Value Investing

Archives: Mauboussin – Why Doing Less Can Leave You with More

 

Michael Mauboussin is considered an expert in the field of behavioral finance and has some famous books on the topic including, Think Twice: Harnessing the Power of Counterintuition and More More Than You Know: Finding Financial Wisdom in Unconventional Places. Below is a classic from Mauboussin.

 

Michael Mauboussin: The Coffee Can Approach

Why Doing Less Can Leave You with More
Inactivity strikes us as intelligent behavior.
Warren Buffett
Berkshire Hathaway Annual Report

It is awfully hard work doing nothing.
Oscar Wilde
The Importance of Being Earnest: A Trivial Comedy for Serious People

Michael Mauboussin: Brewing a Profit

Robert Kirby, one of the founders of Capital Guardian Trust, told a story of a couple he worked with as an investment counselor for about a decade through the mid-1950s. Since wealth preservation was the primary objective of the client, Kirby followed his firm’s guidelines and bought and sold investments to make sure that the portfolio was sensible and well-positioned. Kirby worked primarily with the husband on a portfolio in the wife’s name.

After the husband died suddenly, the wife called to say that she had inherited his estate and was adding his investment portfolio to hers. Kirby reviewed the man’s portfolio and was amused and shocked. He was amused to see that the man had piggybacked the firm’s buy recommendations to his wife. The man purchased about $5,000 of each stock, tossed the certificates into a safe deposit box, and simply ignored the investments. Kirby called it the “coffee can portfolio” because it reminded him of a time when it was common for someone to place his valuables in a coffee can and stick it under his mattress. Since it incurred no transaction or administrative costs, the can’s value hinged solely on what the owner placed in it.

Kirby was shocked when he saw the value of the man’s portfolio, which greatly exceeded that of his wife’s. It was an odd mix, to be sure. There were a number of holdings that had sunk to $2,000, several large positions that exceeded $100,000, and one stock with a value in excess of $800,000. That jumbo position was the result of a small commitment to a company called Haloid Photographic, which later changed its name to Xerox.

The lesson that Kirby took from the episode was not that an investor should buy stocks hoping to find the next Haloid (or Google or Apple). Rather, it was that a portfolio created by acting on only half of the firm’s recommendations and with negligible costs handily outperformed the portfolio to which Kirby fully attended. Buying undervalued stocks and doing nothing did better than attempting to navigate the market’s ups and downs. Warren Buffett expressed a similar point when he said, “Lethargy bordering on sloth remains the cornerstone of our investment style.” 4

Most of us are taught from a young age that effort leads to results. But if you take effort to mean activity, the lesson doesn’t apply for long-term investors. The message here is simple: investors often make changes to their portfolios—with the best of intentions—that do not add value. This is as true for sophisticated institutions as it is for the unsophisticated individual. Doing less can leave you with more.

We examine two kinds of decisions that are deleterious to long-term results. The first is the reallocation of the weightings of the portfolio from one asset class to another. The second is the swapping of active managers within an asset class. The sources of these mistakes include applying a time horizon that is too short, failing to recognize reversion to the mean, seeking job preservation, and succumbing to recency bias—the tendency to overweight what has happened in the recent past.

Most of the studies showing that investors would be better off with less activity rely on counter factual analysis—a careful study of what would have been. For example, this approach would ask, “what would our returns have been had we stuck with money manager A instead of firing A and hiring manager B?” 5 Naturally, the very act of hiring or firing a manager helps determine the manager’s returns just as the act of increasing or decreasing exposure to an asset class affects its returns. Inflows for a fund or asset class contribute to positive relative returns and outflows are linked to negative relative returns. This observation limits counterfactual analysis because the outcomes are not independent of the actions. But that the returns from activity are poor even after considering that the buying helps, and selling hurts, returns indicates the degree to which investors struggle to make good decisions.

The Asset Allocation Decision: What Have You Done for Me Lately?

