It's a problem for institutional investors too!

In three previous posts (here are the first one, second one, and third one) we have been building the case that the rise of a class of "financial advisors" who do not manage money themselves (they do not actually make the buy-and-sell decisions on individual stocks and individual bonds) but rather "pick managers" (selecting mutual funds or portfolios that are managed by someone else) may well have led to lower long-term returns for their clients.

We have suggested that the reason for this may be that these manager-pickers "churn" managers, not out of an underhanded desire to make commissions (the financial advisors are usually paid an annual fee rather than commissions, although many can receive commissions as well) but rather out of a desire to be doing something to earn their fee, as well as out of a desire to replace under-performing managers with better-performing ones.

We believe that the data in several years of the Dalbar Quantitative Analysis of Investor Behavior support this conclusion.

Now a Boston University professor of finance has published a study which indicates that institutional investors may be doing the same thing! A recent article in Advisor Perspectives entitled "Maybe Smart Money . . . Isn't So Smart" describes the research done by Scott Stewart, a former institutional fund manager and now finance professor, using data from Effron PSN.

As the graph above demonstrates, in the words of the article, "Stewart's data show convincingly that plan sponsors destroy value when shifting assets." They typically shift money into managers whose portfolios have recently outperformed, resulting in significant under-performance going forward.

Stewart himself states that: "the effort that plan sponsors are putting towards hiring and firing managers is not just a waste of time. It is actually hurting them."

In other words, data shows that the institutional investment community, which is dominated by institutional "investment management consultants" who (like the "financial advisors" dominating the retail investment world) are not money managers themselves but rather help institutional investors "pick managers" and shift from one manager to the next, is being harmed by the same phenomenon we have been discussing. The data seem to suggest that the intermediary between the investor and the money manager is not adding value but may well be destroying value.

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Can your advisor answer this question?

Previously, we discussed research showing that the average equity investor (measured by the largest data pool available, which is the money in equity mutual funds) has a twenty-year performance record which is barely ahead of inflation, and which is far below the record of many index funds and actively-managed funds over the same twenty-year period. You can read our analysis of this problem here and here.

Today, we offer another angle on this issue: In light of this research, do investors ask potential advisors what the long-term rate of return experienced by their clients has been?

Can an advisor even tell you what the long-term rate of return experienced by his clients has been? He should be able to, but can he?

It is very easy to pull out a track record of a fund or a manager that his clients own right now, and show the twenty-year record (or shorter time period, if the record doesn't go back that far) of that particular fund or manager, but as we have pointed out before, the advisor's clients may very well have just entered that fund or portfolio and thus the history before that time does not reflect returns that the clients themselves experienced.

And, unless that advisor has a very consistent system for all of his clients, it is very possible that some of his clients don't own that particular manager's fund or portfolio at all, and that those who do own that manager's fund or portfolio entered it at very different points in time.

Based on the results of research studies like the Dalbar studies, as well as our own experience in the financial world, we would suggest that most advisors you encounter are not able to tell you what the twenty-year rate of return experienced by their clients has been. If they have not been in the business for twenty years, then we would likewise assert that they are not able to tell you what the fifteen-year, or ten-year, or five-year rate of return of their clients has been (or whatever period of time is appropriate for their time in the business).

The reason for this inability is that most advisors today do not actively manage assets themselves, but rather select managers who do the actual management of the assets. While it is easy to find the record of those third-party managers, it is harder to find the record of the advisor who spends his time moving clients in and out of those managers. And that makes it very hard to know the record that the client (who may have had several managers at one time, and dozens of different managers over the course of twenty years) experienced over the same period of time. And, unless the advisor has a very systematic process which he has used consistently for all his clients as he goes about "picking managers" over the years, he will not be able to tell you what the twenty-year record of his clients was.

The results in the graph above suggest that this is a very important question! It is especially significant in light of the data discussed earlier which suggest that a large percentage of the investors whose data is reflected in the chart above are using professional advisors!

