Herd mentality

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Carlos Sera

Overview

A Tale of Destruction "Success Breeds Failure-The Plight of The Successful Money Manager"

This tale is a Behavioral Tale because primarily it demonstrates the pitfalls of what behaviorists call the group mentality or the herd mentality. It also teaches that past performance is not an indication of future performance and investors must know how it is your Hired Asset Manager or HAM generates the types of returns they do. To succeed investors must understand the risks that each investment in their portfolio represents. The tale gets its name because it demonstrates how quickly wealth can be destroyed, especially in the stock market and especially by the most successful stock money managers. It sounds incredible that the most successful stock money managers and traders destroy wealth, but almost all of them destroy more wealth than they have created at some point in their career. Many destroy more wealth than they ever create. The events of the last few years are a perfect example of successful money managers destroying more wealth than they ever created. How does it happen and what can you do to make sure it doesn’t happen to you?

Protecting capital is a major theme of Financial Tales and of utmost importance to the reader of these tales. Stock market investing is not known for its ability to protect capital over short periods of time. Over long periods of time it is an excellent way to protect capital but in the short run anything can happen. The investor is thus always weighing the risks vs. the rewards of stock market investing. Stock market wealth, left unprotected, can quickly disappear. This tale teaches us that “When Bad Things Happen,” expertise and past performance provides small comfort and little solace. These stock market or stock mutual fund investors, head for the hills, abandon their plans in droves and seek what they consider safety in the arms of the bond or cash siren call.

I like to use the term “When Bad Things Happen” because I am not a fan of confusion. Some people use the expression “A Black Swan” event to describe “When Bad Things Happen.” Others might use the expression “A Low Probability” event. Others may call it a “Once in a Life Time” event. Regardless of what you call it, when it happens to you, if it happens to you, when it happens to you, you won’t care what it’s called. To you it will mean that you have a lot less money than you did just a short time ago.

I won’t name names for this tale. However, if you examine the track records of the most successful stock mutual funds in late February or early March of 2009, you will discover many successful mutual funds that had lost more money for their investors than they had ever made them. How can this be? How can mutual funds with 10, 15, 20 and 25 year records of success lose more money than they ever created? With a little thought, the answer is simple and obvious. The combination of a successful track record draws or lures new investors that are attracted by past performance. They invest a substantial portion of the fund’s money at the top of the stock market and when the market drops the mutual fund drops and is coincidently managing the most money they have ever managed. Let’s look at an example.

Examples

The following table shows what may happen over a 30 year period in a successful mutual fund’s cycle. In this hypothetical mutual fund the fund starts out with $5,000,000 under management and in relative obscurity. The fund makes a 15% return in the first year so it grows to $5,750,000 and through word of mouth an additional $1,000,000 of investment capital is attracted to the fund as word spreads of the fund manager’s investment prowess. Once again in year 2 the fund delivers a 15% return and more money is attracted to the fund. In fact the performance is so good and so consistent at 15% per year that capital flows to the fund at a rate of 30% per year over the previous year’s inflow for over 25 years. By the start of year 28 the fund has over $9 billion under management and more than $1 billion flows into the fund in year 28. People can’t get enough.

What happens next? After 27 year of successful money management the fund is now managing more than $10 billion dollars. The fund’s money manager or HAM has appeared hundreds of times on TV and even more often in print. He or she is a household name, an investment rock star and investors long to hear the opinion of this wise HAM. Then the world falls apart or as I say “Bad Things Happen.” In the 28th year the HAM loses 25% of the investment portfolio. So in year 29, the investing public says “Maybe the guru has lost his touch” and no new money flows into the fund. In year 29 the HAM once again loses 25% of the investment portfolio. So in year 30, the investment public says “The guru’s approach may no longer work” and once again no new money flows into the fund. Finally in the 30th year of operation the manager once again loses 25% of the investment portfolio. We’ve completed the success to failure cycle as well as more than likely a bull market to bear market cycle.

Let’s count up the numbers and examine what happened. We can see that since inception the fund collected $5.169 billion in investor capital. Yet by the end of the 30th year it only has $4.325 billion in investor capital. After 30 years of managing money this fund, this guru or this HAM has lost or destroyed, thus the title of this tale, $844 million dollars of client money.

Does this example seem farfetched? The answer is yes and no. No in that this actually happens to successful managers when things or markets don’t go their way, thus the plight of the successful money manager. Yes in that consistent returns of 15% on a yearly basis don’t happen. Is this example extreme? I don’t think so. In fact I would bet it is the rule rather than the exception and you can witness it at the end of every bear market cycle. The classic example is the real life case of a very successful and much heralded HAM that outperformed or beat the stock market or the S&P 500 every year for 15 years to then go down in flames.

Some people might question the assumption of 3 years in a row where the market or the guru drops 25% each year as too extreme, but it isn’t. In fact if a portfolio loses 25% in year 1 this means a hypothetical $100 dollars is worth $75 at the end of the year. Another 25% drop in year 2 lowers the portfolio value from $75 to $56.25. Lastly a drop of 25% in year 3 leaves the investor with $42.19 at the end of year 3. When all is said and done, the portfolio has dropped 57.81% from its peak, not the 75% that most people think when they see 3 years in a row of 25% drops. People are math challenged I have learned so it’s important to understand the math.

Is a 57% drop reasonable? If you examine the drop in the US stock market from October 2007 through early March of 2009 and analyze the 50%-70% drops in all the major stock indices as well as almost every successful mutual fund, a 57% drop is more than reasonable. Lastly, please note that the market doesn’t have to drop 57.81% over 3 years. If it happens suddenly there is as much wealth destruction as if it happens slowly.

In summary, we learn several things from this tale. Number 1 we learn that most successful managers destroy more wealth than they have ever created at some point in their life. Number 2 we learn that this wealth destruction happens because investors entrust successful managers with more money as they become more successful or said a different way, at the peak of the manager’s vulnerability. Number 3 we learn that despite all that we read and learn from others or from Financial Tales, investors will repeat this process over and over. They will continuously be chasing past performance. Finally we learn that at the end of year 30, the mutual fund firm will still be aggressively marketing the 30 year track record of the fund. How can this be you ask? A calculation of the 30 year track record of the fund in this example will show a 30 year compounded annual growth rate of 10.19% per year for the 30 year period. Not bad for 30 years.

This tale is also meant to make you aware that these low probability events aren’t as low probability as some would have you think. In fact the US stock market has dropped in excess of 40% five times in the last 80 years. Simple math tells us to expect a drop in excess of 40% every 16 years. So be aware. If you are an investor for the next 30 years it will probably happen to you or has already happened to you. If you are embarking on a retirement that you must fund for 20-30 years you must be extra cautious.