Aiming for Consistent Success

09/10/2004 12:00 am EST


John Mauldin

Chairman, Mauldin Economics

"A key part of successful investing is simply avoiding the mistakes that most investors make," says John Mauldin. Known for thinking "out of the box," he looks at investor psychology and asks if investors can improve their performance by tempering high expectations.

"What is the basis for most stock analysts' predictions? Past performance and the optimistic projections of management. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that it will do so for the next five. The actual results for the past 50 years show the likelihood of that happening to be small. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances. The chance of you picking a stock today that will be in the top 25% of all companies every year for the next 10 years is 50 to 1 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for an extended period is an extremely difficult feat.

"Study after study shows the average investor does much worse than the average mutual fund, as he switches from his poorly performing fund to the latest hot fund just as it turns down. Studies show that many investors are purchasing funds based on past performance, usually when the fund is at or near its peak.  Top performing funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking, the more unlikely it is that a fund can repeat at that same level. If a fund does well in one year, it is possibly because its managers took some extra risks to do so, and eventually those risks will bite them and their investors. Maybe they were lucky and had two of their biggest holdings really go through the roof. Finding those monster winners is a hard thing to do for several years in a row.

"Mark Finn of Vantage Consulting has spent years analyzing trading systems. He is a consultant to large pension funds and Fortune 500 companies. He is one of the more astute analysts of trading systems, managers, and funds that I know. He has a team of mathematical geniuses working for him with access to the best pattern recognition software available. They run price data through every conceivable program and come away with this conclusion: Past performance is not indicative of future results. Chasing the latest hot fund usually means you get into a fund that is close to reaching its peak, and will soon top out. What do 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.

"While technical indicators cannot be rigorously programmed to yield an automatic, always winning or low loss, don't-think-about-it trading system, they do provide some useful insight. Volume, direction, momentum, stochastics, and so on 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 control skills. My contention is they have the ‘feel.’ Just like some people can hit 95 mph fastballs, they can look at amazing amounts of data and feel the market. They use solid money management techniques to control the risk. 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 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 not 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. It does not matter how much I practice. I simply don't have the talent to be a scratch golfer. If I wanted to bet on golf, I would bet on a pro, not on me.

"Trying to be in the top 10% or 20% is statistically one of the ways we find ourselves getting below-average returns over time. We might be successful for a while, but reversion to the mean will catch up. The truth is that the majority of top-performing investors in any given period are simply lucky. They have come up with heads five times in a row. There are some good investors who actually do it with sweat and work, but they are not the majority. But I can tell you how to get in the top 20% of investors. If an investor can consistently achieve slightly better than average returns each year over a 10–15-year period, then cumulatively over the full period they are likely to do better than roughly 80% or more of their peers. They may never have discovered a fund that ranked #1 over a subsequent one- or three-year period, but that is more than offset by their having avoided those that dramatically underperform. Avoiding short-term underperformance is the key to long-term out-performance.

"For those that are looking to find a new method of discerning the very top performing funds, my analysis will prove frustrating. There are no magic shortcut solutions, and we urge investors to abandon the illusive and ultimately counter-productive search for them. Those who are willing to restrain their short-term passions, embrace the virtue of being only slightly better than average, and wait for the benefits of this more conservative approach to compound, will do much better in the long run. That's it. You simply have to be only slightly better than average each year to be in the top 20% at the end of the race. It is a whole lot easier to figure out how to do that than chase the very top performers.

"Statistics and experience tell us that simply being consistently above average is damn hard work. In the US stock market, everybody knows everything everybody else does. Past performance is a very bad predictor of future results. Plus, the US stock market is cyclical, so that what goes up one year or even longer in a bubble market will not do well the next. When a fund is the number one fund for the year, that is random. It had a good run or a good idea and it worked. Is it likely to repeat? No. But being in the top 50% every year for 10 years? That is not random. That is skill. That type of consistent solid management is what you should be looking for."

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