pattern recognition
software available. They have run price data through every
conceivable program and come away with this conclusion:

Past performance is not indicative of future results.

Actually, Mark says it more bluntly: Past performance is pretty
much worthless when it comes to trying to figure out the future. The
best use of past performance is to determine how a manager behaved
in a particular set of prior circumstances.

Yet investors read that past performance is not indicative of future
results, and then promptly ignore it. It is like reading statements
at McDonalds that coffee is hot. We don't pay attention.

Chasing the latest hot fund usually means you are now in a fund that
is close to reaching its peak, and will soon top out. Generally that
is shortly after you invest.

What does Finn and his team tell us does work? Fundamentals,
fundamentals, fundamentals. As they look at scores of managers each
year, the common thread for success is how they incorporate some set
of fundamental analysis into their systems.

This is consistent with work done by Dr. Gary Hirst, an analyst and
fund manager. In the 1990's, looking for some technical system to
use, he rigorously programmed the basics for every technical system
and indicator he could find. The result was that he found technical
systems to be useless. They worked when the conditions for which
they were designed were the primary economic background, but when
conditions changed they failed miserably.

Richard Russell made this very astute observation this week on
technical indicators:"I note that the Arms index, the put/call
ratio, the short interest ratio, the McClellan Oscillator and a
dozen other indicators that worked beautifully in the bull market
have ceased to work in this bear market. What does that tell me? It
tells me why so many 'bull market analysts' have been wrong over the
last couple of years.

"It also tells me that this is a bear market, but it's not a
'normal' or 'typical' bear market. It tells me that this is a
'power-house' bear market, a monster, a relentless brute that has,
so far, paid no attention to the regular, time-tested methods that
have worked in bull market corrections and lesser bear markets."

What Hirst found was consistent with what I hear so much in meetings
with managers: In his opinion, if a technical system is
"successful," it is because the money management system (risk
controls, stop losses, etc.) is good. With proper money management,
you could almost invest at random and achieve the same result over
long periods of time. By definition, cutting losses and letting
winners ride is a trend following system. It is basic money
management.

As an illustration, I have seen past performance track records of
fund which are managed using astrology. While I may risk offending
Maggie, one of my long time readers, I think"signals" produced by
looking at the stars is about as random as you can get. I should
also say it may be better than some other technical systems I have
seen.

An excellent example of a good money management system is Doug
Fabian's Maverick Investor System. It is a simple 39 week moving
average system, with a few bells and whistles. When a fund is above
its 39 week moving average, he invests. When it is below, he exits.
While this means he will miss some opportunities in a bull market,
and even though he can get"whip-sawed in certain markets, he avoids
the huge losses that can kill a portfolio for a decade just as you
want to retire. This simple system is so clearly superior to buy and
hold that I do not understand how anyone can maintain otherwise.

Whether you use 39 weeks or some other risk management system, in
secular bear markets, if you want to be successful, you must have
one.

Where are the Bull Market Geniuses?

The bull market bubble made geniuses of many average investors and
managers. They confused luck with skill. They assumed their
brilliant technical analysis produced their wonderful results when
in fact they were on the right side of a self-fulfilling prophecy.
For a short while, people forgot how just #$#@$ hard it is to pick
good stocks.

This reminds me of the study I cited last year from the National
Bureau of Economic Research. Only a very small percentage of
companies can show merely above average earnings growth for 10 years
in a row. The chances of you picking a stock that will be in the top
25% of all companies every year for the next ten years is 50 to 1 or
worse. In fact, the longer a company shows positive earnings growth
and outstanding performance, the more likely they are to have an off
year. Being on top for extended periods of time is an extremely
difficult feat, and we are finding out now that companies which did
perform so well frequently cooked their books - think Cisco -- or
just outright lied. Think Enron.

Yet what is the basis for most stock analysts' predictions? Past
performance and the optimistic projections of a management that gets
compensated with stock options. What CEO will tell you his stock is
over-priced? His staff will kill him, as their options will be
worthless. Analysts make the fatally flawed assumption that because
a company has grown 25% a year for five years that they will do so
for the next five. The actual results for the last 50 years show the
likelihood of that happening are small.

Tails You Lose, Heads I Win

I keep a marvelous must-read book by Nassim Nicholas Taleb called
"Fooled by Randomness" on my desk. I read it often, simply opening
it anywhere and reading a few pages. The sub-title is"The Hidden
Role of Chance in the Markets and in Life." He looks at the role of
chance in the marketplace. Taleb is a man who is obsessed with the
role of chance, and he does a very thorough treatment. While I have
read many of his points elsewhere, he gives us several totally new
(to me) concepts. He also has a gift for expressing complex
statistical problems in a very understandable manner.

I think anyone who wants to trade the markets should read this book.
If you still want to trade, then read it again. If you still want
to trade, then put it on your desk and read it often.

