Boring Portfolio Further Discussion on the Arrogance of Stock Picking

By Whitney Tilson (Tilsonfunds@aol.com)

NEW YORK, NY (Jan. 10, 2000) -- Whoa! I got more e-mails from last week's column than I typically get in a month. Thank you. I appreciate the feedback, and, though it was a struggle this week, I do my best to reply to every e-mail.

Frankly, I was surprised. While I expected flack for questioning mechanical investing (and got some), I thought the rest of my ideas were pretty straightforward. Since there were some creative interpretations of what I said, let me try to boil it down into one (long) sentence:

Picking stocks can be fun and profitable, but it's also risky and very difficult to beat the market over long periods of time (recent history notwithstanding), so if you're going to invest in stocks -- as opposed to index funds, a fine alternative -- then make sure you have the time, skills, and discipline to do it right.

I think it's a sign of the times that this sentence would be considered by some to be controversial or insightful. Heck, I'd give you the same advice were you to undertake any challenging endeavor: piloting a plane, teaching a class, starting a business, building a house, whatever. But when it comes to investing, people are bombarded with messages that they should jump into the market and buy stocks, and of course there is no mention of the risks involved or the skills required to invest properly. Though I'll admit that they make me smile, those online brokerage ads -- such as the tow truck driver who earned enough by trading stocks to buy his own island, or the one with the crazy redheaded kid who calls his girlfriend's father a chicken for not buying more of a stock that he knows nothing about beyond a two-second glance at its price chart -- are doing a real disservice to Americans, and I can't believe the SEC allows them. (When my daughters grow up, if either of them brings home someone who behaves like that kid, I'm not sure who will be in bigger trouble -- the boyfriend for acting like such an idiot or my daughter for dating him.)

Let me be clear: I'm 100% in favor of The Motley Fool's main message that average Americans should take control of their finances and stop letting Wall Street and the mutual fund industry exploit them with hype, poor advice, high fees, and underperformance. But that doesn't mean that everyone should run out and buy individual stocks.

I'd like to use the rest of this column to address some of the issues raised in the e-mails I received.

Who Am I and What's My Motivation?

I acknowledged at the beginning of my column last week that as a professional money manager, my ideas might sound self-serving -- and sure enough, I was accused of trying to scare average Americans out of stocks and into professionally managed funds like mine. It's a hard case to make, though, given that I recommended index funds as the preferred alternative for those who decide not to pick stocks. And I have no interest in helping professional money managers since I don't really consider myself one. I've never worked for a financial firm, and not too long ago I was an individual investor just like you (click here to read my bio). After teaching myself the fundamentals of investing, I began managing my own money, then some of my parents', and now a handful of others' in the form of a single fund structured as a private investment partnership. By law, partnerships like mine are limited to 99 investors, two-third of whom must meet minimum income or net worth criteria, so the idea that I'm trying to scare people away from stock picking for my own benefit is unfounded.

I'm not the manager of the Bore Port and am not being paid for my columns, so what is my motivation? In part, I feel a sense of obligation. I'll confess to doing some pretty stupid things as a novice investor, and the writings of Warren Buffett and those on this site, among others, helped straighten me out. In particular, I learned a lot from the Boring Portfolio and its previous manager, Dale Wettlaufer. I think the perspective here adds a nice balance to The Motley Fool, so I don't want to see the Bore Port wither away.

I also find that putting my thoughts in writing -- and getting plenty of feedback -- helps me think more clearly. And I am motivated by some of the e-mails I receive, like this one:

"Wow, thank you. The pressure to buy individual stocks without having the time was becoming unbearable. For now I'm going to buy the index and spend my limited spare time away from being a surgeon with my spouse and four beautiful children. There is lots of time to get rich (or poor) later."

Or this one:

"I feel, like so many young graduates, at my age (24) that I need to participate somehow, right away in the grand market. I feel guilty that I've wasted time watching on the sidelines. Your article made me realize how irrational I'm behaving about starting to invest."

Or this one:

"After a year of researching investment theories (via reading The Motley Fool, Die Broke, The Truth About Money, DRIP Investor, etc.), I spent another year paralyzed by uncertainty, unable to act on even the simplest investment opportunity. Why? Fear. And thanks to your recent article, I now know it's a rational fear. Because I KNOW I have no talent for generating earnings by investing in this merry-go-round market. It's confusing and overwhelming to the average investor and anyone who says it's not is kidding themselves."

Did I Mischaracterize Individual Investors?

Speaking of average investors, one reader wrote, "I believe your mistake to be an underestimation of the amount of reading and research many individual investors conduct. I've read all the books you mentioned and many, many more, and I study companies inside and out before buying. I'm doing better than the Rule Breaker Portfolio. There may be foolish people investing in companies based on rumor and hype, but frankly, in my circles, I see many educated individual investors, and most are crushing the average. The message you profess scares intelligent people away from fortunes, and into mutual funds."

Well, I don't know about fortunes, especially going forward, and I certainly hope I didn't scare anyone into mutual funds (as opposed to index funds), but I think there's a valid point here. Do I know how many individual investors are informed and prudent, how many are rashly speculating, and how many are somewhere in between? No. Maybe I was way off base when I wrote last week that "countless people are buying stocks without the foggiest notion of what they're doing." But I remain steadfast in my opinion -- based on hundreds of e-mails I've received and thousands of hours reading on the message boards and elsewhere -- that, as I wrote, "an awful lot of people who are investing in individual stocks shouldn't be doing so."

What About Picking Above-Average Mutual Funds?

