Individual Investors and Professional Money Managers Suffer From the Same Basic Defect

Individuals fail to identify the best money managers for the same underlying reasons that most money managers are unable to identify the best investments, which to a large extent is a problem of perception and a lack of relevant knowledge. The set of tools (education, personal experience through trial & error, etc.,) that individuals acquire over time generally allow them to make sensible everyday decisions. So much so, our brains create shortcuts in the decision making processes, which work well when faced with simple problems. For example, how to decide where to eat when out of town? If you're like me (i) you ask someone, (ii) you select at random-though usually a familiar restaurant chain, or (iii) you look for the largest crowd. You generally can't go wrong eating at a crowded restaurant or somewhere familiar. These are pretty good mental models as they relate to restaurant selection and the result is an easy one to measure because it's immediate and isn't ongoing. Moreover, you can't improve taste, because taste is a matter of opinion.

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However, the mental shortcuts that help us pick a good restaurant, hinder our ability to consider the relevant facts when the facts relate to a complex system. When faced with complex decisions, we run into problems because we lack a natural mechanism with which to consider current decisions as they relate to ongoing future outcomes. It's important in this case to recognize when you're outside your circle of competence. One common solution is to seek-out an expert adviser, but this only turns an old problem into a new one. Now you have to select an able and competent adviser.

With Respect to Money Management

Outsourcing investment decisions is the only option for most people without time or interest to invest properly. But when selecting someone to oversee your hard earned money what criteria do you consider? The first item that often comes to mind is experience, however, this concept may be to your ultimate detriment.

The Validity of Experience

In many aspects of life there is a positive correlation between length of time performed and competency. That is, people tend to follow the general premise that having done something with a greater frequency or for a greater length of time makes an individual more qualified, better skilled, and more knowledgeable. This rule of thumb may be reasonable some of the time, but it is not universal. Human nature being what it is, often causes us to base decisions upon habit not reason. In the investment management business, the validity of experience as qualified simply by an act of having done something with greater frequency or for a greater length of time is unfounded. The flaw is in the assumption that investing over time provides the individual with an increased knowledge of the subject. But what can be said about the merit of knowledge based upon the wrong set of facts, truths, or principles?

Performance & Knowledge

Selecting a good money manager may appear as though it's simply a matter of selecting a smart money manager with a good investment record since, ultimately, investment knowledge and investment performance eventually converge, but they don't necessarily converge right away. In some (often many) cases, an investor may possess the correct knowledge, but performance lags. In other cases, an investor may initially perform well, but may not understand that his returns we're akin to gambling, leverage, or both-which means the knowledge they possess is incorrect. Over longer periods of time performance records are very useful in measuring the merit of an investor, but to a much lesser extent when the record is less then 10 or 15 years long. Gauging performance is a very big problem for the average investor, but also for many investment professionals. Investment performance should be measured with respect to the money managers systematic approach i.e. what the money manager is doing and why they are doing what they are doing. Equally important, the money manager must be able to clearly identify and explain why their investments turn out well or poorly.

Lets review the performance of one fund from 1991 through 2001 relative to the S&P 500:

Annualized Returns 1991-2001

Baupost 12.83%

S&P 500 15.25%

Baupost, run by someone I believe is one of the worlds top 5 investors. However, many individuals would be unimpressed by his record through 2001 and therefore uninterested-at the time-in investing with Baupost, because he underperformed the market-but in my opinion, the more important question was why he underperformed? From 1991-2001 his fund underperformed the market because he looked around and said to himself, people are crazy, prices are inflated, and there is little out there we find compelling. He therefore simply said we're going to hold cash until things change. In 1997, 25% of Baupost's portfolio was cash. By the end of April 2001, nearly 50% of Baupost's entire portfolio was cash. This explains largely why Baupost underperformed. The proportion of the portfolio held in cash earns almost no interest, which drives down the overall portfolio's return, but at the same time the value of cash is not subject to market fluctuations. Though he underperformed for 10 years, when the tech bubble blew up, Baupost had plenty of cash to take advantage of cheaply priced securities and as a consequence hugely outperformed since 2001 and therefore also since inception. It would have made as much sense to invest with Seth and Baupost in 1991 as it would now. Having only looked at performance, you would likely not have invested in Baupost.