If you are an investor, you should read this book. Taleb will save
you money. I need to acknowledge his contribution for much of this
next section. Assume you have 10,000 people who flip a coin once a
year. After five years, you will have 313 people who have come up
with heads five times in a row. If you put suits on them and sit
them in glass offices, call them a mutual or a hedge fund, they will
be managing a billion dollars. They will absolutely believe they
have figured out the secret to investing that all the other losers
haven't discerned. Their 7 figure salaries prove it.

The next year, 157 of them will blow up. With my power of analysis,
I can predict which one will blow up. It will be the one in which
you invest!

Ergodicity

In the mutual fund and hedge fund world, one of the continual issues
of reporting returns is something called"survivorship bias." Let's
say you start with a universe of 1,000 funds. After five years, only
800 of those funds are still in business. The other 200 had dismal
results, were unable to attract money, and simply folded.

If you look at the annual returns of the 800 funds, you get one
average number. But if you add in the returns of the 200 failures,
the average return is much lower. The databases most statistics are
based upon only look at the survivors. This sets up false
expectations for investors, as it raises the average.

Taleb gave me an insight for which I will always be grateful. He
points out that because of chance and survivorship bias, investors
are only likely to find out about the winners. Indeed, who goes
around trying to sell you the losers? The likelihood of being shown
an investment or a stock which has flipped heads five times in a row
are very high. The chances are that hot investment you are shown is
a result of randomness. You are much more likely to have success
hunting on your own. (The exception, of course, would be my
clients.)

That brings us to the principle of Ergodicity,"...namely, that time
will eliminate the annoying effects of randomness. Looking forward,
in spite of the fact that these managers were profitable in the past
five years, we expect them to break even in any future time period.
They will fare no better than those of the initial cohort who failed
earlier in the exercise. Ah, the long term." (Taleb)

Don't despair yet. There is hope. I will discuss a few principles
for discerning between the managers who are lucky and those who are
good in a moment. But first, we need to know what we are up against
in our search.

I've Got A Secret System

If you go to an investment conference or read a magazine, you are
bombarded with opportunities to buy a software package which will
show you how to day trade and make 1,000% a year. For $5,000 you can
buy an"exclusive" letter (Just you and a thousand other readers,
and their friends and clients) which will give you a hot options or
stock tip. You will be shown winning trades which make 100% or more
in a short time. You, too, can use this simple tested method to
enrich yourself. Act Now. (Add $6.95 for shipping and handling.)

There are several large databases of hedge funds. As I mentioned
above, these are supposedly the best of the best.

None - not one - nada - zippo - zero of these best managers in the
world can deliver consistent results that you read about in these
ads. The best offshore fund in the world for the five years ending
in 2000 did about 30% a year. You can't get into it. But in 2001
they were flat. They are down slightly this year.

Steve Cohen can deliver some spectacular returns and has for almost
20 years. He has been closed to new money for years. But even this
legend can't put up numbers like I see in the ads.

Here's the reality. If you could make 20% a year steady, in five
years - ten at the most-- you will be managing all the money you can
run. Trust me, the money will find you. You will charge a 2%
management fee and 20% of the profits. On $1 billion, that amounts
to $60 million dollars in fees. That's every year, of course. Why
would you sell a"system" that could do 20% a year?

Once everyone knows about a system, it won't work like it has in the
past. One of the problems I wrestle with every day is trying to
figure out which investment styles may be at the end of their run.
Every dog has its day in the sun. The trick is to figure out when
the sun is setting.

There are physical limits to everything and every system. Knowing
your limits, and the limits of your investment managers, is
critical. Many of the spectacular blow-ups have been from managers
who do not understand the limits of their style.

Take the Janus 20 fund. This is a fund that focuses on the 20"best"
companies, mostly tech. They had an incredible record, and grew to
manage tens of billions of dollars. This was good for the managers,
as annual bonuses grew each year as well. They told their investors
the secret to their success was doing their homework and being
expert on analyzing companies. They were bottom's up value
investors, looking for growth potential, and boy were you lucky to
have found them.

They were a bus load of investors on their way to a train wreck. No
one seemed to think the party would end. But when it did, they had
no exit strategy or even the ability to exit. If you own $5 billion
in Cisco, you are not a shareholder. You are a partner. You are
stuck. If you try to get out, the market will soon get the word that
Janus is bailing, and the shorts will eat your lunch. One of the
reasons long-short hedge funds made so much money in 2000 was just
this phenomenon. Figure out which hedge fund had to dump to cover
redemptions and short the market ahead of them.

In hindsight, their incredible track record was less brilliant
investing and, more simply, participation in the largest investment
bubble in history, with no exit strategy. They got heads 8 times in
a row. They are in the process of getting tails for the third
straight year. Amazingly, they still send out promotional literature
touting their research and predicting they will be there for the
turn-around. Unfortunately, a lot of investor money won't be there.

