Why Investors Fail

Exactly what use is past performance? How can you spot a trend before it starts, and determine when it will stop? And when will the next big bear market rally start? This week we examine why so many investors fail, and why a few succeed over and over again. While I am sure that none of my regular readers make these mistakes, this will be a useful column to send to your friends who have not been as successful as you. Oh, yes, and I tell you how to know when the next big rally starts. Let's keep that detail to ourselves. No use tipping your friends on this one.

But first, I must admit a BIG mistake. Last week, after several pages of detailing why deflation is a big problem in our near future, I ended by writing that the Fed must begin NOW to fight inflation. I meant the Fed must begin NOW to fight deflation . Many of you wrote, asking me to explain. As my friend Mac Ross wrote: 'John, there are now 1 million plus readers taking Excedrin trying to figure out what you meant.' I do apologize. Since Alan Greenspan did not abandon his easy money policy, as a result (other than reader confusion) there has been no material damage.

It's a Cruel, Cruel Investment World

It's been a very busy week. I have been continually reminded at every stop in my travels how difficult it is to make money in the stock market. I have spent the last few days speaking at and attending the Fund of Hedge Funds Forum in New York, and then a private meeting in DC of investment newsletter publishers from around the world. I was privileged to have dinner in La Jolla with Richard Russell of Dow Theory fame, and one of the hottest hands in the investment world of late. I have had the privilege of interviewing a number of managers and analysts, and have been reviewing Nassim Taleb's must read book, Fooled by Randomness . I will pass on a few of the more noteworthy ideas, especially from Mr. Russell, that I have gleaned from this investment elite to you.

If you have been having trouble making money in the stock market this year, you are not alone. Hennessee reports that the average hedge fund was down 1.3% for September, and is now down 5.5% for the year! The hedge fund industry is on track for its first losing year ever.

Think about that for a second. In the bear markets of 2000 and 2001, the average hedge fund managed to make a profit. Some did quite well, thank you. So, it is not just the bear market that is the problem. This market environment is proving to be the toughest conditions that most of us have ever seen.

One would think that because high net worth investors and huge pension funds are willing to pay high fees for their expertise, they believe these hedge managers are at the top of the investment management world. These funds have some of the best research and brightest minds and they are having problems.

To be sure, they have out-performed their peers in the mutual fund world, but that is small comfort if your returns are negative. Charging high management fees does not necessarily mean you are a good investment manager. However, if you don't produce results, you will soon be out of business. While investors are often more patient than they should be, negative returns soon wear thin.

Why Investors Fail

While the professionals typically explain their problems in very creative ways, the mistakes that most of us make are much more mundane. First and foremost is chasing performance. Study after study shows the average investor does much worse than the average mutual fund, as they switch from their poor performing fund to the latest hot fund, just as it turns down.

Mark Finn of Vantage Consulting has spent years analyzing trading systems. He is a consultant to large pension funds and Fortune 500 companies. He has a team of certifiable mathematical geniuses working for him. They have access to the best pattern recognition software available. They have run price data through every conceivable program and come away with this conclusion:

Past performance is not indicative of future results.

Actually, Mark says it more bluntly: Past performance is pretty much worthless when it comes to trying to figure out the future. The best use of past performance is to determine how a manager behaved in a particular set of prior circumstances.

Yet investors read that past performance is not indicative of future results, and then promptly ignore it. It is like reading statements at McDonalds that coffee is hot. We don't pay attention.

Chasing the latest hot fund usually means you are now in a fund that is close to reaching its peak, and will soon top out. Generally that is shortly after you invest.

What does Finn and his team tell us does work? Fundamentals, fundamentals, fundamentals. As they look at scores of managers each year, the common thread for success is how they incorporate some set of fundamental analysis into their systems.

This is consistent with work done by Dr. Gary Hirst, an analyst and fund manager. In the 1990's, looking for some technical system to use, he rigorously programmed the basics for every technical system and indicator he could find. The result was that he found technical systems to be useless. They worked when the conditions for which they were designed were the primary economic background, but when conditions changed they failed miserably.

