"I'd rather be lucky than good."
Former Yankees pitcher Lefty Gomez is said to have been the first to utter this familiar line, after his outfielders ran down three hard-hit balls in one inning. And we can all empathize -- sometimes a lucky break seems to net us more good fortune than all of our hard work.
But I'm here to tell you that, as an investor, being good is much better than being lucky over the long run. It was the same for Lefty Gomez; he didn't get into the Hall of Fame by being lucky. He won 20 or more games four times for the Yanks in the years leading up to WWII, and helped his team win seven pennants.
In fact, getting lucky a few times as an investor can be downright dangerous.
Anchor away!
Let's say you've been watching the movement of several stocks. Up, down, up, down. "Just like a bouncing ball," you think. "I know I can time these movements, and make a few bucks buying and selling." And so you try it, and it works. For a couple of weeks, you buy Pfizer (NYSE:PFE) and Coke (NYSE:KO) and Pepsi (NYSE:PEP) and Amazon.com (NASDAQ:AMZN) and whatever else on downturns, and then sell them the same day for a profit.
Soon, though, you run into a few losses because the bouncing ball doesn't bounce back up all the time. Despite a good profit in the first couple of weeks, you wind up breaking even for the month. The next few months, you lose money.
Despite a lack of success, you continue trying this "system" on and off for a few years. Why? Because -- through randomness and luck -- it worked really well the first few times. Our brain remembers this, and doesn't easily forget the information. In fact, the process is call "anchoring," and David Gardner wrote about it a few years ago in a special series called The Psychology of Investing.
Quoting from the book Inevitable Illusions: How Mistakes of Reason Rule Our Minds by Massimo Piattelli-Palmarini, our brain "remains anchored to the first product we obtain. We seem never to stray far from that -- or never far enough. It is as though we were unable to forget our first estimate." Piattelli-Palmarini is referring to an experiment explained in part two of the special, but it's easy to apply the example to our Internet day trader.
Similarly, as David pointed out, those who got their start during the Great Depression likely had a tough time moving money into stocks again. "My grandparents were 'anchored' in the belief," he wrote, "that the market was risky and might crash again at any time."
We can ask the same question now, after living through a crash of our own and a two-year bear market that shaved off about half the market's value. Will new investors stay out of stocks for years because of that experience? I hope not, because I believe it's a huge mistake for anyone with a long-term outlook to not be in the market and to not stay in the market.
Let's assume the S&P 500 returns 8% over the next 40 years (it averaged 11.9% -- dividends reinvested -- from 1928 to 2002). A 21-year-old who contributes $2,500 a year to an index fund in her IRA will have nearly $700,000 by the time she's 61. If she waits 10 years before she starts, however, she'll only have $333,000 at age 61. Waiting 10 years, anchored in her fear of another crash, is a mistake that'll cost her a third of a million dollars. Should the market average 10% over this time period, the difference will be two-thirds of a million bucks: $1.2 million vs. $500,000.
Mutual fund madness
There's another way randomness and luck can cost you money: by chasing the hottest mutual funds or stocks, solely on recent performance. If you take the average returns of all equity mutual funds in any one year, for example, there will be several that outperform that average by a significant amount through randomness and luck.
Burton Malkiel has some good examples in his book, A Random Walk Down Wall Street. During the late 1980s and 1990s, he found that a mutual fund manager who was better than average in one year had less than a 50% chance of beating the average the next year. He also followed the top 10 funds of 1968 -- which was close to the top of a bull market -- for six years. The results were "perfectly disastrous," with four of the funds going out of business by 1974 and the rest worth a fraction of their 1968 value.
Though not as drastic, the trends continued through the decades. The top five funds in the '70s -- Twentieth Century Growth, Templeton Growth, Quasar Associates, 44 Wall Street, and Pioneer II -- finished, respectively, in places 176, 126, 186, 309, and 136 in the '80s.
But wait, there's more. Compare results for the five best-performing funds from 1978 to 1987 to the ensuing 10 years:
Avg. Avg.Fund 1978-87 1988-97Fidelity Magellan 30.93% 18.88%Federated Capital Appreciation 26.08 15.60AIM Weingarten 23.35 16.68Van Kampen American Capital Pace 22.24 15.30Alliance Quasar 22.08 15.83S&P 500 20.95 18.04
To be fair, there are always some consistent performers. It's just that it's extremely hard to identify them ahead of time. That's certainly one reason we've steered investors toward index funds -- that way you don't even have to deal with the problem of finding good, consistent funds. Another reason is that by almost any measurement, broad-based index funds, such as those tied to the S&P 500, have outperformed the majority of managed funds over the years.
If you still want to try to beat the S&P, look for a no-load fund with a relatively low expense ratio that suits your investing philosophy. It helps if it's not a giant with tens of billions in net assets. James Cloonan, chairman of the American Association of Individual Investors, calls these behemoths "closet index funds with higher expenses," and recommends those with less than $2.5 billion under management. Check out our own Mutual Fund Center for more information.
Lefty's legacy
Do keep randomness and luck and "anchoring" in your thoughts. Don't interpret early investing results as gospel. Don't chase hot mutual funds or stocks. Finally, do keep a certain humility about you, especially when things are going well. There was no finer example of this last tenet than Lefty Gomez himself. I'll leave you with a few more of his sayings:
"I want to thank all my teammates who scored so many runs and Joe DiMaggio, who ran down so many of my mistakes."
"A lot of things run through your head when you're going in to relieve in a tight spot. One of them is, 'Should I spike myself?'"
"I talked to the ball a lot of times in my career. I yelled, 'Go foul. Go foul.'"
"I was the worst hitter ever. I never even broke a bat until last year when I was backing out of the garage."
In the spirit of humility, Rex "Righty" Moore would like to thank all the little people he stepped on to get to where he is today. He owns no companies mentioned in this article. The Fool's disclosure policy is leading the National League Central division.
