What is even more surprising than the poor results of active investment management is that most investors in the stock market lose money even when they pick the right investment! We're going to go into some detail on this point because it seems so counter-intuitive, but it is perhaps the most important lesson of successful investing. How can you lose money with a winning investment? It's all about timing. In any given fund, the return that the typical investor earns is usually about half of the return of the fund, and this has nothing to do with fees or expenses.
Fidelity Magellan Fund, when it was run by Peter Lynch, was one of the most successful investment funds of all time, with a great long term record. Yet Lynch has said that most investors in the fund lost money, for the very simple reason that investors tend to overwhelmingly succumb to what is called "recency bias"; they invest in the funds that have had great records in the last year, or the last few months. Investments tend to be very volatile, and revert to the mean, so that an investment with a great recent record is more likely to under perform the market in the future than to outperform it. And Lynch's experience was the rule, not the exception. Here's an excerpt from a Wall Street Journal article illustrating this point:
“ Meet the decade's best-performing U.S. diversified stock mutual fund: Ken Heebner's $3.7 billion CGM Focus Fund, which rose more than 18% annually through Tuesday and outpaced its closest rival by more than three percentage points. Too bad investors weren't around to enjoy much of those gains. The typical CGM Focus shareholder lost 11% annually in the 10 years ending Nov. 30, according to investment research firm Morningstar Inc. 'Best Stock Fund of the Decade: CGM Focus', Wall Street Journal, Dec 31 2009 ”
John Paulson was not a well known investment manager when he made one of the greatest financial plays of all time, betting against sub-prime mortgages in 2007. His well publicized success attracted billions in new money, and his fund became one of the biggest on Wall Street, with $36 billion under management by the end of 2008. But, having attracted all that money, his fund then became one of the worst performers; his Advantage Plus fund was down 52% in 2011 and his Advantage Fund was down 35%. The Advantage fund was reportedly down another 19% in 2012. An investor in a general stock index fund would have made about 17% over the 2011-2012 period; an investor in Paulson's Advantage fund would have lost almost half their investment. Overall, we believe Paulson has lost more money than he has made, because his great successes occurred when he was managing less money, and his failures occurred when he had far greater assets under management. Yet, Paulson is still a multi-billionaire. In what other line of business could you basically be a failure; having lost more than you've made, yet still become, and stay, a billionaire?
Bill Miller's Legg Mason Capital Management Value Trust's beat the S&P 500 index for 15 consecutive years from 1991 through 2005; one of the longest streaks ever recorded. But then his fund lost 55% in 2008, and that one year of losses wiped out most or all of his long term outperformance; most investors would have been better off in an index fund.