Investors behaving badly

Few things in investments amuse me more than stories of investors behaving badly. These stories are entertaining, but more importantly studying the mistakes of others has been an excellent tool that has helped me to improve my investment approach. It’s also much cheaper than making my own investment mistakes (of which there have been quite a few).

This post considers two examples of investors behaving badly. The common thread between both examples is the importance of discipline – being able to stick with an investment strategy over time.

Why is discipline important? Because it helps to ensure consistency. The ability to consistently stick to a proven investment process is an important characteristic shared by skilled investors that have successfully beaten the market over the long-term*.

There is a mountain of evidence, both academic and anecdotal, demonstrating that humans can’t be relied upon to act consistently over time. A change in our circumstances, mood or the influence of others can effect our decisions. Physical factors such as a lack of sleep or a full stomach can also influence our decision-making.

Even the number and timing of decisions that we make each day can have a big impact on our decision-making. For example, in an article entitled Do you Suffer From Decision Fatigue? The New York Times sites research by Jonathan Levav of Stanford and Shai Danziger of Ben-Gurion University.

The professors studied 1,100 decisions by an Israeli parole board. They found that prisoners who appeared early in the morning received parole about 70 percent of the time. In contrast, those who appeared late in the day were paroled less than 10 percent of the time.

It seems that as the day wore on, the parole board judges experienced “decision fatigue”. The result was that, in most cases after a day of decision making, the judge was too tired to figure out if the prisoner deserved an early release – so it was easier and safer to simply deny parole.

Decision fatigue is just one example of the limitations of human decision making. Successful investors understand that they can’t rely on themselves to be consistent when picking stocks, which is why they stick to an investment process. Being disciplined and consistent allows them to profit from the inconsistency of others in the market.

Poor decisions are made by professionals and amateurs alike. Our first example is the performance of a professionally-managed US mutual fund, the Value Line Fund. In its article Winning Stock Picker’s Losing Fund The Wall Street Journal wrote.

Value Line Investment Survey is one of the top independent stock-research services, touted for its remarkable record of identifying winners. Warren Buffett and Peter Lynch, among other professional investors, laud its system.

But the company also runs a mutual fund, and in one of Wall Street’s odder paradoxes, it has performed terribly. Investors following the Value Line approach to buying and selling stocks would have racked up cumulative gains of nearly 76% over the five years ended in December, according to the investment-research firm. That period includes the worst bear market in a generation…

By contrast, the mutual fund — one of the nation’s oldest, having started in 1950 — lost a cumulative 19% over the same five years.

How does a mutual fund turn a winning stock picking strategy into a losing investment? The simple answer is that they followed the Value Line Survey inconsistently.

The discrepancy has a lot to do with the fact that the Value Line fund, despite its name, hasn’t rigorously followed the weekly investment advice printed by its parent Value Line Publishing Inc…

…Most of all, the discrepancy between the performance of the fund and the stocks it touts shows that investors don’t always get what they think they’re buying in a mutual fund. For even though Value Line’s success is built around stocks ranked No. 1 by the company’s research arm, the fund’s managers have in recent years dipped into stocks rated as low as No. 3…

…Part of the underperformance stems from previous fund managers who didn’t rely entirely on Value Line’s proven model, opting instead to venture into lower-rated stocks, betting that active fund managers could unearth overlooked gems that one day would shine as top-rated stocks. Thus, investors who thought they were buying into Value Line’s winning investment strategy instead were buying into fund managers who thought they could outperform by second-guessing the company’s research — a tactic that didn’t work well.

In short, by not sticking to its investment process, the Value Line Fund got itself caught in a negative performance feedback loop. Portfolio managers tried to second-guess the Value Line Survey only to under-perform. They were then replaced with new portfolio managers who tried to turn the performance around by – you guessed it – second-guessing the Survey. And so on and so forth.

But the most ironic part of this story was that there was a mutual fund that stuck to the Value Line Survey, beating both the S&P 500 and the Value Line Fund.

The First Trust Value Line 100 closed-end fund, run by Lisle, Ill.,-based First Trust Portfolios, adheres far more rigorously to Value Line’s investment principles, owning only the top-rated stocks.

Each Friday, First Trust managers log on to the Value Line site to download the week’s list of Value Line’s 100 most-timely stocks. During the next week, they sell the stocks that have fallen off the list and buy those that have been added. The result: Since its inception in June 2003, the First Trust Value Line fund’s net-asset value is up 12.4%, slightly better than the 11.6% gain the Standard & Poor’s 500-stock index posted in the same period.

Value Line’s own fund, meanwhile, gained 3.1% in that same time.