A likely rebuttal from an advisor who is not able to show what all of his clients experienced in returns over the past twenty years might be, "But every one of my clients is different, so of course I cannot tell you what the rate of return everyone received over that period of time! Each one may have had different managers, because each one has a unique situation."

Of course it is true that each investor has different needs based on different time horizons and different specific situations, but is it really true that each needs a completely different system for the equity portion of their investments? Do they need a completely different system for their bond investments? How about for their cash investments?

We would argue that while the allocations of equities and bonds and cash differ from client to client, and even account to account for one client or client family, it does not follow that clients should each have a different process governing the portion of their market assets which are allocated to equities (or to bonds either). To do so makes it impossible for an advisor to see what kind of twenty-year returns his clients have experienced.

And it is the long-term returns that are clearly the problem for investors, as you can see in the graph above. A family's wealth is not determined by its one-year rate of return, but by the rate of return experienced over decades.

for later posts dealing with this same topic, see also:

• "Investor Behavior or Advisor Behavior -- 2009" 06/26/2009.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Investors fleeing equity funds for bond funds" 08/25/2010.

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Say "tax rate cuts," not "tax cuts"

For years we have argued that the real issue with respect to taxes is not "cutting taxes" but rather cutting the tax rates! In other words, the goal is not to necessarily take in less money overall (which is the way many politicians as well as their echo, the media, frame the issue when they say things like "how will we pay for this tax cut?").

That's why you should insist on the more precise phrase "tax rate cuts" rather than "tax cuts," because cutting tax rates -- especially in the highest income tax brackets -- has an immediate and powerful effect on productive behavior, leading to higher tax revenue.

In our opinion, nobody can explain this as well as economist Art Laffer, whose name is synonymous with this concept and with the "Laffer Curve" which illustrates its effect. He explains in a piece published in today's Wall Street Journal (and available to all, subscriber or not, in the new no-subscription-required Wall Street Journal Editorial Page) that tells the story better than we can.

For readers who may not be completely familiar with the concept of "marginal" tax rates, you can refer to the diagram at the top of this post. Think of your taxable income as water that is poured into a giant barrel that looks something like the diagram at the top of this blog post.

Your taxable income is taxed at a different rate as it fills up the barrel -- from the bottom rate for the first $8,000 or so of your taxable income (for a single filing status, and the bottom $16,000 or so if you are married filing jointly), which will be taxed at the lowest rate of 10%, all the way up to the very top of your income stream. That last part -- the part that is at the top of your particular income tax barrel -- is called your marginal income. That is the part that Art Laffer is talking about in his article. He states, "It's the marginal tax rate that elicits the supply-side response."

People whose income streams go all the way up to the highest bracket (which goes on forever, as indicated by the arrows in the diagram) are the ones who (logically) make the most changes to their behavior when their marginal tax rates are raised or lowered by the government.

As indicated in Art's article, history demonstrates that lowering the rate on the highest bracket has a tremendous positive effect on job creation and economic production, which in turn helps everyone else including those in lower marginal brackets (those whose marginal or top rate is in a lower bracket than the top bracket).

This assertion is very closely related to one that we posted here last week, in the fourth paragraph from the bottom of the entry.

Tax rates may seem like a political issue, but they are immediately and profoundly important in their economic impact.

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For later posts on this same subject, see also:

• "The 'wealthiest' rates matter to everyone" 12/03/2010.

A twenty-year perspective for the recent market turbulence

Another powerful insight -- particularly in light of the recent market turbulence -- from the most-recently published Dalbar Quantitative Analysis of Investor Behavior (QAIB) is the fact that the average investor underperformance is greatest over long periods.

In a previous post, we discussed Dalbar's research which has consistently shown that most investors achieve unsatisfactory returns over long periods of time, which the Dalbar studies themselves say is due to the fact that "investor behavior erodes the returns on even the best performing fund."

The graph above includes not only those 20-year results which were shown in the previous post, but adds the perspective of short-term returns. The Dalbar study reveals that for short periods, such as one year, the average investor achieves comparable returns to the market. It is over long periods that investors sabotage their own performance by making mistakes driven by fear and other emotions, and particularly (the study notes) the mistake of selling during downturns.

