I spend a lot of time trying to teach my children to be good losers. The effort is mostly futile, and seems to go against human nature. Quite apart from helping make friends on the sports field, the (rare) ability to lose gracefully is important for investors, too.To see this, consider one proven way to make money over the long run: value investing. This involves buying shares that are cheap on measures such as price to book, on the basis that most people tend to overreact to unfashionable or poorly performing companies and push their price down too far. Those willing to go against prevailing wisdom and buy anyway should, therefore, make outsize returns, on average over long periods.
The problem comes with the “on average over long periods.” Value investors have to be prepared to underperform the dedicated followers of investment fashions for years at a time before bouncing back. But history suggests they are not.
Investors of all types tend to buy into what has done well, and sell what has done badly. Unfortunately, that means buying investment styles such as value just as their run of success comes to an end, and selling out just as a run of poor performance is about to turn round.
The result is not good. In fact, it is downright terrible. The average value mutual fund in the US beat the S&P 500 (before fees) from 1991-2013, returning 9.4 per cent. Yet, the average investor in a value mutual fund made just 8.1 per cent, according to research by Jason Hsu, co-founder of Research Affiliates, Brett Myers, assistant professor of finance at Texas Tech and Ryan Whitby, assistant professor of economics and finance at Utah State. They would have done better simply holding an S&P index tracker, as long as they did not abandon it when times looked tough.
The problem is well established; the same difficulty applies to other investment styles in mutual funds, to hedge funds and to individual stocks. Broadly, investors trade too much, and lose out as a result.
Unfortunately, it is hard to avoid. A buyer of an individual fund presumably thinks the manager is skilled, and the style they follow works. If the fund underperforms, they should cut the manager some slack; no one can beat the market every year. But how long will they be willing to wait before concluding that they were wrong?
Worries about identifying skill can be avoided by picking an automated version of the style they want, now known as “smart beta.” But the same problem applies: how many years of underperformance will the investor be willing to put up with before concluding they were wrong to pick value, for example, or that the anomaly of value outperformance has vanished? In the past, the answer was not long enough.
The same problem applies even to trackers of the market as a whole. Many investors abandoned stocks altogether in early 2009, in what turned out to be one of the best-ever buying opportunities.
There are ways to modify one’s behavior as an investor. Committing in advance to be ready to ride out, say, three years of underperformance, or a 50 per cent drop in equities, might help. Alternatively, those who recognize how they are likely to behave could avoid such strategies, or – in the extreme – avoid looking at relative performance at all.
Mr Hsu points out that the self-defeating behavior of investors who correctly chose winning strategies, such as value, but underperformed because of their timing, has interesting implications. One puzzle about the persistence of the long-run outperformance of value stocks, or of high-quality companies or other successful strategies, is why they are not arbitraged away once discovered.
One answer is that an arbitrageur will not be willing to risk the years of underperformance. The only strategies that can possibly beat the market once widely known are those likely to go through periods of underperformance longer than arbitrageurs can hold on.
Even so, for value to win, someone else must lose. It is plausible that investors in growth stocks are repeatedly misled into overpaying for the latest fashionable technology. Hope triumphs over experience.
But if value investors as a whole have not beaten the market, as those in mutual funds have not, then perhaps there is no need for an explanation. Those who stick with value can keep outperforming precisely because so few other investors stay loyal to the strategy over time.
There are times when being a sore loser can work in an investor’s favor: those who sold out of Japanese equities in 1992, after they had fallen 50 per cent from their peak, are still better off than those who stuck with the market over the past 23 years.
In other large markets, investors were better off avoiding a tantrum.
By: James Mackintosh