So what do we learn? Investors need to be disciplined enough to stick to their investment process! Investing is all about the future. The future is uncertain and unknowable. In other words it is impossible to control the performance of any single investment, let alone a portfolio of investments. Successful investors know this, which is why they focus on what they can control – their investment process. And when they identify a process that works they stick to it through inevitable short-to-medium term under-performance (see my earlier post Beating the Market Part 2 – Short-Term Under-performance).

Remember, successful investors often appear to be “eccentric, unconventional and rash” because they usually invest differently to the herd. For example, they may look for opportunities in different places or they may run concentrated portfolios that have very little in common with market capitalization-weighted benchmarks. This is possible because they stick to an investment process that they believe will work over the long-term. The process gives them the confidence to be different. And as we’ve considered in an earlier post (Beating the Market Part 3 – “Sheep Get Slaughtered”), investors can’t beat the market unless they invest differently.

Now to our second example. This time its do-it-yourself investors behaving badly. In 2005 Joel Greenblatt published the first edition of The Little Book That Beats the Market, one of my all-time favourite investment books. The book presents a simple, systematic strategy, which Greenblatt calls the “magic formula”. The strategy identifies companies that are both cheap and profitable and its long-term performance is nothing less than spectacular.

Greenblatt also created a free website Magic Formula Investing where investors can screen for magic formula stocks. In an article for Morningstar entitled Adding Your Two Cents May Cost a Lot Over the Long Term Greenblatt describes what happened next.

So after hundreds of emails from readers asking for more help in managing their portfolios, I had an idea. It was based on an idea I had long ago about creating a “benevolent” brokerage firm that sought to protect its customers from the most common investing errors. The firm would still let clients pick individual stocks, but those stocks would have to be selected from a pre-approved list based on the principles and formula outlined in the book. We would encourage clients to hold a portfolio of at least 20 stocks from this list to aid in the creation of a diversified portfolio and to send them reminders to make trades at the proper time to help maximize tax efficiency. We wouldn’t allow margin accounts so that customers could pursue this investment strategy over the long term.

Greenblatt partnered with a brokerage firm, DLJdirect, to provide just such a service. Following the recommendation of Blake Darcy, the CEO of the new venture, they included a checkbox that allowed investors to opt for a “professionally managed” account that would follow a pre-planned system to buy top ranked stocks from the list at periodic intervals. No judgment involved, just automatically follow the plan.

After 2 years, Greenblatt decided to compare the performance of the do-it-yourself investors versus the do-it-for-me investors. You might be wondering: how different could the performance of the two groups be since they’re constructing portfolios using the same short list of stocks?

Well, as it turns out, the self-managed accounts, where clients could choose their own stocks from the pre-approved list and then follow (or not) our guidelines for trading the stocks at fixed intervals didn’t do too badly.  A compilation of all self-managed accounts for the two year period showed a cumulative return of 59.4% after all expenses. Pretty darn good, right?  Unfortunately, the S&P 500 during the same period was actually up 62.7%…

…Well, a compilation of all the “professionally managed” accounts earned 84.1% after all expenses over the same two years, beating the “self managed” by almost 25% (and the S&P by well over 20%). For just a two year period, that’s a huge difference! It’s especially huge since both “self-managed” and “professionally managed” chose investments from the same list of stocks and supposedly followed the same basic game plan.

The evidence pointed to the inescapable conclusion that.

… on average the people who “self-managed” their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some!

How did this happen? Greenblatt identified 4 bad behaviours that were at fault:

  1. Self-managed investors avoided buying many of the biggest winners.
  2. Many self-managed investors changed their game plan after the strategy underperformed for a period of time.
  3. Many self-managed investors changed their game plan after the market and their self-managed portfolio declined (regardless of whether the self-managed strategy was outperforming or underperforming a declining market).
  4. Many self-managed investors bought more AFTER good periods of performance.

Each of the 4 bad behaviours listed by Greenblatt involve a failure of discipline. 

In the first case, DIY investors second-guessed the formula by avoiding problem companies that turned out to be the biggest winners. Many of the stocks selected by the magic formula are cheap because there’s something wrong with them. Otherwise they probably wouldn’t be cheap to begin with. Many do-it-yourself investors felt uncomfortable holding these stocks. By avoiding these stocks they limited the effectiveness of the investment strategy.

In the second case investors let short-term underperformance shake their confidence in the strategy. Lacking discipline, they stopped applying the magic formula consistently.

In the third case investors let fear of a market fall cause them to sell out indiscriminately, while in the fourth case they did the opposite.

These stories illustrate a lesson that I’ve come to appreciate more and more over my career as an investor. Having the right strategy is, in some ways, probably less important then being able to stick with the right strategy!


*Of course you can get lucky in the short-to-medium term without a disciplined investment process.

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