The lesson of the study is often said to be that investors need professional advisors to help them, but as we noted, the people who provide the data for these Dalbar studies state that their research has indicated that about 80% of mutual fund investors (the source of the data) seek professional advice in their mutual fund decisions outside of retirement plans at work. So this problem is not at all limited to those without advisors but may well be caused in part by advisors!

The lesson of the study is also not simply that everyone should "just index." It is not the vehicle itself that is the problem, but the behavior. As Dalbar says, "investor behavior erodes the returns on even the best performing fund." Bailing out of an index fund when the market drops 20% will hurt you just as badly as bailing out of an actively-managed fund. And, we have argued elsewhere why we do not buy into the current index-fund bandwagon.

The lesson of the terrible long-term performance shown in the graph above is that the average investor (and the average advisor, according to our understanding of the data) is fairly capable at picking short-term performers, but does not have the consistency required to achieve long-term success.

If you look around at the panic taking place right now, and count the voices advising you from all angles to "take action" in order to "recession-proof" your portfolio or otherwise make changes to your investment process in light of the market's behavior, you can see why long-term success is so elusive.

It is easy to jump on something that has done well (which is why the average investor has a decent one-year track record) but it is much harder to stay true to a long-term process. Many investors (and many advisors) have no real consistent long-term process beyond finding what has done well lately and switching into that every couple of years.

We advise readers that the first critical requirement is to have a consistent discipline that is based on successful fundamental principles. The second is to realize that, if your allocations of capital are currently set in accordance with your various time horizons and cash-flow needs, then you don't need to panic and make wild changes during market turbulence. Those kinds of wild changes lead to the results in the graph above, and you don't want to go there.

A few lessons from 2002

Here's a picture of what it looks like when things get ugly in the stock market.

This is a chart of the Dow Jones Industrial Average during the last bear market, which stretched from January of 2000 through October 2002.

Note the three different bottoms, marked by red arrows on this chart (these three successive bottoms are also visible in the chart we posted in this previous blog entry).

One lesson from this chart is that it is very difficult to predict the real bottom in any significant correction. The third arrow marks the actual low for the bear market of 2000 - 2002, which occurred in October, 2002 for both the Dow and the S&P 500. Investors who were waiting for another bottom after that one may well have missed the strong rally that began in March, 2003. Overall in 2003, the Dow was up 25.3%.

Also, this type of diving three or even more times as the market tests for the final bottom is not unique to the chart above -- you can see it in other significant corrections, for example between the dates of January 1, 1981 and December 31, 1982.

Another lesson from the above chart is that, if you have cash available and your financial assets include an equity strategy as part of your long-term growth component (based on a time horizon of more than five years), you should add to your equity strategy during market corrections. Remembering the three arrows in the chart above, you should be willing to add and then add again later during corrections (if your cash-flow situation makes that possible).

Many investors (even wealthy investors and supposedly "sophisticated" investors) did not do that during the period covered in the chart above, and therefore missed the opportunity to add to equity positions during periods of lower prices.

The chart below shows that investors were pulling money out of equities and pouring money into bonds at greater and greater rates right up until the market bottom in the fall of 2002. The chart depicts net fund flows into equity mutual funds minus net fund flows into bond mutual funds. When the red line is above zero, flows into equity funds outweighed flows into bond funds. When the red line is below zero, flows into bond funds outweighed flows into stock funds.

Clearly, bond fund inflows were peaking at the very bottom of the equity market (second yellow circle). In fact, you can see the three bottoms from the first chart (the ones marked with red arrows) reflected in this chart as well.

Most investors will make similar mistakes in the current correction, and in future corrections, because adding money to equity positions during market drops takes intestinal fortitude and far-sightedness, and because the conventional wisdom is shouting that it is time to head for bonds and take cover. In fact, a Wall Street Journal article from this past Friday states that "Traders said it appears investors are shuffling money directly from stocks into bonds."

However, investors with historical perspective should be adding now, if possible, and remain prepared to add more in future months, knowing that drops like the one we are experiencing are opportunities.