How to Know When the Next Bear Market Rally Begins

First, let me make this very clear: There is no technical
indicator, or even fundamental system, that can tell us when the
next bear market rally will begin. All of this talk on TV about this
indicator or that system telling us we are at the bottom is just
voodoo investing. It is an exercise in wishful thinking.

The Nobel prize in economics this year is going to a psychologist,
Dr. Daniel Kahneman, who helped pioneer the field of behavioral
economics. If I can crudely summarize his brilliant work, he
basically shows that investors are irrational. But what gets him a
Nobel is he shows that we are predictably irrational. We continue to
make the same mistakes over and over. One of the biggest is our
common inability to take a loss. He goes into long and magnificent
explanations of why this is, but the bottom line is that taking a
loss is so painful, we simply avoid it.

While technical indicators cannot be rigorously programmed to yield
an automatic, always winning, low losses, don't think about it
trading system, they do provide some useful insight. Volume,
direction, momentum, stochastics, etc. are reflective of market
psychology. With a great deal of time and effort, astute traders can
use this data to determine what Mark Finn calls the"gist" of the
market.

The great traders become adept at using this data to help them
determine market psychology and thus market movement. They also
employ excellent money management and risk controls skills. It is my
belief they are simply guessing. They will look at you and swear
they are not."Look," they say,"the Vix is over 50! You gotta
trade!!"

Well, maybe. Until that indicator fails, and it does from time to
time. Maybe most of the time they are right. But it is still a
guess.

I readily admit that some people are quite skillful. My contention
is they have the"feel." Just like some people can hit 95 MPH fast
balls, they can look at amazing amounts of data and feel the market.
They use solid money management techniques to control the risk, and
they make money for themselves and their clients. Like Alex
Rodriguez at the plate, they make it look easy.

And thus many ordinary people think they can do it. And most fail.

For some reason, we take this failure personally. It seems so easy,
we should be able to do it. But after years of interviewing
hundreds of managers, and looking at thousands of funds, and mounds
of data, I have come to believe it is a gift, just like hitting
baseballs or golf balls.

If it were easy, everybody could do it. But it's not, so don't beat
yourself up if you are the one with the gift. It would be like me
getting angry at myself for not being a scratch golfer. It is not
going to happen in my lifetime. If I wanted to bet on golf, I would
bet on a pro, not on me.

And thus, I come to my insight on how to determine when the next big
bear market rally begins. I will ask Richard Russell.

Richard has been writing the Dow Theory Letter since 1958. At 78,
he is writing more copy (daily) and better than at any time in his
life, and shows no sign of slowing down. He gets up at 3 AM, reads
ten papers, scores of letters and services, and then just writes
some of the best copy anywhere, along with copious amounts of useful
data. He has been as consistently right as anyone for that period,
and his"feel" for the market puts him in hall of fame categories.

He recently wrote that he would try and guess when the next
sustained rally would start. He gives no guarantees, and says it may
happen and he will miss it. Maybe it started on Thursday, and he
missed it. And then, maybe this is a true sucker's rally in a longer
term bear market. As those of you who have read me for some time
know, I have been of the opinion that we are in a long term secular
bear, and the"bottom" is several years off. We will get lots of
trading opportunities.

My bet is that Russell's best guess is better than 99.5% of all the
writers and analysts out there, and I don't know who the other 0.5%
are. You can get his work online for a mere $250. Just for the
record, I get nothing from Russell, although he did buy dinner last
Saturday in La Jolla. But then, I gave him my professional opinion
on the diamond market. I got the better deal.

So, if he calls the turn, I will take credit for being smart enough
to tell you to follow his advice. If he is wrong, I hope I made you
a believer in stop losses and risk control. You can access his web
site at www.dowtheoryletters.com.

Baggage Claim Blues

I finish this letter, written in four cities and three airports,
standing at a counter in Reagan Airport baggage claim, where
American Airlines has somehow misplaced an entire planeload of bags.
I am so-o-o-o looking forward to getting home.

My next trip will be to New Orleans, November 7-10 for the New
Orleans Investment conference. (www.neworleansconference.com), where
Mr. Russell will also be speaking. In addition to addressing the
main conference, I will also hold a private 'Invitation Only'
session on Thursday night just for Accredited Investors. If you are
an Accredited Investor, you can get an invitation by registering for
my free Accredited Investor E-letter (www.accreditedinvestor.ws)
which deals with hedge funds and private offerings. If you are
already registered, you will automatically receive an invitation.

I look forward to seeing you there.

By the way, you can read chapters from my book in progress, Absolute
Returns, by going to www.johnmauldin.com. Let me know what you
think of the new site.

Your ready to be in his own bed (next to his bride) analyst,

John Mauldin
John@2000wave.com

Copyright 2002 John Mauldin. All Rights Reserved

To subscribe to John Mauldin's E-Letter please click here:
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• Why Investors Fail... - Rossi, 12.10.2002, 11:45