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Individual Investors and Professional Money

Managers Suffer From the Same Basic Defect

Posted on 07 June 2010. Tags: Defect, investing, Matt Pauls

Individual Investors and Professional Money Managers Suffer From the Same Basic Defect

Individuals fail to identify the best money managers for the same underlying reasons that most
money managers are unable to identify the best investments, which to a large extent is a problem
of perception and a lack of relevant knowledge. The set of tools (education, personal experience
through trial & error, etc.,) that individuals acquire over time generally allow them to make
sensible everyday decisions. So much so, our brains create shortcuts in the decision making
processes, which work well when faced with simple problems. For example, how to decide where
to eat when out of town? If youre like me (i) you ask someone, (ii) you select at random-though
usually a familiar restaurant chain, or (iii) you look for the largest crowd. You generally cant go
wrong eating at a crowded restaurant or somewhere familiar. These are pretty good mental
models as they relate to restaurant selection and the result is an easy one to measure because its
immediate and isnt ongoing. Moreover, you cant improve taste, because taste is a matter of
opinion.

However, the mental shortcuts that help us pick a good restaurant, hinder our ability to consider
the relevant facts when the facts relate to a complex system. When faced with complex decisions,
we run into problems because we lack a natural mechanism with which to consider current
decisions as they relate to ongoing future outcomes. Its important in this case to recognize when
youre outside your circle of competence. One common solution is to seek-out an expert adviser,
but this only turns an old problem into a new one. Now you have to select an able and
competent adviser.

With Respect to Money Management


Outsourcing investment decisions is the only option for most people without time or interest to
invest properly. But when selecting someone to oversee your hard earned money what criteria do
you consider? The first item that often comes to mind is experience, however, this concept may
be to your ultimate detriment.

The Validity of Experience


In many aspects of life there is a positive correlation between length of time performed and
competency. That is, people tend to follow the general premise that having done something with
a greater frequency or for a greater length of time makes an individual more qualified, better
skilled, and more knowledgeable. This rule of thumb may be reasonable some of the time, but it
is not universal. Human nature being what it is, often causes us to base decisions upon habit not
reason. In the investment management business, the validity of experience as qualified simply by
an act of having done something with greater frequency or for a greater length of time is
unfounded. The flaw is in the assumption that investing over time provides the individual with
an increased knowledge of the subject. But what can be said about the merit of knowledge based
upon the wrong set of facts, truths, or principles?

Performance & Knowledge


Selecting a good money manager may appear as though its simply a matter of selecting a smart
money manager with a good investment record since, ultimately, investment knowledge and
investment performance eventually converge, but they dont necessarily converge right away. In
some (often many) cases, an investor may possess the correct knowledge, but performance lags.
In other cases, an investor may initially perform well, but may not understand that his returns
were akin to gambling, leverage, or both-which means the knowledge they possess is incorrect.
Over longer periods of time performance records are very useful in measuring the merit of an
investor, but to a much lesser extent when the record is less then 10 or 15 years long. Gauging
performance is a very big problem for the average investor, but also for many investment
professionals. Investment performance should be measured with respect to the money managers
systematic approach i.e. what the money manager is doing and why they are doing what they are
doing. Equally important, the money manager must be able to clearly identify and explain why
their investments turn out well or poorly.

Lets review the performance of one fund from 1991 through 2001 relative to the S&P 500:

Annualized Returns 1991-2001


Baupost 12.83%
S&P 500 15.25%

Baupost is run by Seth Klarman, whom I believe is one of the worlds top 5 investors. However,
many individuals would be unimpressed by his record through 2001 and therefore uninterested-
at the time-in investing with Baupost, because he underperformed the market-but in my opinion,
the more important question was why he underperformed? From 1991-2001 his fund
underperformed the market because he looked around and said to himself, people are crazy,
prices are inflated, and there is little out there we find compelling. He therefore simply said were
going to hold cash until things change. In 1997, 25% of Bauposts portfolio was cash. By the
end of April 2001, nearly 50% of Bauposts entire portfolio was cash. This explains largely why
Baupost underperformed. The proportion of the portfolio held in cash earns almost no interest,
which drives down the overall portfolios return, but at the same time the value of cash is not
subject to market fluctuations. Though he underperformed for 10 years, when the tech bubble
blew up, Baupost had plenty of cash to take advantage of cheaply priced securities and as a
consequence hugely outperformed since 2001 and therefore also since inception. It would have
made as much sense to invest with Seth and Baupost in 1991 as it would now. Having only
looked at performance, you would likely not have invested in Baupost.