For later posts dealing with this same topic, see also:

• "Invest like Mr. Howell" 05/18/2009.
  

Economic ignorance hurts

Today, Fed Chairman Ben Bernanke testified on Capitol Hill before the House Budget Committee, giving prepared remarks and answering questions posed by lawmakers on the committee.

The proceedings were generally a cause for dismay. In fact, although no one ever knows the exact reasons for a market's movements on any given day (although the news media will confidently tell you that they do, which is nonsense), it is very possible that the markets were further rattled by the goings-on today in Congress.

The main thrust of the question-and-answer session was the issue of which would better assist the economy, rebates or tax cuts, with lawmakers using their questions more to make their own assertions on the topic and to get Bernanke to echo their opinions in a newsworthy soundbite than to hear what he had to say.

The question of tax rebate "stimulation" versus tax rate cuts is an excellent illustration of the very important conflict between the demand-side worldview and the supply-side worldview which we have discussed in numerous previous posts, most notably this one.

The mentality behind sending a tax rebate of, say, $800 dollars in the form of a check to every taxpayer ($1,600 to every taxpaying couple) is a classic demand-side attempt to "stimulate" the consumer (recall that in the previous blog posts we have also noted that demand-side thinking is also called "consumptionist" thinking). It is a very clear example of the thinking that "the consumer drives the economy."

On the other hand, the supply-side approach believes that the real engines of the economy are the business which produce goods and services (which is why it is also called "productionist" -- see the essay "Production versus Consumption" by economist George Reisman, first published in 1964). If the economy needs help, a productionist or supply-sider is much more inclined to recommend action that will enable the formation of new businesses, as well as enable greater investment (and ultimately greater production) in businesses which are already producing in the economy right now.

Greater investment in businesses creates more jobs, which stimulates demands far more than any $800 check will do. And, while demand-siders argue that the check is much faster, the primary tool of stimulating business formation and business investment -- cutting the tax rates on capital gains that result from successful investment in such businesses -- has immediate and dramatic effects.

If you are a venture capitalist and you know that if you risk $2 million in a start-up business which may pay back $12 million in a few years, but which may also go to zero if that start-up fails (as many start-ups do), you might be willing to risk that $2 million if you get to keep 85% of the gain (even though there is a risk that there will be a total loss). But if the government tells you that they will tax the gain at 50% (instead of 15%) you may calculate that it is no longer worth risking the total loss of $2 million for the possibility of making only $4 million (after taxes) instead of $8.5 million. In that case, you may not fund the entrepreneur at all, and a business will not form that (under a less onerous tax rate) might have blossomed and added great value (and many jobs) to the world.

Changes in tax rates cause immediate changes in the decisions of those who are allocating large amounts of capital for the formation of new businesses and the expansion of existing businesses. In fact, even the prospect of taxes rising within two or three years will have a big impact on the allocation of capital right now -- in the example above, that venture capitalist may very well have to wait at least two years before any tangible results come from his investment, so he is making his calculation based on his assessment of the future tax rates that will hit his potential capital gains. The prospect of higher tax rates in the future will have a big impact on the very important allocations of large amounts of capital today. These large allocations of capital, the productionist or supply-sider argues, are the engines which actually drive the economy.

Giving every individual taxpayer $800 is not going to create any new businesses (except in the highly unlikely event that 10,000 of those rebate-holders decide to band together and form a venture fund with their rebate checks and fund a couple start-up companies).

Today's remarks on Capitol Hill were particularly dismaying for a number of reasons. First, many of the members of the House Budget Committee displayed a complete disdain for the impact of tax rate cuts -- one lawmaker even suggested that the rate cuts of 2003 would cost the government trillions of dollars (when in fact, the rate cuts resulted in tax revenue increases, due to their salutary effect on the economy).

Even worse, that lawmaker was able to get Ben Bernanke to repeat after him that "tax cuts generally don't pay for themselves" -- causing listeners to the televised remarks to wonder if Mr. Bernanke is a demand-sider, although in defense of Mr. Bernanke it seemed that the Congressman was "leading the witness." It was clearly a shameless display of grandstanding to get a soundbite, as the lawmaker himself admitted at one point when he reminded the Chairman that many news agencies would pick up his comments.

