Jun 26, 2001 at 12:00AM
I forget who offered this whimsical piece of advice, but it made me laugh. However, I don't think that picking stocks that go up is the most important determinant of long-term investment success -- a sound portfolio management strategy is. Unfortunately, few professional money managers -- and, studies show, too few individual investors -- manage their portfolios in what I believe to be a rational way, making it nearly impossible for them to beat the market over time even if they are good stock pickers.
As I've noted in earlier columns, it's hard to beat the market -- especially after all costs and taxes are considered -- as evidenced by the paucity of people (both professionals and individuals) who have been able to do so over an extended period. Those that have been successful have followed a wide range of portfolio management strategies, but I firmly believe that history shows -- and the future will continue to show -- that investors with the best odds for beating the market by a reasonable margin (say, 5-10% annually after all costs and taxes) manage their portfolios in a certain way. Here are the key elements of successful portfolio management.
Make Long-term Investments
My horizon is at least five years -- and ideally a lifetime -- on pretty much all of my investments. The average mutual fund, in contrast, churns its portfolio 86% annually, while the figure was 80% for individual investors, according to Barber and Odean's powerful study from 1991 to 1996. And it's getting worse. According to an article in Saturday's New York Times, "Among Nasdaq stocks, the hottest shares last year, the average holding period was five months, down from roughly two years [a decade ago]."
With so many people churning stocks like mad -- and doing so well (or at least boasting of it) -- why am I recommending the opposite approach? First, holding portfolio turnover to a minimum has the obvious benefit of keeping taxes and trading costs low (yes, trading costs have fallen dramatically, but don't forget about the bid-ask spread). With the S&P 500 rising 20% or more each year for the past five years, worrying about these costs might seem passï¿½, but they matter a great deal in the long run. Taxes especially can crush your long-term returns. As I wrote in an earlier column on "Deferring Capital Gains Taxes":
"Consider three scenarios whereby you earn 10% returns per year for the next 20 years on an initial $1,000 investment. If your profits were taxed annually as short-term capital gains (39.6%), in 20 years your investment would be worth $3,231. If it were taxed annually as long-term capital gains (20% rate), it would be worth $4,661, 44% more. And if you were to instead buy one stock that compounded at 10% annually, and then after 20 years sold it and paid the 20% capital gains tax, you would have $5,582, 73% more."
Many people trade because they think the stock they're buying will outperform the one they're selling. But another study by Odean shows that precisely the opposite is the case: The stocks investors bought underperformed those they sold by an average of 3.2% in the following year, and this doesn't even factor in substantial taxes and trading costs. Ouch!
Odean's studies showed a strong correlation between the amount of trading investors did and their returns. Hyperactive traders, with an average of 1,000% annual turnover, had just a 11.4% annualized return after expenses. The least-active investors barely traded, changing just 2.3% of their holdings annually, yet they managed a market-beating 18.5% annualized return (the S&P 500 Index was up 16.9% annually during the period). Note that these figures do not include the tax penalty paid by heavy traders.
But what if hyperactive traders tended to pick worse stocks, such that their lower performance was due to this, rather than their trading? Not so, according to the study. Had the least-active traders done no trading, their returns would have only been 0.25% better annually, whereas the heavy traders would have done more than seven percentage points better annually.
Not surprisingly, Barber and Odean concluded, "Our central message is that trading is hazardous to your wealth."
Only Invest When You Believe the Odds Are Heavily in Your Favor
The future is very difficult to predict. Even when I'm highly confident about an investment, I consider myself lucky to be right a bit more than half the time. Therefore, I only invest when I'm as confident as I can possibly be about a favorable outcome. That doesn't mean I don't take risks -- I have invested in some fairly speculative situations -- but I have to believe strongly that there is a highly favorable risk-reward equation before I will invest.
This means that I make relatively few investments. Why dilute my best ideas with inferior ones? In contrast, I read a few weeks ago that the average mutual fund holds 132 stocks. That's crazy! I hope not to make that many investment decisions in my lifetime. How can an investment manager -- even supported by a team of analysts -- possibly keep track of that many companies and industries? And I'll never be persuaded that the manager is highly confident of so many investments.
Hold a Concentrated Portfolio
An obvious consequence of making few investments is making big ones. To invest successfully, I believe you have to find stocks that the market is mispricing, which doesn't happen very often. These days, it's hard to find good companies trading at a bargain price, or great companies trading at anything close to a reasonable price. Thus, when I find an attractive situation where I'm highly confident of a favorable outcome, I invest a meaningful amount -- usually at least 5% of my fund. In general, my top five holdings account for 50% of my fund, and the top 10 holdings, 80%.
So that they are not labeled "undiversified," most mutual funds cannot invest more than 5% in a single stock, and I rarely find a fund where the top 10 holdings account for more than 25-30% of the fund.
Conclusion and a Word of Caution
I'd like to think that I'm a good stock picker, but if you told me that I had to manage my fund as the average mutual fund manager does -- 86% annual turnover, 132 holdings, and no investment larger than 5% of the fund -- then I would give my investors their money back and find a different career because I don't think I could beat the market over a long period of time, after all taxes and costs are considered, no matter how good a stock picker I was.
Be careful, though. Investing in the way I have recommended increases the chances for beating the market, but holding a concentrated portfolio is almost certain to lead to more short-term volatility and can result in large losses. If you aren't certain that you know what you're doing, then I believe you are better off with a highly diversified portfolio -- and perhaps an index fund.
-- 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.
- Jun 26, 2001 at 12:00AM