The Synergies Are Humongous

Why do average investors actually pocket annual returns that are less than half of the market's results?

Synergy, baby, synergy.

I recently came across a quote that helps explain this paradox. It also provides an outline for how superior investors get their results.

A common misperception in the market is that to be a great manager, one needs to be a great analyst. In reality, a portfolio manager's role is not one-dimensional. He or she is a strategist, an analyst, and a trader simultaneously. And to be a great portfolio manager, one needs to be just above-average in each function because the synergies are humongous. It seems a simple task, but in reality, it is a difficult feat.

The quote comes from Rudolph-Riad Younes, as quoted in Kirk Kazanjian's book The Market Masters, and refers to Younes' job as a manager of an international investment fund. In essence, his job as manager of a fund is not all that much different from yours in managing your own investment portfolio. And there is, as we shall explore, a humongous chasm between being good at that and succumbing to the pitfalls of the average investor.

The bad side of synergy
Let's start by showing just how tragically poor the average investor actually does with his or her investments and how the synergistic triumvirate of subpar strategy, trading, and analysis cause and account for the lackluster performance.

According to John Bogle -- legendary founder of Vanguard, all-around champion of investors, and inveterate market researcher -- the stock market, as measured by the S&P 500 index, produced annual returns of 13% from 1983 through 2003, slightly higher than its long-term average. Yet during this same period, mutual fund investors pocketed returns of only 6.3% annually -- less than half the market's raw returns. That's a tragic differential, synergistically explained by poor analysis, poor strategy, and poor trading.

Here, according to Bogle, is how that is explained.

Let's explain that. Managed mutual funds reported results 3% less than the market's returns. That underperformance is caused by two things -- the management fees that mutual funds charge investors and pay themselves (1.5% to 2.0% annually), and the trading fees that mutual funds spend as they relentlessly swap in and out of their holdings (1.0% to 1.5%).

In other words, the first 3% of potential returns that fund shareholders miss are caused by their strategic decision to buy managed mutual funds in the first place, as well as the trading costs that mutual funds fritter away.

The next 3.7% that fund investors miss is caused by the timing of their fund investments. Although funds as a whole produce reported returns that are essentially equal to the market's returns after subtracting costs, the total dollar result achieved by investors is far, far worse. Bogle's research showed the average investor has an uncanny ability to buy the wrong fund.

Why? Well, after a mutual fund starts doing well and has impressive numbers to report, investors flock into the fund with new dollars -- chasing the attractive past performance that funds are publishing in their newspaper ads.

But those results, typically, occur for only a small number of early investors. Once attention is focused on a fund, or a particular sector, then massive amounts of investor dollars follow, just in time for the fund's performance to crumble. This is all the product of poor analysis.

Fund families, of course, are legendary for setting up hot specialized sector funds just in time for that that particular sector to crater. Take a look at the performance of the U.S. Oil Fund (AMEX:USO), set up in April -- just in time to catch the top of oil prices. Investors rushed in, having been inundated with talk about how oil would keep going higher, and the fund is now down more than 20% from where it was established.

Bogle singles out a number of publicly traded companies as having mutual fund families with the poorest returns, including Merrill Lynch (NYSE:MER), Morgan Stanley (NYSE:MS), and Goldman Sachs (NYSE:GS). These companies have been very effective at getting their clients to buy the wrong mutual funds, and they have been pocketing big fees in the process. Good for the shareholders of Merrill Lynch, et al., but not good at all for the shareholders of Merrill Lynch's mutual funds.

The good side of synergy
So, how do you pursue a strategy that gives you better-than-average returns as an investor, by only being a little bit better than average in the three interrelated elements of strategy, trading, and analysis?

1. Strategy.

Pick your own stocks -- you'll save 1.5% to 2.0% in management fees. Don't just own large-cap stocks, either -- own at least some small caps. Over time, small-cap stocks have beaten the average returns of the S&P 500 by approximately 2 percentage points annually. We explore the reasons for that every day in Motley Fool Hidden Gems. Don't worry about being perfect, though -- be just a little bit better than average.

2. Trade very little.

This is the easiest one. Trading is expensive, and it's unproductive when overused.

There is no costless way to trade shares. Even with the recent announcement by Bank of America (NYSE:BAC) heralding its zero-cost trading, there is still the cost of spreads on your trades, and the potentially enormous tax costs. No doubt Bank of America's move is an important one, and it's not one to be laughed off. Note how the shares of E*Trade (NYSE:ET) and TDAmeritrade (NASDAQ:AMTD) suffered last week as investors predicted people will flock to even cheaper trading. But still, to be a better-than-average investor, you must keep your trading to a minimum. There is no credible research that shows that trading at anywhere near the level practiced by mutual funds improves results.

3. Analysis.

Don't, don't, don't buy the hot thing. That is madness -- pure madness. Take advantage of the other side of madness and buy quality, out-of-favor companies. Know the balance sheets, and know the quality of the management team. Learn these things through your own research, or learn them from those, like us on the Hidden Gems team, who spend a lot of time joyfully scouring the public filings.

Buying companies that are out of favor (analysis), holding them instead of trading them, and focusing on small-cap companies has powered Hidden Gems to returns of 39% versus the market's returns of 18% since inception in 2003. A difference that, while not necessarily "humongous," sure ain't bad. Take a free trial, and learn more about our strategy, trades, and analysis today.

Bill Barker owns none of the stocks mentioned in this article. Bank of America is an Income Investor recommendation. The Fool's disclosure policy is also synergistically humongous.