Destructive Investing Tendencies

The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC.

"Knowledge is knowing that a tomato is a fruit. Wisdom is not putting it in fruit salad."
-- Miles Kington

Dear Fellow Fool Funds Shareholder:

A few days ago I got a call from a Bloomberg reporter wanting to talk with me about the stock market news of the day. She asked me about things like the Twitter IPO, and the fact that the S&P 500 and the Dow Jones Industrial Average keep hitting new highs, and what I was hearing about the upcoming jobs report, and whether I thought the markets could continue running through the end of the year.

So much of the business side of running an asset-management company is about getting your name out there that I can see exactly why trying to come up with credible answers for these questions might seem like a good use of psychic energy for a lot of people. It's Bloomberg, after all.

The thing is, I had nothing. These questions are almost wholly uninteresting to me, and on the balance I think that people who spend 10 minutes per year thinking about such things have wasted at least nine of those minutes. So for many of the questions my answers were, essentially, "that sort of consideration is irrelevant to our process."

I felt bad for the reporter, who was extremely nice, and professional, and self-evidently very, very smart. We eventually had a good conversation about other things that had nothing to do with whether I foresaw a short-term reversal (I don't). But I couldn't help wondering, as I have in the past, whether people's tendencies to focus on these kinds of things (hot IPOs, short-term trends, macroeconomic reports that have almost no bearing on how many burritos Chipotle will sell) are destructive to their investing returns over the only time frame that matters -- the long term.

Is overtrading destructive?
We've written several times about studies showing that investors who trade the most have the poorest returns. (See "The Behavior of Individual Investors" by Brad Barber and Terrance Odean for a prime example.) We've also talked a lot about studies demonstrating that the average holder of a mutual fund generates substantially lower returns than the fund itself over time, through buying and selling at the wrong times. A Wall Street Journal article from December 2009 offers a stark example: The CGM Focus Fund was the best-performing fund from January 2000 to the end of 2009, with a 10-year average return of 18%. While investors in the CGM Fund might have been congratulated for their wisdom, it's unlikely most of them felt like celebrating. According to a Morningstar "dollar-weighted" study, on average investors in the CGM Focus Fund lost 11% per year.

How is this possible? Easy -- investors allowed short-term results to determine how they invested. They poured money in after CGM Focus had generated market-beating gains, and they yanked it out after the fund had plunged. Ken Heebner, the talented manager of the fund, is known as a swing-for-the-fences kind of guy, so these swings tended to be dramatic. Most dramatic was the fund's 80% rise in 2007, after which people flocked in, investing $2.4 billion, only to catch its equally spectacular 48% drop in 2008.

Do you love investing?
This may seem like an odd question for a fund manager to ask. After all, mutual funds are, by their very design, made for people who don't like to invest and would prefer to have a professional do it. This is why The Motley Fool's decision to launch a company to get into the mutual fund business struck so many people as being odd. "Aren't you the 'do-it-yourself' guys?"

Yes. But The Motley Fool had years of conversations with true dyed-in-the-wool Fools who explained how much they loved investing, but how little time they had for it. After all, while investing is one of the most important things people can do, under almost no circumstances is it the most important thing.

But even if you're going to choose to invest in mutual funds, or even index funds (which are awesome investment options for many folks), you still have a lot of responsibility to follow along at home. I firmly believe that many people would enhance their passive investing results if they took the time to understand what's in the funds to which they have entrusted their money. After all, a mutual fund can do no better than the collection of companies that it's invested in. It's impossible.

One neat way to view mutual fund investments is the possibility that they include holdings that would be very hard or expensive for individual investors to buy by themselves. For example, one of our portfolios owns shares of one of the most obscure banks in the world -- Gronlandsbanken, or the Bank of Greenland. It is the only bank serving Greenland, the world's largest island. (In-house we call it the "Bank of Polar Bears," a term coined by Tim Hanson's polar bear-obsessed 3-year-old.)

Another portfolio owns shares of Lippo Malls Indonesia Trust, a Singapore-based REIT that is profiting from the massive shift in Indonesia from an informal consumer economy to a formalized one, driven by an exploding number of Indonesians entering the middle class. A third portfolio owns American companies, which are by definition not too difficult for American shareholders to buy, but did you know that the portfolio is among the largest shareholders of Carter Bank & Trust, a small-capitalization bank based in Martinsville, Va., which has demonstrated years of -- in our opinion -- extraordinary discipline in its lending and an extremely dedicated deposit base?

It has been said that there are few great, truly original ideas left in investing, that the market is so efficient that it eliminates opportunity as soon as it has been created. We completely, utterly disagree that the market is fully efficient, but we do believe that it is largely efficient. Opportunities exist because too much money chases last week's or last year's gains and shies away from last week's or last year's losses. Too much money is invested thematically and not on a company-specific basis.

We are, at our core, passionate investors in businesses that display what we believe are long-term, wealth-generating capabilities and are run by competent, decent managers. We are certain that there are plenty of other methodologies to make money in the markets. But this is what we know, and the statistical inferences that overtrading and chasing fads are mathematically losing strategies make us believe that we're on the right track.

Bill Mann does not own shares in any of the companies mentioned in this article.


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