When Will They Ever Learn

The thoughts below come from our good friend Gene Hoots.  Gene is an invaluable resource for our firm and has served on the Board of our Family Office for decades.  His experience and advice has served us well through difficult times, as he has the rare ability to objectively assess the “big picture” while others (ourselves included) can often be overrun by emotion. His comments below have important implications for managing overall portfolio volatility.

Some of you may remember the song that Pete Seeger wrote about human nature and war called “Where Have All the Flowers Gone?”  The Kingston Trio had a huge hit with it in 1961.  At the end of each verse, the chorus asks, “When will they ever learn?  When will they ever learn?”

An article about the best performing mutual fund in the country over the last ten years caused us to reflect on the mistakes that people make and to ask the same question about human nature as it applies to investing – When will they ever learn?  Human nature being what it is – the answer is probably “Never.”  

The few truly great investors repeatedly tell us the secret of their success – conservative, patient, consistent decisions.  And yet most investors never listen to them.  I have had many conversations with people who ask my advice – I tell them the same thing over and over, yet in the next conversation they are anxious to tell me how they have picked a great hot stock or have timed the market perfectly.  From my random sample of such conversations, it would be easy to conclude that nobody ever picked a stock that went down and nobody ever suffered a loss in a bear market – everyone seems to get in at the bottom and out at the top.

Yet objective data tell a very different story.  And this article reinforces the point dramatically.

The decade’s best-performing U.S. diversified stock mutual fund, Ken Heebner’s $3.7 billion CGM Focus Fund, rose 18.2% annually and outpaced its closest rival by 3.4 percentage points a year.  Too bad investors didn’t enjoy much of those gains. The typical CGM Focus shareholder lost 11% annually in the last 10 years according to investment research firm Morningstar Inc.

These investor returns, also known as dollar-weighted returns, incorporate the effect of cash flowing in and out of the fund as shareholders buy and sell. Investor returns can be lower than mutual-fund total returns because shareholders often buy a fund after it has had a strong run and sell as it hits bottom. 

At the close of a dismal decade for stocks, the CGM Focus results show how even strategies that work well don’t always pay off for investors.  The gap between CGM Focus’s 10-year investor returns and total returns is enormous.  “A huge amount of money came in right when the performance of the fund was at a peak,” says Mr. Heebner.  “We don’t have any control over what investors do.”

“Best Stock Fund of the Decade: CGM Focus,” Eleanor Laise, The Wall Street Journal,   December 31, 2009

So here was an amazing opportunity for investors to make 18.2% a year during the lost decade when most people made no money at all.  The investment would have been worth more than five times its original amount.  And yet taken as a whole, the investors in the fund made such poor decisions about jumping in and out that as a group they ended with only 31 cents for every dollar they invested. 

You have to work very hard to do that poorly.  When will they ever learn?

Unfortunately Gene, we don’t think “they” will ever learn.  Which is why it is important for investors to consider their own stomach for volatility before chasing what appear to be stellar returns.  Ken Heebner’s performance is undoubtedly exceptional, IF you are able to ride out the temporary storms.  The story above shows that most investors cannot.  To us, it seems that the greatest lesson is perhaps choosing a manager with a similar “stomach for volatility” as your own.  In, the Margin of Safety, Seth Klarman states that:

“Perseverance at even modest rates of return is of the utmost importance in compounding your net worth.  An investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal.”

Consistently good returns compound at very attractive long term rates.  Just ask investors in Klarman’s Baupost Group.  At Broyhill, managing volatility does emphatically not mean managing month to month performance.  But by avoiding deep and extended draw downs, we aim to keep investors from doing themselves great harm.  Consider that it takes a 100% gain to simply claw back to even, after experiencing a 50% loss.  This is difficult enough in itself, but becomes increasingly unlikely when one considers the facts above – the majority of investors are more likely to pull the plug after losing half their wealth and subsequently miss the potential to recoup those losses.