Don't Chase Performance

Investors have an awful, unshakable habit of piling into the hottest investment fad at precisely the wrong time. Whitney Tilson argues that you shouldn't let the recent stock market turbulence scare you into switching your assets into bonds or housing, which offer a false illusion of safety.

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By Whitney Tilson
October 23, 2002

If there's one thing as certain as death and taxes, it's that investors will chase performance, almost always to their detriment.

Consider the study from 1984 through 1995, which showed that while the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P 500), the average investor in a stock mutual fund earned only 6.3%. Put another way, over those 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 -- not to mention about 2.5 times as much by buying an S&P 500 index fund.

How can this be? Simple. Like moths to a flame, investors are invariably drawn to top-performing funds. They pile into them at their peaks, ride them down, and then repeat the process again and again. For a recent example of this phenomenon, consider the tens of billions of dollars investors put into Janus mutual funds in early 2000 -- money that has all but evaporated.

When it comes to mutual funds, past performance is indeed no predictor of future success. A study by the Financial Research Corp. of Boston found that from 1988 to 1998, the average performance of funds placing in the top 10% of their peer groups in one year almost invariably fell back toward the middle of the next year. In fact, the study found that, out of the 40 quarterly periods measured, only once did the average performance of the top 10% of funds place into even the top 25% in the subsequent year. (For more on this topic, I recommend a 1999 article by William Bernstein.)

So what should an investor do? Invest in the worst-performing funds? Nope, studies show that they do even worse. The answer is to find an investment manager with a sound investment strategy and a proven ability to carry it out (I shared my thoughts on this topic in Traits of Successful Money Managers). The mutual funds or fund families I suggest considering are (in no particular order): Longleaf (about which Zeke Ashton recently wrote), Clipper, Oakmark, Olstein, Third Avenue, and Tweedy Browne (I'd recommend the Sequoia Fund as well, but it's been closed to new investors since 1982). For further information, check out The Motley Fool's Mutual Fund Center and our How to Pick the Best Mutual Funds.

Chasing performance is, of course, not limited to mutual funds. The same phenomenon is occurring, I believe, in the bond and housing markets today.

As investors have fled stocks over the past two and a half years, they have sought safety in other areas to such an extent that bonds have outperformed stocks over the past five, 10, and 15 years. That's an amazing fact, given the unprecedented bull market that prevailed for most of the last two decades. Such outperformance by bonds is quite rare. According to statistics in Jeremy Siegel's Stocks for the Long Run, from 1871 to 1996, stocks outperformed bonds in 72.1% of five-year periods, 82.1% of 10-year periods, and 94.4% of 20-year periods (there was no data on 15-year periods).

Though recently stocks have spiked up and bond yields have risen from multi-decade lows, I think it's very unlikely that bonds will continue to do better than stocks over the next five or more years. That's not to say I think stocks will be a great investment, but with the yield on the 10-year Treasury note a mere 4.26% (as of yesterday's close), the hurdle isn't very high. The legendary Bill Gross, manager of the largest bond fund in the world, Pimco Total Return Fund, disagrees (surprise!). He thinks the fair value for the stock market is Dow 5,000, for several reasons. I agree that stocks remain overvalued, but think he's a bit too bearish on stocks, and far too bullish on bonds.

In addition to bonds, investors seeking safety have primarily fled to housing. While it hasn't yet reached bubble proportions nationwide, it's coming close in some cities, generally on the East and West Coasts. Take a look at my hometown, New York City, N.Y. The city is still struggling to recover from 9/11, faces its worst budget crisis in decades, and is reeling from huge layoffs by Wall Street firms, yet housing prices still rose 11% in the year ended June 2002. Having recently bought an apartment there, I can attest to the craziness of the housing market.

And New York is hardly alone. According to the cover story in this week's Fortune, "Since the boom began in 1995, housing prices have jumped 51%, or 32 points above inflation. The run-up has added $50,000 in wealth, on average, for every one of the nation's 72 million homeowners. In many markets the gains are even more extraordinary. In Boston, home prices have risen more than 110% since 1996, to an average of $398,000. In San Francisco and San Jose, a three-bedroom ranch will run you about $500,000, almost twice what it fetched seven years ago."

A recent front-page story in The Wall Street Journal (subscription required) had similar data: "In Miami, home prices have shot up 58% since the beginning of 1998, while incomes have risen only 16%. In New York's Long Island suburbs, an 81% increase in home prices compares with a 14% rise in incomes. In Boston, home prices have jumped 89%, compared with income gains of only 22%. And in some cities, including San Diego, Miami, and Washington, D.C., the run-ups have accelerated in the past year -- confounding expectations that the market would cool off before it got too far out of line."

This kind of nonsense cannot and will not continue -- most obviously because mortgage interest rates are highly unlikely to fall much further (since mid-1990, the rate on a 30-year mortgage dropped from 10.5% to a recent 40-year low of 5.95%). I don't expect a collapse in housing prices -- rather, they will likely return, at best, to the 5% growth rate of the past 30 years. Stocks are likely, I believe, to do a few percentage points per year better.

The stock market has been, for many people, a frightening place to be for the past few years, but fleeing to bonds or housing right now is the wrong move. If you can stomach the volatility and have a sound investment strategy (admittedly, two very big "ifs"), stocks are a better bet.

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money-management firm. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at The Motley Fool is investors writing for investors.