Researchers have documented that individual investors earn lower returns than those achieved through a buy-and-hold strategy. For example, John Bogle, founder of the Vanguard group, examined the performance of exchange-traded funds (ETFs) for five years through mid-2009 and found that investors earned annualized returns that were on average 4.5 percentage points lower than the reported returns of the ETFs they invested in. The reason is the timing of the flows into and out of the ETFs. The central concept is the distinction between a fund’s return and an investor’s dollar-weighted return. The fund’s return is simply the compounded annual growth rate in net asset value per share. The dollar-weighted return considers an investor’s timing. Because investors have a tendency to buy a fund after it has done well, they miss the upside but suffer from the subsequent underperformance. Further, they sell after a drop and fail to enjoy the subsequent rebound.

The Investment Company Institute maintains excellent records of the investments in and out of mutual funds. The overall pattern is clear, as Exhibit 1 shows. Investors buy when the market has done well (see the late 1990s into 2000) and sell when the market has fared poorly (see 2002 and 2008). This analysis does not suggest that all you need is a simple buy-and-hold strategy. Such an approach would have yielded a negative return for the first decade of the 2000s, for instance. The analysis does feature the virtue of buying undervalued securities and holding them. Investors are notoriously poor at doing this. Only time will tell how the massive inflows into bond funds and exodus from equity funds in 2008 and 2009 will play out, but it’s hard to make the math show that bonds will do better over the next decade, even adjusted for risk.

Michael Mauboussin
Michael Mauboussin

You might reason that the poor asset allocation decisions are to be expected from retail investors, who lack the training and resources to make better decisions, but that institutional investors would be immune to such mistakes. However, research shows that institutional plan sponsors, including retirement plans, unions, endowments, and foundations, also fail to add value when they move from one asset class to another.

A recent paper summarized a study of the decisions of plan sponsors controlling thousands of products and trillions of dollars over a span in excess of 20 years. The authors conclude that, “Portfolios of products to which they allocate money underperform compared with the products from which assets are withdrawn.” In other words, the plan sponsors would have been better off in the aggregate had they done nothing. The exception to the general pattern was global fixed income investors. (See Exhibit 2.) The researchers estimate that plan sponsors had forgone over $170 billion in value through their purchases and sales of products, a sizeable sum even considering the size of the asset base.

The authors show that asset allocation was not the only source of the value slippage. In fact, asset allocation represented only about one-third of the relative underperformance of assets getting inflows versus those seeing outflows. The other two-thirds was attributable to what the authors call “product selection,” which reflects how well investors pick individual managers.

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Manager Selection: If You’re Hot, You’ll Soon Be Not

Investors have a tendency to allocate capital to funds that have done well in the recent past. Andrea Frazzini and Owen Lamont, professors of finance, call the predictable propensity of investors to lower their realized returns through reallocation decisions the “dumb money” effect. The researchers quantified the effect by comparing the realized returns to the returns for a portfolio assuming the investor had stayed put. This counterfactual analysis shows that activity costs investors over one percentage point a year in returns, which when added to the fees from active management, contribute to the overall underperformance of investors versus their benchmarks. Research shows that investors in hedge funds also earn dollar-weighted returns that are much lower than buy-and-hold returns.

Just as with allocation decisions between asset classes, institutions struggle to allocate funds to managers fruitfully. Professors Amit Goyal and Sunil Wahal did a careful analysis of the selection and termination moves of 3,400 plan sponsors, reflecting over 9,600 distinct decisions. They concluded that the moves of the plan sponsors did not add value. For example, the managers whom the sponsors hire recently outperformed the market and the managers whom they fire have underperformed on average (although the termination decisions are complex). But “the performance of the fired firms exceeds that of the hired firms” in subsequent periods. 15

Full PDF here The_Coffee_Can_Approach_Michael_Mauboussin

Via Wedgewood Partners