I received many e-mails from people who, after reading my article, were persuaded that they should not be picking stocks. But the urge to try to do better than the market is very strong -- hey, I've got it too -- so many asked me to recommend mutual funds that would beat the index in the future. I am not a financial advisor so I'm not qualified (nor is it legal for me) to give specific advice to anyone about how they should allocate their assets, etc. But even if I were, I don't have any confidence in my ability -- or anyone else's -- to pick a fund that would beat the market, after fees and taxes, over a long period of time. Why?

First, given how few funds beat the market, the odds of picking a winner are stacked against you from the beginning (especially if it is a fund that is part of one of the large brokerage firms, as this damning article in yesterday's New York Times highlights; to read it, you'll have to register, which is free). According to data in Fortune last month, here is the percentage of domestic equity funds that have beaten the S&P 500 over different time periods:

1 year:       33%
3 years:      10%
5 years:       7%
10 years:     12%
15 years:     11%

Pretty grim, isn't it? Ah, but you wouldn't pick just any fund. You'd pick one with a great track record, that would therefore be more likely to outperform in the future, right? Unfortunately, numerous studies have shown that when it comes to mutual funds, past performance is no indicator of future success. An article in The New York Times on July 4, 1999 noted that:

"A number of studies confirm that obsessing over mutual fund performance is largely a waste of time. One report, issued in March by the Financial Research Corp. of Boston, found that from 1988 to 1998, the average performance of funds placing in the top 10 percent of their peer groups in one year almost invariably fell back toward the middle the next year.

"'In fact,' the study found, 'out of the 40 quarterly periods measured, only once did the average performance of top-decile funds place into the first quartile in the subsequent year.' (That was in the first quarter of 1991.)

"The Financial Research study also found that Morningstar's closely watched five-star rating system didn't matter much either, because there wasn't much difference in the subsequent performance of funds awarded three, four, or even five stars. The study's conclusion: 'Past investment performance fails miserably as an indicator of future performance.'"

Yet investors continue to chase performance, with disastrous results. As I wrote in an earlier column on "The Perils of Investor Overconfidence," the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P 500) from 1984 through 1995, yet the average investor in a stock mutual fund earned only 6.3%. This means that over these 12 years, the average mutual fund investor would have ended up with nearly twice as much money by simply buying and holding the average mutual fund, and nearly three times as much by buying an S&P 500 index fund. Factoring in taxes would make the differences even more dramatic. Ouch!

If you need further convincing, see the links I've provided below. Still, there's nothing I can say to the person who e-mailed me with the comment, "Now what is the average investor supposed to talk about at cocktail parties? Their index fund?" I'm afraid there's a lot of truth to this comment.

Investing for Entertainment, Learning, or Empowerment

A number of people e-mailed me with comments like these:

"When people ask me for stock picks, I always tell them to get into indexed mutual funds. But, my wife and I get great personal satisfaction picking our own stocks. This is as close as my wife and I will come to owning our own business. We are captains of our destiny."

Or, "My wife and I enjoy investing in stocks more as a shared pastime than as a route to riches. We do our research but understand our limitations. Ninety-five percent of our investments are handled through our professional service."

Or, "Don't forget that a lot of us are investing what we can afford to lose, much the same as the winning 10-20 Holdem player stepping up to claim a seat in the 20-40 Holdem game simply to measure his worth against all the others."

To those who want to pick stocks for reasons other than returns, I say go for it, but please be careful about how much money you're wagering.

Am I Nuts? Are My Investors?

In the past two columns, I've pointed out how hard it is to beat the market and argued in favor of index funds. Yet I don't believe that it's impossible to beat the market, or I wouldn't be trying to do so. Next week I will share my thoughts on my strategy for beating the market.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilsonfunds@aol.com. To read his previous guest columns in the Boring Port and other writings, click here.

Additional reading on the argument for index funds:
Rule Maker Portfolio, 1/29/99: Funds vs. Makers: The Three Fs
Fool on the Hill, 12/9/98: Actively Managed Money
Fortune, 12/20/99: The Man Your Fund Manager Hates
Fool on the Hill, 12/2/99: Vanguard 1, Fool 0 (on the impact of taxes)
Boring Portfolio, 10/21/98: Turnover Kills
Forbes, 8/23/99: The Hidden Cost of Trading

Boring Portfolio

1/10/00 Closing Numbers
Ticker Company Dly Pr Chg Price
APCCAMER POWER CONVERSION-1/4$25.25
BRK.BBERKSHIRE HATHAWAY'B'-7$1,813.00
COSTCOSTCO WHOLESALE CORP15/16$95.00
CSLCARLISLE COS-7/8$34.13
GTWGATEWAY INC1/2$64.13

  Day Week Month Year
To Date
Since
10/1/98
Annualized
Boring .46% .46% -2.98% -2.98% 37.38% 28.20%
S&P 500 1.12% 1.12% -.79% -.79% 43.32% 32.51%
S&P 500(DA) 1.12% 1.12% -.79% -.79% 45.02% 33.74%
NASDAQ 4.30% 4.30% -.48% -.48% 139.08% 97.73%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
2/9/99200GTW36.278$64.1376.76%
4/20/99460APCC14.477$25.2574.42%
9/13/99110COST69.101$95.0037.48%
8/13/96200CSL26.325$34.1329.63%
12/31/9812BRK.B2,278.333$1,813.00-20.42%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
2/9/99200GTW$7,255.50$12,825.00$5,569.50
4/20/99460APCC$6,659.25$11,615.00$4,955.75
9/13/99110COST$7,601.13$10,450.00$2,848.88
8/13/96200CSL$5,264.99$6,825.00$1,560.01
12/31/9812BRK.B$27,340.00$21,756.00($5,584.00)
  Cash: $10,490.52  
  Total: $73,961.52  

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.