All investors (both know-nothings and know-somethings) want to make optimal, rational
investment decisions, but rarely do. Some do well strictly from the law of large numbers, e.g. if
enough people throw a dart some will get pretty close to the bulls-eye, but not all are skilled. This
hurts investors that are looking at performance numbers, strictly. Moreover, it is commonplace
for most people to assume that if a person of business is wealthy he is wealthy because he was or
is a good businessman (or has good business sense), but this is also wrong-headed. It is critically
important to separate out those who do well by chance and those who do well for identifiable
(often repeatable) reasons. Unfortunately it is hard to correctly identify a know-nothing
businessperson from a know-something businessperson, if you either know nothing about
business or are otherwise a know-nothing business person.

If, as a money manager, you are unable to identify how much an asset is truly worth and
disciplined enough to only pay a reasonable price for it, then you will not earn above average
returns. If, as in individual investor, you are unable to identify a money manager with such
knowledge, then you will not earn above average returns either.

The point of this rather elaborate discussion is that good investors are easily identified by good
businessmen (smart private business owners) because good investors are good businessmen. By
definition, this means that individuals are likely to employ the wrong mental model when
selecting their money manager. It also means that your money manager is similarly likely to
employ a flawed mental model when making investment decisions. As with all solutions to adult
problems, nothing worthwhile in life comes easy. Fortunately, the average individual is perfectly
able to learn the right questions to ask and to be well enough informed to make sound investment
decisions, but you need a good foundation based upon good information. There is no single right
answer, but there is a single book that will help the average investor make sensible investment
decisions. The intelligent Investor, written by Benjamin Graham is still by far the best book ever
written. Graham provides a road-map of the proper way to think about investing. The
intelligent Investor is not the final answer, but its a start.

Keep in mind the best investors didnt alter their approach midway through their career. Either
you get it right from the start, or you never get it at all. If a money manager has a long track
record, look at their track record, its important. If a money manager has little or no track
record, dont pay too much attention to performance, good or bad. Its not that performance is
unimportant, but its not all-important when the record is short. In either case, spend plenty of
time trying to understand how they think about business. (Youll find a few tips further below.)
Also, before investing with any money manager, meet with them. Take some time beforehand
and create a checklist of questions to ask and answers to expect.

Helpful Hints

A Few Questions to Ask:

Whats the money managers goal/objective & How do you think about risk?

Worrisome answer
Be wary any time you hear terms like risk profile, beta, alpha, optimal portfolio, volatility, or
other terms sounding Greek/foreign. Dont take any advice blindly, including mine-have them
explain any term that you dont completely understand. If it still doesnt make sense to you,
youre probably correct, it doesnt make sense.

Reasonable answer
Objective is to avoid permanently losing capital while earning an attractive return. In the
broader sense, risk is the potential for long-term capital loss.
What does the money manager do e.g. how do they select investments?

Worrisome answer
Youll know it when you hear it. (Anytime you find yourself scratching your head.)

Reasonable answer
Select common stocks that they believe are undervalued at the time of purchase. Views common
stocks as units of ownership of a business. Do not place any merit on technical stock market
studies, specific sectors, trends, or generally fashionable securities. Significant time is spent
looking at the balance sheet, earnings history, and prospects of each investment to appraise
underlying business or investment value.

How the money manager you determine whether their investment decisions were
good or bad?

There is only one answer to this question.


The logic at the time of initial investment must be consistent with the reasons for any change in
the value of a securities value over a reasonable period of time. A reasonably correct and
thorough answer isnt easily identified, which is why you need to do a little homework before
making these important decisions. Again, I recommend Ben Grahams, Intelligent Investor
available at any local library or book store.

How much of the money managers net worth is invested in the fund/partnership?

Dont feel uncomfortable asking this question, its completely reasonable and a common question
asked by smart investors. If the large majority of their money wont be invested alongside yours
there better be a really, and I mean really good reason. Anything less than 60% is a bad sign.

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-Matt Pauls

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