Finally, the most embarrassing display of the day's proceedings came when Representative Marcy Kaptur (D-Ohio), who has been on the House Budget committee for an entire year as of tomorrow, confused the Chairman of the Federal Reserve with Treasury Secretary Hank Paulson. She obviously had no idea of Bernanke's background as an academic, which is simply astounding.

It's hard to blame the markets for reacting in a negative way today to the various displays of economic ignorance coming out of the House Budget Committee, a government body with some degree of power to directly impact the economy.

For later posts related to this same subject, see also:

• "Air Vulgaria" 07/10/2009.

• "Don't squash innovation" 03/31/2010.

• "Lower tax rates stimulate growth" 07/27/2010.

• "The 'wealthiest' rates matter to everyone" 12/03/2010.

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Remaining calm without being blind or obstinate

In the current turbulent market environment, some subtle aspects of the Growth Stock Theory of Investing are valuable for investors.

As we have explained in previous posts, one of the key tenets that Rowe Price outlined in his 1973 essay entitled "A Successful Investment Philosophy based on the Growth Stock Theory of Investing" is that most of the big fortunes of the country were made not by timing market cycles but by "retaining ownership of successful business enterprises which continued to grow and prosper over a long period of years."

During periods of stock market capitulation, it often takes a cast-iron stomach to "retain ownership" in a company even when you believe it still has solid growth prospects. But if you want to own those companies for "a long period of years," there will be periods in the interim when the market interrupts with sickening drops that have little or nothing to do with the actual growth prospects of those successful business enterprises.

However, just as it is opposed to the market-cycle approach followed by most "investors," the Growth Stock Theory of Investing is also opposed to a passive "buy and hold" strategy! A shallow view of the previous paragraphs might lead one to conclude that Price was advocating a blind, obstinate resolve to hold a company for decades through hell and high water. But nothing could be further from the truth.

The very term "growth stock" that he selected came from his observation that "corporations have life cycles similar to those of human beings" -- an assertion Price made in a series of articles published in Barron's Financial Weekly in the spring of 1939. He wanted to select companies that were still in the "growth" part of their life cycle.

This observation enabled him to continue to hold a company (if it was still in that growth phase of its life-cycle) regardless of the inevitable market cycles.

BUT it also meant that he was not in the camp of the typical "buy-and-hold" investor, who can sometimes be accurately accused of holding onto a stock that is in the declining phase of its life cycle. Holding onto a company that has stopped innovating may seem conservative, but it can actually be very risky, even foolhardy (as we pointed out in another previous blog post).

Price's 1939 observation (he actually published it in Barron's in 1939, but said that he recognized the truth ten years earlier, so it could in fact be called a 1929 observation) has received a modern re-formulation in a term called the "topple rate" published in a February 2005 McKinsey paper called "Extreme Competition." In that article, authors William I. Huyett and S. Patrick Viguerie examined the rate at which companies in an industry's top quintile (by revenue) fell out of that top quintile. This rate they called the topple rate.

We heard the term in a talk given by Rich Karlgaard in 2005, who later discussed it in a blog article he wrote the same year.

The conclusion of the McKinsey paper (and Rich's 2005 blog post) is that the topple rate has been increasing in recent decades. In other words, the amount of time a company spends at the top of its industry has been dropping rapidly.

The "life cycles" identified by Mr. Price have (in general) been speeding up. While a growth stock investor in 1939 might have been able to own a business that would continue to grow and prosper for many decades, it is now more likely that a growth stock investor can own a business that will continue to grow and prosper for many years, but not for many decades. Rather than obstinately holding companies for some predetermined number of years, someone with a deeper understanding of the Growth Stock Theory of Investing will watch those companies closely for signs that they no longer fit the criteria of a growth company, for signs that they are no longer in the phase of their life cycle that warrants their retention for the future.

However, those signs are found in the company, not in the stampedes of markets like those seen in recent weeks. A true growth stock investor can remain calm during market volatility, without falling into the opposite trap of blind or passive "buy-and-holding."

