Note from the Editor: Tom Madell, Ph.D. is the publisher of the Mutual Fund Trends/Research Newsletter. He has offered his comments about the state of affairs in the mutual fund industry. Dr. Tom is a frequent contributor to the column and as always, his opinions should not be considered ours. Unless of course we agree which is often the case. Be sure to follow the links he has provided to receive additional thoughts on a passion that has become a life's work, mutual funds.
09.22.03
Is Successful Investing Like Buying a New Car?
Many people may subconsciously think of successful investing as quite a
bit like buying a new car. Certainly, there are some similarities. Purchasing
a new vehicle involves a big
layout of money and so you want to be as sure as you can that you will make
the right choice. And since you probably plan to rely on that vehicle for
many years, you are
motivated to carefully compare the various models and features available in
arriving at your decision. But once your choice is made, you usually
anticipate sitting back
in the years that follow and enjoying what your effort has brought you,
confident that your one-time choice was the right one.
So, wouldn't it be great if we could apply the same formula to our
investing? After doing our initial legwork to select our investments, we
could then turn our attention away from these decisions, confident that our
one-time choices were the best
possible, and capable of delivering the returns that we are hoping for
without any further effort on our part.
Obviously, it would make life a lot easier if our one-time choices of
investments was all that was necessary to "deliver the goods" such as in the
car purchasing example. In today's hectic world, where every hour available
can seem to be a precious commodity, there are also several additional
considerations which tend to
reinforce "the simpler is better" approach to dealing with one's investments.
First, there has been the move toward indexing. Here, the rationale is
that no one can consistently beat the market averages, and given this, that
no "active" strategy appears makes sense other than just holding a
representative basket of investments.
Second, and closely related, we have all seen time and again how the experts
and active fund managers themselves, with all their research and data, have
typically underperformed rather than beaten the markets. Reasonable
conclusion: "If even these guys can't
effectively use data to beat the markets, what chance do I have? I am better
off just holding on to my investments, for better or for worse, rather than
trying to periodically take current data into consideration in an effort to
improve investment results."
Last but not least, since most of us in reality
don't seem to have the time (or perhaps rather the desire) to follow
some of the factors affecting
our investments: We reduce our mental stress, or what psychologists call
"dissonance", by adopting the belief that trying to manage your investments
doesn't work anyway.
And so we subconsciously convince ourselves we are actually acting
smartly by not paying much attention to them. To
allow ourselves to believe otherwise would be to suggest
that we are perhaps acting negligently, putting our money (and maybe even our
ability to successfully retire) at risk.
Yet in spite of the aforementioned use of various types of
data, it seems that economists and analysts are too frequently off the mark
when attempting to
forecast the short to intermediate direction of the economy and its resulting
impact on asset prices. Why, and what does this mean for us as ordinary
investors?
While there are undoubtedly relationships between key ongoing economic
data and the performance of many types of investments, many times by the time
the data is measured and reported, it is apparent that asset prices have
already adjusted in
anticipation of the release. This serves to greatly diminish the
predictive value of any given economic statistic.
For example, stock prices usually react positively to a expansion in
growth, that is, gross domestic product (GDP). However, by the time the GDP
statistic is reported,
and then updated, well after the end of each calendar quarter, stocks may
have already moved up. (This has been the case recently.) Since GDP is made
up of a number of
components, some reported sooner than the overall statistic, some investors
are "jumping the gun", often correctly estimating the final number
prior to its release. These
investors act early on this information, and
move asset prices as a result. The element of "surprise"
when the statistic is finally released, then, rather than the absolute
magnitude of the statistic itself may be the major factor to move asset
prices during the period after its release.
Further, multiple instances of the data are often required to reliably
elicit a predictive relationship with asset prices. This is due to the fact
that a single
measurement may be too tentative. A trend offering several confirmations is
usually a more effective forecaster since "statistical blips" up or down can
occur which carry little significance for long-term asset prices. This
confirmation may effectively take too long, diminishing its predictive use,
while in the interim, new
readings may fail to support it. As a result, important factors
as for example inflation and interest rates, while reliably affecting asset
prices, may only
do so after an extended and unknown period of time. Thus, someone who invests
in interest-sensitive stocks or bonds at the start of what later is confirmed
to be a period of sustained rising
interest rates may not suffer any ill effects for a while, but only
after the trend is more clearly established.
What is the bottom line? Is there enough of a predictive advantage to
justify at least minimally following ongoing economic data looking for the
basic underlying trends? Yes, but you should keep the above limitations in
mind. This is unless you are among those rare few investors who really
never touch their investments or for whom the potential added
performance truly isn't important.
But many people seem to be unsettled by the fact that some of data tends
to be contradictory or doesn't appear to be working as predicted in the
short term. They wrongfully conclude, I suspect, that most such data is
essentially of minimal
value and are no longer willing to spend their time seeking it out. It is far
easier mentally for one to assume that a hardly perfect relationship simply
does not matter than to be able to patiently await its likely outcome in
spite of its frequent "on again, off again" nature. But, for those
who do track these relationships over the longer term, investing a minimal
amount of time at it on a regular basis, I suggest they will find that the
above kinds of relationships between economic data and
subsequent investment outcomes are usually on target. And if acted upon to
make periodic adjustments to your portfolio, this information can
help to improve your investment performance over investors who do not put in this small amount of effort.
Tom Madell, Ph.D.
Mutual Fund Trends/Research Newsletter
