FOOL ON THE HILL
Investor Fantasy vs. Reality

Stocks are a great place to build personal wealth over time, but many investors want more than just long-term appreciation. The search for consistent outperformance continues, even though it is a lost cause. Investors should realize early on in their investing careers that periods of underperformance are unavoidable, even for the greatest investors.

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By Brian Graney (TMF Panic)
December 29, 2000

What is it that investors want? Judging by the number of publicly traded companies that have fallen out of the market's good graces and into the penny-stock junk heap over the past few months, investors at this point might be happy with any kind of positive annualized return from their portfolios this year. In broader terms, however, investors generally want their stock holdings to appreciate in value faster than the market as a whole as measured by some benchmark, such as the S&P 500 index. Most investors would agree that this is what active management of your own investing money is all about.

Building personal wealth over time through ownership of stocks is a fairly reasonable desire for an individual to have, but unfortunately most of us cannot leave well enough alone. That's not terribly surprising. Human beings tend to have limited needs -- food, clothing, shelter, and companionship among them -- but unlimited wants. It's not enough to rely on the concepts of compounding and long-term buy and hold to build personal wealth over years and years. We want perfection, stock prices that continually rise every year without a hitch. Long-term outperformance alone just won't cut it. Many of us want consistent outperformance, as in all of the time. That would be great. That's what we really want.

Most materialistic people eventually realize that it's impossible to have everything they want and give up on the idea. But in contrast, some investors never quite experience the same epiphany. They keep looking for consistent outperformance like confused tourists looking for "J" Street in Washington, D.C. (For readers outside the Beltway, no such street exists.) These are the folks that jump from strategy to strategy, from stock to stock, or from mutual fund to mutual fund in the hopes of beating the market over any and all time periods. This futile search for consistent outperformance exacts a heavy price, not only in terms of trading fees and tax implications but also in terms of the time that must be devoted to such an undertaking.

Pure and simple, consistent outperformance in investing doesn't exist. The sooner an investor comes to grips with this reality and accepts the fact that periods of underperformance will occur during an investing lifetime that may stretch for decades, the better off that investor will be. That doesn't mean long-term outperformance in stocks is a fiction, mind you. It's just that Mike Tyson has a better chance of emceeing the next Miss America pageant than you have of beating the S&P 500 index by a percentage point or two during every single year of your natural life.

The point of all this is not to close out another year of Foolish commentary on a downer. If you need a depressing reminder of the year that was, check out our Year in Review feature. Nor is it intended to explain away the bummer of a year that many investors staring at 40% to 50% year-to-date losses have had, including some folks right here at the Fool. Rather, the purpose of bringing up consistency on the final trading day of 2000 is to remind investors that as the new year begins, what has taken place during the past year is only relevant up to certain a point.

In investing as in business, it's a careless mistake to automatically extrapolate last year's great performance into an equally great performance in the year to come. There's no iron law in the stock market stating that a 3,800% winner one year can't become a 93% loser the next. (And I'm not just pulling those numbers out of my jingle-belled jester hat. This is exactly what happened to a company called Pumatech (Nasdaq: PUMA) this year.) But just as importantly, this extrapolation fallacy also works in reverse. Big investing losses one year do not necessarily mean further losses the next. Nor does a big single-year hit mean that you are inherently doing something "wrong."

A look at the annual returns of a few individuals from the group dubbed "The Superinvestors of Graham-and-Doddsville" by Warren Buffett in 1984 shows that some of the greatest investors of the last century actually underperformed the market anywhere from 25% to 33% of the time. One superinvestor in particular, Charlie Munger, underperformed the market in five out of fourteen years and suffered through back-to-back 31% annual losses during the notorious bear market years of 1973 and 1974. Given the shellacking of the Nasdaq this year, many investors today can no doubt empathize with one-year annual losses of similar magnitudes.

If investing records were graded solely on consistency, an investor like Charlie Munger would not earn very high marks. But that doesn't change the fact that Mr. Munger, like his superinvesting cohorts, ended up spanking the market averages over time. It is possible to underperform the market, sometimes even for long stretches of time, and still come out ahead of the averages over a multi-year period, so long as your investing strategy is sound. That is the real point to be made. If year-to-year consistency has any place at all in investing, it is in relation to an investment strategy, not investment performance.  

Like great baseball players, great investors don't worry so much about their batting averages as their swings. The idea is not to start a season with the intention of hitting .400. The idea is to hit balls, and accept the batting average that your swing produces over an entire season's worth of pitches. If you adopt the same mindset when it comes to your personal investing strategy, then one loss-filled year does not necessarily mean that you lack what it takes to make it in the stock market big leagues. While an alluring notion, consistent outperformance in investing is a myth. That will be as true in the best of market years as in the worst.