Monday, 22 June 2009

Learn from the Worst: The Fallen

"From the errors of others, a wise man corrects his own."

We are going to examine how and why investors have failed so that you'll be ready when confronted with the same pitfalls.

The Fallen

It's a pretty crowded place. There are the professionals - the mutual fund managers, the newsletter publishers, and the individual stock pickers.

Mutual Fund Managers

Most mutual fund managers fail to beat the returns you'd get if you had just bought an index fund that tracks the S&P 500. (The S&P 500 index is generally what people refer to when they talk about beating 'the market').

John Bogle (Vanguard Group): From 1983 through 2003, the average equity fund returned an average of 10.3% annually, while the S&P grew at a 13 % pace. A 2.7% spread between the S&P and mutual fund managers' performances may not seem like all that much. But, the compounded returns you get in the stock market can turn that kind of difference into a lot of money very quickly. A $10,000 investment that grows at 13% per year compounded annually, for example, will give you a shade over $115,000 after 20 years; at 10.3% per year, you'd end up with about $44,000 less than that (approximately $71,000).

O'Shaughnessy: "The best 10 years, ending December 31,1994, saw only 26% of the traditionally managed active mutual funds beating the S&P index." That means that just over a quarter of fund managers earned their clients market-beating returns in the best of those periods!

"Less than half of the funds that beat the S&P 500 for the 10 years ending May 31, 2004 did so by more than 2% per year on a compound basis." What's more - this is a key point - these statistics didn't include all the funds that failed to survive a particular 10-year period, meaning that his findings actually overstate the collective performance of equity funds.

Newsletter Publishers

These are investors - some professionals and some amateur - who write monthly or quarterly publications (many are published online) that give their assessment of the economy as well as their own stock picks. They sound official and authoritative and sometimes even have large reseach staffs working for them.

But while they can attract thousands of readers, more often than not their advice is lacking. Hubert Financial Digest monitors investment newsletters and tracks the performance of their picks said in a 2004 Dallas Morning News article that about 80% of newsletters don't keep pace with the S&P 500 over long periods of time.

And just as their individual stock picks are often subpar, newsletter publishers also have a difficult time just picking the general direction of the market.

A National Bureau for Economic Research study of 237 newsletter strategies done in the 1990s found that, between June 1980 and December 1992, there was "no evidence to suggest that investment newsletteres as a group have any knowledge over and above the common level of predictability."

While their advertisements and promises may sound tempting, the data indicates that newsletter publishers and money managers have a weak record when it comes to beating the market. Their collective track record, however, is far better than that of individual investors.

Individual Investors

John Bogle: He has addressed the issue of individual investors' returns and his findings paint an equally glum picture. He told that congressional committee in 2004 that he estimated individuals investors in equity fund has averaged an annual gain of just 3% over the previous 20 years, during which time the S&P 500 grew 13% per year.

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