For later posts dealing with this same topic, see also:

• "Ownership of businesses through multiple economic cycles" 09/04/2008.
  

• "The Unstoppable Wave" 01/12/2009.

• "Schumpeter, Creative Destruction, and your portfolio recovery plan" 01/27/2009.

• "Clayton Christensen, disruptive innovation, and your portfolio recovery plan" 02/04/2009.

• "The importance of a proper sell discipline" 05/27/2009.

• "If Rip Van Winkle took a one-year nap before September 15, 2008" 09/14/2009.

• "The Unstoppable Wave: Revisited" 12/22/2009.

• "Some lessons from 2009" 12/28/2009.

• "Market-timing and train-timing" 05/25/2010.

• "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital" 07/13/2010.

Subscribe (no cost) to receive new posts from the Taylor Frigon Advisor via email -- click here.

Volatility is back in the market

Volatility is back in the market, after several years of below-average volatility.

The current volatility is above average and is a reminder of what equity markets are more commonly like.

The current stormy weather is threatening to get worse before it gets better.

As discussed in this previous post, research suggests that "investors make most mistakes after down turns," which is akin to jumping off a ship in the middle of a hurricane. With a full-force correction (a market retreat of 10% or more from the previous high -- the third this year) in force, many investors are jumping ship or preparing to do so if the plummet continues.

We wrote two months ago that "all the loudspeakers of the giant financial retail firms and the financial news media are constantly blaring a message that you have to time cycles -- cycles of the dollar, cycles of the Fed, cycles of quarterly economic acceleration or deceleration."

If, however, you base your strategy not on timing cycles but on the real source of most of the great wealth created for families in this country for the past hundred years, the ownership of shares in successful businesses for a period of years or even decades, then you should both expect interim volatility and be prepared to weather it.

Unlike most of what you hear, we advise that you realize that there will always be ebbs and flows in the mighty financial ocean, but that these by themselves don't make you change your mind about businesses with solid prospects that you intended to own for many years.

You can read more on this subject in our most recent market commentary, which is posted in the commentary section of the Taylor Frigon Capital Management website.

Investor behavior. . . or Advisor behavior?

Every year the Dalbar Quantitative Analysis of Investor Behavior (QAIB) is released, showing the results of the financial research firm's examination of investor behavior a twenty-year period beginning in 1987. The results for 2007 are not in yet (that QAIB, which will be called the 2008 QAIB, will come out in March or April 2008), but the 2007 QAIB shows results for the 20-year period stretching from the beginning of 1987 through the end of 2006.

As in previous years, the study's results have shown that "the average investor earned significantly less than mutual fund performance reports would suggest," according to the study. The reports have consistently demonstrated that over time, investors underperform the actual investment vehicles available to them. The study found that the average annualized return over the twenty year period was only 4.3% (the overall market had an annualized return of 11.8% over the same twenty year period). Dalbar's analysis argues that it is erratic investor behavior, rather than the funds selected, that causes this tremendous performance erosion over time.

Dalbar's examination of the data for the entire mutual fund industry over a long period of time reveals that the tendency to rush in when the market is going up and rush out when the market is going down reduces investor returns to a fraction of what they would have made if they invested consistently over the same long period. The study found that "investors make most mistakes after down turns" and suggested that "These mistakes occur because investors are driven by the fear that the markets will not recover -- even though broad indices show that markets do indeed recover."

The study provides a variety of data that shows that it is not the investment vehicle that is the problem, but rather the investor behavior. It suggests that professional advisors can help with this behavioral problem.

BUT the Dalbar data does not differentiate between investors who have a professional advisor and those who do not!

Dalbar uses equity mutual fund data from the Investment Company Institute, which tracks a variety of data concerning the mutual fund industry .

A review of the 2007 ICI Fact Book reveals that ICI states that "ICI research finds that approximately 80 percent of mutual fund investors seek professional advice when buying mutual fund shares outside of retirement plans at work" (Section 5 -- 12b1 fees).

