Business Risk

It is very difficult to find a good money manager. 90 percent, maybe 95 percent, of the advice that the average investor gets from "professionals" is mediocre or bad advice. However, I think that there are some important "ifs" to the suggestion that anyone can manage their own money. Further, many of the problems you experience in search of professional money Management are at least partially structural and have very little to do with the education or intelligence of the people involved. I think that it is important to understand those structural problems, this is a basic element of successful money management and of successfully picking someone else to manage money for you.

Perhaps the most important of these structural problems is that the market place selects for poor long term performance. A managers performance is almost universally evaluated using short-term results. Most investors are focused on short term results. They do not have patience that is required to outperform the market in the long term. In the media managers are compared using quarterly, monthly, or even daily returns, This creates pressure on managers to focus on short term performance. As Seth Klarman says "Managers who do well in the short term are rewarded with more assets," he said. "Those who do not do well in the short term often don't survive to see the long term."
In a bear market frightened clients make things worse for managers and “career risk” that managers are guided by what their clients think, or what they are afraid their clients are thinking. An example of this can be seen in the behavior of managers in the tech bubble (See “Style Drift” below)

Client Letter September 2009

Business Risk
As Seth Klarman said in a recent interview; "Managers who do well in the short term are rewarded with more assets," he said. "Those who do not do well in the short term often don't survive to see the long term."

Client Letter May 2005

Private Equity, Hedge Funds, & Value Investing.
There is one thing I have learned through 38 years of investing: the market will always do what it has to do to prove the majority wrong. Or as Buffett says, you pay a high price for a cheery consensus. This is not because the market is perverse, but because the market is a zero-sum game and frictional costs mean that there will always be more losers than winners."

Client Letter November 2004

Some Thoughts on Risk
here is no such thing as a risk free investment all investments carry some risk... A good investment is one minimizes the risk that the investor faces, and that pays you well for taking the risk. All investments decisions should start with measuring risk. Modern Portfolio Theory teaches that assessing the risk involved in any common stock investment is a function of the volatility of the stock involved. In other words, if the price of a stock moves big in one direction or the other on a regular basis, it carries a higher average risk as an investment. Charlie Munger on the other hand regularly refers to this method of risk assessment as "twaddle."

Client Letter July 2004

Patterned Irrationality
"I believe that markets are usually inefficiently priced, both in detail and in aggregate, and that they are driven by very fallible, emotional investors who have neither the mathematical nor the psychological means to process data efficiently." - Jeremy Grantham

I personally have come to the view that markets may be efficient at evaluating data but are almost always a little psychotic. In this regard Ben Graham's metaphor about Mr. Market is helpful. Mr. Market knows all the numbers and is perfectly capable of using the numbers to arrive at a logical figure for the intrinsic value of a stock. The problem is that he is bi-polar and his figure for a company's intrinsic value is affected not only by the numbers, but also by his mood.

Client Letter August 2003

A Different Drummer
Bogle says that during the greatest bull market in history the average equity fund investor has received just 2.7% per year return. In other words after taxes and inflation the average Joe that had his money in mutual funds for the last eighteen years is probably in the hole. This is indeed something to ponder. At first it does not seem possible, but mindless pursuit of performance gets the crowd to always buy last years winners and we all know how that turns out.

Client Letter September 2000

Style Drift
What happens when mutual fund managers chase Performance at the expense of investor suitability rules.

But a visit to the Morningstar WEB site reveals a different picture. The large cap growth funds top four stocks are Microsoft, Intel, General Electric, and Cisco. 17% of the funds assets are invested in 4 stocks with an Average PE of 81. 23, of the top 25 positions (65% of total assets) the average PE was 77.9. The other two stocks had no earnings at all. This is what the wonderful world of mutual fund people are selling to widows these days

Index Funds

Client Letter September 2003

Which Index Fund
There are hundreds (maybe thousands) of index funds and they are all basically sector funds. Some of these indexes will return something close to the returns of the S&P 500 during the twentieth Century, some will do better, some will do worse, but if you know which is which, you are a lot smarter than I am.

Client Letter February 2000

Index Funds
A wonderful new vehicle? So says Tom Gardiner. But money has been pouring into Index funds for the last ten years. Now this flow of money has created distortions in the capital markets and threatens to make passive management passé.