Richard Russell made this very astute observation this week on technical indicators: "I note that the Arms index, the put/call ratio, the short interest ratio, the McClellan Oscillator and a dozen other indicators that worked beautifully in the bull market have ceased to work in this bear market. What does that tell me? It tells me why so many 'bull market analysts' have been wrong over the last couple of years.

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"It also tells me that this is a bear market, but it's not a 'normal' or 'typical' bear market. It tells me that this is a 'power-house' bear market, a monster, a relentless brute that has, so far, paid no attention to the regular, time-tested methods that have worked in bull market corrections and lesser bear markets."

What Hirst found was consistent with what I hear so much in meetings with managers: In his opinion, if a technical system is "successful," it is because the money management system (risk controls, stop losses, etc.) is good. With proper money management, you could almost invest at random and achieve the same result over long periods of time. By definition, cutting losses and letting winners ride is a trend following system. It is basic money management.

As an illustration, I have seen past performance track records of fund which are managed using astrology. While I may risk offending Maggie, one of my long time readers, I think "signals" produced by looking at the stars is about as random as you can get. I should also say it may be better than some other technical systems I have seen.

An excellent example of a good money management system is Doug Fabian's Maverick Investor System. It is a simple 39 week moving average system, with a few bells and whistles. When a fund is above its 39 week moving average, he invests. When it is below, he exits. While this means he will miss some opportunities in a bull market, and even though he can get "whip-sawed in certain markets, he avoids the huge losses that can kill a portfolio for a decade just as you want to retire. This simple system is so clearly superior to buy and hold that I do not understand how anyone can maintain otherwise.

Whether you use 39 weeks or some other risk management system, in secular bear markets, if you want to be successful, you must have one.

Where are the Bull Market Geniuses?

The bull market bubble made geniuses of many average investors and managers. They confused luck with skill. They assumed their brilliant technical analysis produced their wonderful results when in fact they were on the right side of a self-fulfilling prophecy. For a short while, people forgot how just #$#@$ hard it is to pick good stocks.

This reminds me of the study I cited last year from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above average earnings growth for 10 years in a row. The chances of you picking a stock that will be in the top 25% of all companies every year for the next ten years is 50 to 1 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely they are to have an off year. Being on top for extended periods of time is an extremely difficult feat, and we are finding out now that companies which did perform so well frequently cooked their books - think Cisco -- or just outright lied. Think Enron.

Yet what is the basis for most stock analysts' predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is over-priced? His staff will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that they will do so for the next five. The actual results for the last 50 years show the likelihood of that happening are small.

Tails You Lose, Heads I Win

I keep a marvelous must-read book by Nassim Nicholas Taleb called "Fooled by Randomness" on my desk. I read it often, simply opening it anywhere and reading a few pages. The sub-title is "The Hidden Role of Chance in the Markets and in Life." He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he does a very thorough treatment. While I have read many of his points elsewhere, he gives us several totally new (to me) concepts. He also has a gift for expressing complex statistical problems in a very understandable manner.

I think anyone who wants to trade the markets should read this book. If you still want to trade, then read it again. If you still want to trade, then put it on your desk and read it often.

If you are an investor, you should read this book. Taleb will save you money. I need to acknowledge his contribution for much of this next section.

Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven't discerned. Their 7 figure salaries prove it.

The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!


In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something called "survivorship bias." Let's say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had dismal results, were unable to attract money, and simply folded.

If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases most statistics are based upon only look at the survivors. This sets up false expectations for investors, as it raises the average.

Taleb gave me an insight for which I will always be grateful. He points out that because of chance and survivorship bias, investors are only likely to find out about the winners. Indeed, who goes around trying to sell you the losers? The likelihood of being shown an investment or a stock which has flipped heads five times in a row are very high. The chances are that hot investment you are shown is a result of randomness. You are much more likely to have success hunting on your own. (The exception, of course, would be my clients.)