This suggests that a significant percentage of the mutual fund investors who are following damaging investment patterns discussed in the annual Dalbar surveys have professional advisors!

Our experience suggests that the heart of this problem lies in the fact that the vast majority of advisors today (whether they are at a big brokerage firm or a tiny independent shop on Main Street) are basically "selectors of other managers." In other words, they are in the business of selecting mutual funds or other managed vehicles for their clients.

Because of the divide between those who actually manage the money and those who advise clients (see this previous post on the subject), advisors can show performance records that go back many years but which none of their clients were in during those many years. In other words, they can have the same kind of "rear-view mirror" selection of investment vehicles that causes the results found in the Dalbar studies every year.

When an advisor holds up the performance record of a potential investment vehicle to a client (whether the vehicle is a mutual fund, an index fund, a separately managed portfolio, or something else), very few clients ever ask "I see how that investment has performed, but how long have your assets and your clients' assets been in that vehicle?"

In other words, the track record that you see on any managed portfolio (or an index fund or ETF) only represents a potential return. Actual returns have been shown to be significantly lower among the population that shops around (erratically) among all those potential investment vehicles.

Because the vast majority of advisors do not manage their clients' assets themselves, but instead select other managers (or index funds) to manage their clients' assets, could it be that they are as prone to switching vehicles as anyone else?

The actual portfolio managers who invest in their own portfolios ("eat their own cooking") year after year will receive those actual portfolio returns (their actual returns will be the same as the "potential returns"), but advisors and other investors who switch in and out of those portfolios (studies consistently find) achieve only a fraction of the potential return.

It is interesting to note that this is probably a fairly modern phenomenon, coinciding with the rise of the mutual fund industry and the "outsourcing" of money management. The period covered by the Dalbar studies is the same period in which this outsourcing of money management grew astronomically.

It's easy to forget that prior to the advent of the internet, the ordinary person could see stock quotations only once a day, in the morning paper. If he wanted more information, he could call a broker for a quote, or go down to a local brokerage branch office and "watch the tape" in the lobby. Back then, brokers truly had access to more information than the average investor.

The advent of the internet changed the entire model. Today, the old-school "broker" is a thing of the past. He has been replaced with the "financial advisor" who no longer "picks stocks" for his clients but instead picks managers. The fear in the brokerage days was that there might be unscrupulous brokers who "churned" their clients' accounts for commissions. But, since the advisor typically works for some kind of annual fee (often some portion of the fee stream paid to the mutual funds or other managers he selects for his clients), the danger is that the advisor will change managers more frequently than he should, both because he can fall into the same performance-chasing traps that the annual Dalbar surveys discuss, and in order to justify his existence as the "picker" of good managers.

This is not an "investment vehicle problem" -- the solution is not to say "Oh, that means you should buy index funds, or ETFs, or SMAs, instead of mutual funds." This is a financial industry problem. Mutual fund managers and other professional managers are vitally important to investors -- it is the "advisor" system that has grown up after the era of the broker that may be the problem. We would argue that the data in fourteen Dalbar surveys argues strongly that something is wrong not just with individual investors, but with the rise of advisors whose job is basically to "pick managers."

for later blog posts dealing with this same subject, see also:

• "A twenty-year perspective for the recent market turbulence" 01/23/2008.

• "Can your advisor answer this question?" 01/28/2008.

• "It's a problem for institutional investors too!" 01/30/2008.

• "The intermediary trap" 02/21/2008.

• "So when do you fire a manager?" 02/01/2008.

• "The intermediary trap and the current bear market" 11/03/2008.

• "Lessons from the Madoff Scandal, part two" 12/18/2008.

• "Invest like Mr. Howell" 05/18/2009.

• "Don't be hasty, young Jim Cramer" 05/21/2009.

• "Investor Behavior or Advisor Behavior -- 2009" 06/26/2009.

• "Some lessons from 2009" 12/28/2009.

• "What a farmers' market can teach us about money management" 01/18/2010.

• "March 9 anniversary" 03/09/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Investors fleeing equity funds for bond funds" 08/25/2010.

