Why Investing in the Obvious Seldom Works: The Inferior Returns of the Typical Investor.

When Peter Lynch, the money manager who made Fidelity Magellan mutual fund a legend in its time, gave investment advice, he told people to “invest in what they know”. If there were crowds in front of a Dunkin Donut location, think about investing in Dunkin Donuts. If people were wearing athletic shoes as fashion statements, think about investing in Nike or Adidas.

Peter Lynch made it sound as if this was the way he invested. It was no more the way he invested than tossing footballs is the way Peyton Manning earns a living. Peter Lynch was a master at financial analysis, as well as having the advantage of managing funds when the market was just beginning to go up. But to the audience of public investors, who wanted to think of themselves as capable of doing what Peter Lynch did, it sounded like they could do the same thing. It was the equivalent of preaching the thrill of skydiving, without mentioning the role played by a functioning parachute.

With the market hitting records, it is insightful to remember that, if investing were as easy as some people believe, everyone would be rich. The fact that everyone is not rich, and some people have lost their savings investing, should not be forgotten in heady times such as the present.

The latest investment fad to befall us is the index funds. The rationale goes something like this: since managers so often do not beat the market, an index fund will give you close to the market’s rate of return without having to figure out what to invest in, or even how to invest. If index returns are good, you get your fair share. If they are not good, you are doing no worse than anyone else.

The problem with indexes is that they take no measurement of risk, which rises and falls over time. That an index fund invests in the most overvalued parts of the market is axiomatic. Those are the parts of the market that are most represented in the index, by virtue of their current values. So as an index represents less value and more speculation, buying the index makes one a party to holding the market up, even when others may be leaving.

Conversely, when index funds fall, most investors do what they always do: they bail out. This causes the index fund to fall further still. At some point, the index fund will go back up, but most investors will not get back in until way past the point where they bailed. In fact, the average retail investor has a return of less than three percent per year on his or her investments. This dismal return is the result of several factors: getting in and out at the wrong time, transaction costs, changing strategies too often, and taking too much risk in an effort to attain a given level of return. Usually, their investment choices are dictated by the recent experience of other investors.

Even the accusation that indexes beat the returns of active managers has its qualifiers. Active managers outperform indexes in falling markets, as well as the start of up markets. The reason for this is that better managers keep an eye on risk as well as return. Index funds do not pay attention to risk levels, assuming that whatever risk exists at a given level of the market is acceptable. Thus, as market tops are formed, index funds, which are not charged with calibrating risk, plow ahead, while active managers with a longer view, concerned about relative valuations, hold back.

So the current fascination with index funds is an indicator of a market in the late stages, when risk takes a back seat to return. Index investing is, in essence, momentum investing, as those stocks and industries that do better than others get more of the index funds’ dollars, making them go up even more. Valuation and fundamentals are of no relevance to an index, much as they are of no relevance to technical analysis. In a Standard and Poor’s 500 Index fund, half of its value resides in a tenth of the stocks in the fund. This is not diversification as much as concentration. This is how people who believe that such an index fund is made up of 500 equal stocks get a nasty surprise.

So how much longer can the index trend last? No one can say for sure. The longer it lasts, the more severe will be its denouncement. While no one sees a market downturn of a magnitude of taking investors out, history does not exactly give advance warning of what it intends to do, save in retrospect. What does seem certain is that those who invest through funds have less conviction of what they own, and are less likely to see matters through. By washing the nervous nellies out of the market in a decline, the stage is set for another upturn. Initially there are fewer participants. These few, early participants, are the ones who wind up making the most money. Their success attracts others, some with short memories. By so doing, the cycle begins anew.

The Economy

Economic activity points to an ongoing continuation of the economic recovery. There seems to be a solid increase in job growth, as well as an acceleration in GDP. This should be considered welcome signs of solid economic fundamentals.

The decline in gas prices has acted as a de facto tax cut. It puts money into everyone’s pockets in proportion to the cost of gasoline relative to one’s total expenditures. For this reason, it helps the working poor more than the wealthy. It will be interesting to see if retail chains that cater to such consumers, such as Walmart, benefit and to what extent.

Interest Rates

China has become the latest country to lower interest rates to get its economy moving again. With interest rates down almost worldwide (only Russia and Venezuela seem to need to keep rates high to maintain their currencies), the obvious questions becomes, when and where will interest rates rise.

With a material portion of the world’s debt, the US will probably be the first to raise rates. When, is an open question. Some have tied it to the direction of the budget deficit, which has been trending down for four years. When the budget deficit reverses course and starts to rise again, that will be a sign that the US government will need to raise rates to continue to borrow ever-increasing amounts of money. Of course, the act of raising rates will require more interest expense on the Government’s books, which will require more debt to be issued to pay for the same. The only way to reverse the spiral will be to either cut spending or raise taxes. While this trend may not be manifested until the latter part of this decade, be sure to watch for it.

Inflation

Inflation has not yet arrived on the scene. Job growth thus far has not be accompanied by higher wages. On the surface, firms have not yet had to compete for workers.

This will probably change in 2015. The ongoing demographic shift to an older population will eliminate much of the labor supply, while a dearth of young workers and a hostile immigration policy will keep that supply from being replenished. While much of the reaction to the President’s immigration reform focuses on procedure, little is being said about policy. Like Obamacare, people are hostile to the concept, but like the specifics. Perhaps the Republicans will get credit for saying the same thing as the President, but saying it better. It won’t be the first time that has happened.

The Stock Market

Stocks are in a very interesting place. Most surprises seem to benefit them, from the falling price of oil to the stronger consumer and falling deficit.

It remains to be seen if stocks can keep up this kind of track record of things going their way. The law of averages would suggest this will not happen. Having said that, the time of when the market’s luck will change is an open question. Perhaps it will be several things, like rising wages resulting in higher interest rates, and a rising deficit resulting in a falling dollar. In any event, the market has gone through this year in a better mindset than anyone since Forrest Gump. Hopefully, the transition to a more normal environment, of things being both better and worse will not be too much of a shock. Life isn’t the movies, not for prolonged periods of time.

Warren M. Barnett, CFA November 30, 2014

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Warren Barnett

Warren Barnett is the founder and President, and Portfolio Manager for Barnett & Company. He was associated with the investment banking firm of Kidder, Peabody & Company and the investment counseling firm of Davidge & Company in Washington before returning to Chattanooga to accept a position in the trust department of a local bank. Perceiving the local need for the type of firms with which he was associated in Washington, he established Barnett & Company in 1983. He obtained the Chartered Financial Analyst professional designation from the Institute of Chartered Financial Analysts, Charlottesville, Virginia in 1986. Mr. Barnett graduated from The McCallie School in Chattanooga. He received his Bachelor of Science degree in Accounting from the University of Tennessee at Knoxville and his Master of Business Administration degree in Finance from the Owen School of Management at Vanderbilt University.
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