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That brings us to the principle of Ergodicity, "...namely, that time will eliminate the annoying effects of randomness. Looking forward, in spite of the fact that these managers were profitable in the past five years, we expect them to break even in any future time period. They will fare no better than those of the initial cohort who failed earlier in the exercise. Ah, the long term." (Taleb)

Don't despair yet. There is hope. I will discuss a few principles for discerning between the managers who are lucky and those who are good in a moment. But first, we need to know what we are up against in our search.

I've Got A Secret System

If you go to an investment conference or read a magazine, you are bombarded with opportunities to buy a software package which will show you how to day trade and make 1,000% a year. For $5,000 you can buy an "exclusive" letter (Just you and a thousand other readers, and their friends and clients) which will give you a hot options or stock tip. You will be shown winning trades which make 100% or more in a short time. You, too, can use this simple tested method to enrich yourself. Act Now. (Add $6.95 for shipping and handling.)

There are several large databases of hedge funds. As I mentioned above, these are supposedly the best of the best.

None - not one - nada - zippo - zero of these best managers in the world can deliver consistent results that you read about in these ads. The best offshore fund in the world for the five years ending in 2000 did about 30% a year. You can't get into it. But in 2001 they were flat. They are down slightly this year.

Steve Cohen can deliver some spectacular returns and has for almost 20 years. He has been closed to new money for years. But even this legend can't put up numbers like I see in the ads.

Here's the reality. If you could make 20% a year steady, in five years - ten at the most-- you will be managing all the money you can run. Trust me, the money will find you. You will charge a 2% management fee and 20% of the profits. On $1 billion, that amounts to $60 million dollars in fees. That's every year, of course. Why would you sell a "system" that could do 20% a year?

Once everyone knows about a system, it won't work like it has in the past. One of the problems I wrestle with every day is trying to figure out which investment styles may be at the end of their run. Every dog has its day in the sun. The trick is to figure out when the sun is setting.

There are physical limits to everything and every system. Knowing your limits, and the limits of your investment managers, is critical. Many of the spectacular blow-ups have been from managers who do not understand the limits of their style.

Take the Janus 20 fund. This is a fund that focuses on the 20 "best" companies, mostly tech. They had an incredible record, and grew to manage tens of billions of dollars. This was good for the managers, as annual bonuses grew each year as well. They told their investors the secret to their success was doing their homework and being expert on analyzing companies. They were bottom's up value investors, looking for growth potential, and boy were you lucky to have found them.

They were a bus load of investors on their way to a train wreck. No one seemed to think the party would end. But when it did, they had no exit strategy or even the ability to exit. If you own $5 billion in Cisco, you are not a shareholder. You are a partner. You are stuck. If you try to get out, the market will soon get the word that Janus is bailing, and the shorts will eat your lunch. One of the reasons long-short hedge funds made so much money in 2000 was just this phenomenon. Figure out which hedge fund had to dump to cover redemptions and short the market ahead of them.

In hindsight, their incredible track record was less brilliant investing and, more simply, participation in the largest investment bubble in history, with no exit strategy. They got heads 8 times in a row. They are in the process of getting tails for the third straight year. Amazingly, they still send out promotional literature touting their research and predicting they will be there for the turn-around. Unfortunately, a lot of investor money won't be there.

How to Know When the Next Bear Market Rally Begins

First, let me make this very clear: There is no technical indicator, or even fundamental system, that can tell us when the next bear market rally will begin. All of this talk on TV about this indicator or that system telling us we are at the bottom is just voodoo investing. It is an exercise in wishful thinking.

The Nobel prize in economics this year is going to a psychologist, Dr. Daniel Kahneman, who helped pioneer the field of behavioral economics. If I can crudely summarize his brilliant work, he basically shows that investors are irrational. But what gets him a Nobel is he shows that we are predictably irrational. We continue to make the same mistakes over and over. One of the biggest is our common inability to take a loss. He goes into long and magnificent explanations of why this is, but the bottom line is that taking a loss is so painful, we simply avoid it.