All investors (both know-nothings and know-somethings) want to make optimal, rational investment decisions, but rarely do. Some do well strictly from the law of large numbers, e.g. if enough people throw a dart some will get pretty close to the bulls-eye, but not all are skilled. This hurts investors that are looking at performance numbers, strictly. Moreover, it is commonplace for most people to assume that if a person of business is wealthy he is wealthy because he was or is a good businessman (or has good business sense), but this is also wrong-headed. It is critically important to separate out those who do well by chance and those who do well for identifiable (often repeatable) reasons. Unfortunately it is hard to correctly identify a know-nothing businessperson from a know-something businessperson, if you either know nothing about business or are otherwise a know-nothing business person.

If, as a money manager, you are unable to identify how much an asset is truly worth and disciplined enough to only pay a reasonable price for it, then you will not earn above average returns. If, as in individual investor, you are unable to identify a money manager with such knowledge, then you will not earn above average returns either.

The point of this rather elaborate discussion is that good investors are easily identified by good businessmen (smart private business owners) because good investors are good businessmen. By definition, this means that individuals are likely to employ the wrong mental model when selecting their money manager. It also means that your money manager is similarly likely to employ a flawed mental model when making investment decisions. As with all solutions to adult problems, nothing worthwhile in life comes easy. Fortunately, the average individual is perfectly able to learn the right questions to ask and to be well enough informed to make sound investment decisions, but you need a good foundation based upon good information. There is no single right answer, but there is a single book that will help the average investor make sensible investment decisions. The intelligent Investor, written by Benjamin Graham is still by far the best book ever written. Graham provides a road-map of the proper way to think about investing. The intelligent Investor is not the final answer, but it's a start.

Keep in mind the best investors didn't alter their approach midway through their career. Either you get it right from the start, or you never get it at all. If a money manager has a long track record, look at their track record, it's important. If a money manager has little or no track record, don't pay too much attention to performance, good or bad. It's not that performance is unimportant, but it's not all-important when the record is short. In either case, spend plenty of time trying to understand how they think about business. (You'll find a few tips further below.) Also, before investing with any money manager, meet with them. Take some time beforehand and create a checklist of questions to ask and answers to expect.

Helpful Hints

A Few Questions to Ask:

What's the money manager's goal/objective & How do you think about risk?

Worrisome answer

Be wary any time you hear terms like risk profile, beta, alpha, optimal portfolio, volatility, or other terms sounding Greek/foreign. Don't take any advice blindly, including mine-have them explain any term that you don't completely understand. If it still doesn't make sense to you, you're probably correct, it doesn't make sense.

Reasonable answer

Objective is to avoid permanently losing capital while earning an attractive return. In the broader sense, risk is the potential for long-term capital loss.

What does the money manager do e.g. how do they select investments?

Worrisome answer

You'll know it when you hear it. (Anytime you find yourself scratching your head.)

Reasonable answer

Select common stocks that they believe are undervalued at the time of purchase. Views common stocks as units of ownership of a business. Do not place any merit on technical stock market studies, specific sectors, trends, or generally fashionable securities. Significant time is spent looking at the balance sheet, earnings history, and prospects of each investment to appraise underlying business or investment value.

How the money manager you determine whether their investment decisions we're good or bad?

There is only one answer to this question.

The logic at the time of initial investment must be consistent with the reasons for any change in the value of a securities value over a reasonable period of time. A reasonably correct and thorough answer isn't easily identified, which is why you need to do a little homework before making these important decisions. Again, I recommend Ben Graham's, Intelligent Investor available at any local library or book store.

How much of the money managers net worth is invested in the fund/partnership?

Don't feel uncomfortable asking this question, it's completely reasonable and a common question asked by smart investors. If the large majority of their money won't be invested alongside yours there better be a really, and I mean really good reason. Anything less than 60% is a bad sign.

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Posted in Home Improvement Post Date 12/04/2018


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