• "Be centered, be still -- 2011" 03/17/2011.

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Look for Paradigm Shifts

In every business landscape, the current predominant business model is always subject to being overturned by a new and more efficient business model that delivers new value over the old one.

If a company can find a way of completely changing the landscape in a particular field, that company can "outflank" its competition by shifting the entire paradigm.

A familiar example would be Apple's development of iTunes and the iPod players, which took a new delivery model for music (one that already existed, but was only used by a small number of consumers) and made it so practical and easy that it rapidly displaced the currently dominant means of obtaining music. Several companies that relied on the old model (buying music in a store) went out of business as a result. Apple's new developments completely changed the existing paradigm.

A paradigm shift is an important concept in the classic Growth Stock Theory of Investing. In his 1973 treatise on the subject (discussed in this previous post), T. Rowe Price stated:

"Most corporations, like people, pass through a life cycle of growth, maturity and decline. Common sense tells us that an investment in a business enterprise affords greatest gain possibilities and involves less risk while the long-term earnings trend is rising. [. . .] The risk factor increases after maturity is reached and decline begins."

In other words, although many people think that big, established companies are "safer" investments than average, it is important to realize that every established company must continue to deliver more value than the alternatives, and that other companies are always looking for ways to usurp their position of leadership. If a large company is not alert, it can be outflanked by a more effective new company, especially if that new company is able to change the entire paradigm with a new business model that is more efficient than the existing model.

This concept is closely analogous to the military concept of a "flanking maneuver." One of the clearest visual examples of this concept took place on May 2, 1863 in the famous flanking movement executed by the Confederate forces in the second day of Chancellorsville. In the illustration above, from the 1865 biography of Stonewall Jackson by his friend, chaplain and onetime Chief of Staff R. L. Dabney, we see one of the most famous flanking movements of the American Civil War.

On the second day of the battle, Lee sent 26,000 men -- well over half of his available forces -- under Stonewall Jackson on a flanking maneuver depicted on the map above by a large red arrow. The Union forces had been reacting to what they thought was the real threat posed by Lee's main body (see the small blue arrows in the map above) but were completely outflanked by Jackson's bold and deep flanking maneuver and were forced to withdraw to later positions which are sketched in the original map above but not colored in blue.

A flanking maneuver is particularly effective because your opponent is positioned with his fields of fire primarily in one direction, and your arrival on his flank or in his rear forces him to reorient rapidly to try to deal with the new threat. Often he is unable to turn effectively in time.

A paradigm shift "outflanks" the existing business model in exactly the same way. The existing business must rapidly try to catch up, but if they did not see it coming in time, they will often be unable to shift fast enough. All of their production systems and incentive structures are geared towards the old model, and they may be unable to effectively re-work those in time to prevent the new company from completely dominating the landscape.

It is also important to realize that a paradigm shift does not always take place because of new technology. New technology often does enable a paradigm shift, but a paradigm shift can take place from the creative application of almost any new and more efficient business model, whether it uses some new technology or not. A company with a clear vision and a more efficient way of providing greater value can outflank an entrenched leader and completely alter the landscape, and the history of business is replete with examples of this taking place.

Paradigm shifts are always taking place in one part of the business landscape or another. We believe that some important paradigm shifts are taking place right now, and others are being set up to take place in the next few years.

For later blog posts dealing with this same topic, see also:

• "The Unstoppable Wave"01/12/2009.

• "Schumpeter, Creative Destruction, and your portfolio recovery plan" 01/27/2009.

• "Clayton Christensen, disruptive technology, and your portfolio recovery plan" 02/04/2009.

• "Look for paradigm shifts, part 2" 04/23/2009.

• "Beautiful Growth Companies, part III" 05/14/2009.

• "The koi pond analogy of investing" 08/25/2009.

• "The Unstoppable Wave: Revisited" 12/22/2009.

• "Exaflood update" 06/01/2010.

• "Have you heard of this company? HITT" 07/06/2010.

• "Have you heard of this company? IIVI" 08/05/2010.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "Another wake-up call" 11/29/2010.

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