While technical indicators cannot be rigorously programmed to yield an automatic, always winning, low losses, don't think about it trading system, they do provide some useful insight. Volume, direction, momentum, stochastics, etc. are reflective of market psychology. With a great deal of time and effort, astute traders can use this data to determine what Mark Finn calls the "gist" of the market.

The great traders become adept at using this data to help them determine market psychology and thus market movement. They also employ excellent money management and risk controls skills. It is my belief they are simply guessing. They will look at you and swear they are not. "Look," they say, "the Vix is over 50! You gotta trade!!"

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Well, maybe. Until that indicator fails, and it does from time to time. Maybe most of the time they are right. But it is still a guess.

I readily admit that some people are quite skillful. My contention is they have the "feel." Just like some people can hit 95 MPH fast balls, they can look at amazing amounts of data and feel the market. They use solid money management techniques to control the risk, and they make money for themselves and their clients. Like Alex Rodriguez at the plate, they make it look easy.

And thus many ordinary people think they can do it. And most fail.

For some reason, we take this failure personally. It seems so easy, we should be able to do it. But after years of interviewing hundreds of managers, and looking at thousands of funds, and mounds of data, I have come to believe it is a gift, just like hitting baseballs or golf balls.

If it were easy, everybody could do it. But it's not, so don't beat yourself up if you are the one with the gift. It would be like me getting angry at myself for not being a scratch golfer. It is not going to happen in my lifetime. If I wanted to bet on golf, I would bet on a pro, not on me.

And thus, I come to my insight on how to determine when the next big bear market rally begins. I will ask Richard Russell.

Richard has been writing the Dow Theory Letter since 1958. At 78, he is writing more copy (daily) and better than at any time in his life, and shows no sign of slowing down. He gets up at 3 AM, reads ten papers, scores of letters and services, and then just writes some of the best copy anywhere, along with copious amounts of useful data. He has been as consistently right as anyone for that period, and his "feel" for the market puts him in hall of fame categories.

He recently wrote that he would try and guess when the next sustained rally would start. He gives no guarantees, and says it may happen and he will miss it. Maybe it started on Thursday, and he missed it. And then, maybe this is a true sucker's rally in a longer term bear market. As those of you who have read me for some time know, I have been of the opinion that we are in a long term secular bear, and the "bottom" is several years off. We will get lots of trading opportunities.

My bet is that Russell's best guess is better than 99.5% of all the writers and analysts out there, and I don't know who the other 0.5% are. You can get his work online for a mere $250. Just for the record, I get nothing from Russell, although he did buy dinner last Saturday in La Jolla. But then, I gave him my professional opinion on the diamond market. I got the better deal.

So, if he calls the turn, I will take credit for being smart enough to tell you to follow his advice. If he is wrong, I hope I made you a believer in stop losses and risk control. You can access his web site at www.dowtheoryletters.com.

Baggage Claim Blues

I finish this letter, written in four cities and three airports, standing at a counter in Reagan Airport baggage claim, where American Airlines has somehow misplaced an entire planeload of bags. I am so-o-o-o looking forward to getting home.

My next trip will be to New Orleans, November 7-10 for the New Orleans Investment conference. (www.neworleansconference.com), where Mr. Russell will also be speaking. In addition to addressing the main conference, I will also hold a private 'Invitation Only' session on Thursday night just for Accredited Investors. If you are an Accredited Investor, you can get an invitation by registering for my free Accredited Investor E-letter (www.accreditedinvestor.ws) which deals with hedge funds and private offerings. If you are already registered, you will automatically receive an invitation.

I look forward to seeing you there.

By the way, you can read chapters from my book in progress, Absolute Returns, by going to www.johnmauldin.com. Let me know what you think of the new site.

Your ready to be in his own bed (next to his bride) analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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