You Can Manage Your Own Money If…

I would be the last person to try to discourage someone from trying to manage his own money. As I said above, it is a lot easier and more common to get bad advice than it is to get good advice. On the other hand, anything you learn in the process of investing is important, even if it just helps you to understand the difference between good advice and bad advice. And finally, in this business, there is no way to learn anything important without getting your feet wet.

But not everyone can be a good money manager. Warren Buffett said at one of the Berkshire Hathaway Annual Meetings that I attended in the mid-nineties that he reads between 1,200 and 2,000 annual reports and other financial statements a year. Most of my clients, and I suspect most investors, do not have time to read 2000 annual reports a year. While they clearly have the intelligence to read and understand a financial statement, most of them find this activity boring and have no desire to make this a full-time job.

So my first "if" would be, you can manage your own money if you have the ability to understand financial statements, and if you are willing to devote considerable time to this activity.

The second big "if" is more difficult. It has to do temperament. If you have the temperament to buy what no one else is interested in, the patience to ignore bubbles, and the courage not to panic when crowd is running for the exit, then you can manage money. These are qualities that I rarely see in human beings and find mostly in investors who have had a great deal of experience with the market.

Structural Problems

This is a much more complicated subject, so I will only attempt to touch on the surface here and there. Much of the bad advice people receive is the result of structural problems in the way advice is delivered to customers.

1. There will always be more losers than winners.

In the stock market there are only two grades, an "O" for out performing the market and a "U" for underperformance. The performance is a zero sum game, for every winner there is a loser. By definition this means that at least fifty percent of the people have to underperforms. Add in the impact of frictional costs, and a little addition and subtraction will tell you that most players will end up with a "U." This is not Lake Wobegone

The good news (for small investors) is that in this game, size is very important. Unlike any other business, in money management bigger is not better. Most of the money under "professional management" today is in the hands of people that are too big to outperform the market. The largest frictional cost for a large institution whether a mutual fund, hedge fund or any large manager of private accounts is the cost of trading—and I do not mean commissions. I mean how much you move the stock up when you buy, and how much it goes down as you try to get out. There is no attempt in the industry to keep track of this expense and so investors ignore it, but my guess is that it is a lot more important in explaining under-performance than commissions or management fees. Indeed I have read estimates that run as high as 7% from a large mutual fund. When it comes to performance size is a hug anchor. Warren Buffett has said that it was easy for him to beat the market when he was managing $10 million but that with $100 billion out performance is nearly impossible.

In this regard the individual investor (assuming he has the time to do his homework, the temperament to remain patient, and some experience with markets) has a big advantage. He does not have to buy 300 companies and his trades will not move the market.

2. The best managers do not need business.

I am speaking here about managers who can add value for the investor in the sense that they consistently show returns that exceed the returns of the overall market by a margin greater than the fee charged by that manager.

There are of coarse exceptions, but generally the managers that are good are not going to come find you. They are too busy doing stock research to spend a lot of time pursuing new business. Also, sales and money management are very different skills, and a good manager is not necessarily a good salesman.

If a money manager is managing over 100 million and they have a long term record of beating the S& P by 5% or more they may not be looking for new accounts. First because their management income is increasing rapidly from internal growth, and also because this internal growth will eventually get them to the point where their size will become an anchor for the performance of the accounts of their existing customers. Good Managers with less than $100 million may still be looking for new customers, but these are small operations with very little time or money to spend on looking for new business, so are hard to find.

3. Mutual funds are not good vehicles for managing money.

They buy too many companies, they have too much money, and the money is always flowing the wrong way (Money is flowing in at market tops, and out at the bottom) therefore expensive, "out" when stocks are going down). For The manager that is fully invested this forces him to buy high and sell low. This does not help you investment results.

4. Too many people paid by commission.

Much of the financial advice people get comes from someone earning his living from a commission. There is a conflict of interest here that means the advice you get has no value, or less. (Sometimes it will bite you in the ___.) If your stockbroker has a nice car or a big boat, ask his advice about buying a car or a boat, but never, never buy stock that he recommends. As a registered rep in the seventies I learned that one rule was universal to all wire houses. The higher the commission offered to sell a product, the worse the quality of the investment.