Personal Investments

Doug Beer, who’s an economist, stopped by my office last Friday. “I’d like to find out how you do so well with your investments,” I said, “so I can pass the word along to our clients.”

“It sounds like some of your clients don’t do that well,” Doug said.

“They don’t,” I replied. “Those who buy stocks themselves tend to do poorly, but so do the purchasers of mutual funds.”

“Why do you think that is?”

“Probably part of it is chasing last year’s winners,” I said. “The fund companies create advertisements showing how well some of their funds did. It’s not unusual to see promotions of funds that have earned over 15% for the last five years.”

“Many winners are sector funds,” Doug said. “A sector like technology or energy may do well compared to the market for a period. Then it stops. The reason is the stocks become so popular, they become overpriced, and the bargains are found elsewhere. Remember the tech mania of the late 90s? That was an example of sector imbalance that went on for a long time. It cost investors a lot of money.”

“Large businesses are a mystery to most investors,” Doug continued. “As a comparison, people who have homes that increase in value by 20% a year don’t expect that trend to go on forever. They know it will stop in a year or two. But a business can keep growing for a long time, longer than a generation. Wal-Mart, for example, has had a great run for 40 years. Microsoft has grown super fast for nearly 20 years, although now it seems to be slowing down. These growth cycles are much longer and more profitable than the housing cycle.”

“And that makes stocks a mystery?”

“Yes. Microsoft has continued to do what it does well, but it’s finding it more difficult to come up with new products leading to super growth. One day, it will become an average stock. But who knows when? It’s very hard to know when a great company’s growth is going to slow down. We tend to think about companies in a non-analytical way. We tend to use pattern recognition instead of logic when we pick investments.”

“I don’t follow,” I said.

“When we formally learn a specific skill, whether it’s setting up a press, or bookkeeping or how to swing a golf club, we go about it analytically,” Doug explained. “But when we pick up skills by imitation, which is the way we learn most things, we depend on pattern recognition. Studies have shown that when meeting someone new, most people decide to accept or reject the person in about one minute. It’s too fast for analytical thinking.”

“It’s through pattern recognition?” I asked

“Exactly. We pick people who remind us of other people we’ve liked. We pick authority figures who are tall. We often pass up competent people for sexually attractive ones — all mistakes of simple pattern recognition.”

“And you think we pick mutual funds the same way.”

“Of course,” said Doug. “Mutual funds are sold on the basis of past performance, even though they carry a legal caveat not to regard past performance as a predictor of the future. But if we have no other predictors, we have to rely on past performance. And the fund companies respond to this with advertising that works — advertising that promotes past winners. That’s great for them since most fund companies are huge, with dozens of funds. At least a few of those funds will do unusually well in any year, so those are the funds they’ll promote.”

“And what happens when the funds do poorly?” I asked.

“Some portion of their investors will stay with the fund company. They’ll switch from technology funds to large company funds or energy funds.”

“Which rewards the fund company for attracting them in the first place, even with misleading advertising.”

“As I said,” replied Doug, “You can’t be angry at a business for doing what works. The objective of a fund company is to get customers. They spend their big money on advertising, not on research.”

“If you think that’s why most investors do poorly, is there a way they can do better?”

“Sure, and I’d like to discuss it with you another day. I’m out of time for today.”

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto. To receive more information or to be added to the company’s e-mail list, contact hbulmash@bulmashcullemore.com with “Investor Intelligence” in the subject line.