Most investors occasionally wonder how professional investors manage money. They do it honestly but surprisingly badly.
The pain inflicted on the nation's pension funds by the decade-long bear market in stocks has been compounded by the fact that 80 percent of pension fund managers have done even worse than the market. Most investment managers have a good year once in a while, but performance statistics indicate a remarkably consistent long-term record of poor results.
In investing, the object is to buy low and sell high, but pension fund managers generally do it the other way around. They maintained a low exposure to common stocks through the great bull market of the 1950s and 1960s. They began investing heavily in stocks near the market peak in the late 1960s and were not discouraged by the 1969-70 bear market. In 1971 and 1972, the percentage of pension fund cash flow going into stocks reached a record of more than 100 percent, which left pension funds exposed to the 1973-74 bear market, the worst decline since the Depression. In the first quarter of 1978, pension fund cash flow going into stocks reached a record low of zero percent, indicating that pension managers were avoiding the same stock market they earlier bought eagerly at higher prices.
The performance record of mutual funds is also dismal, and few outperform the market over a long period of time, particularly after adjusting for risk.In fact, mutual fund managers are one of the best contrary indicators of the stock market. They consistently sell stocks to raise cash near market bottoms and reduce cash to buy stocks near market peaks.
During the last decade, most professional investors have been unable to outperform their children's savings accounts, and the obvious question is why.
Certainly the credentials of professional investors are impressive. On the whole, they are intelligent and well educated, with a disproportionate number having graduated from prestigious business schools. They also have the services of their research organizations and extensive computer capability. In person, they appear to be sincere, hard-working men who genuinely want to do well for their clients, which in most cases is what they really are.
Impressive credentials are part of the problem. Investment management emphasizes credentials, form and appaerance over ability to perform because ability is a very difficult quality to identify. The investment manager with a degree from the right school, a dark suit and a soothing manner probably will do well for himself even if he is a reliable mediocrity who spends every afternoon playing golf.
Another problem is size. The size of professionally managed funds is so large that it is hard for them to beat the market because to some extent they are the market. In addition, investment management fees and brokerage charges reduce the return on client assets.
Money may be managed conventionally or competently, but not both. Early in their careers, most investment managers make an emotional commitment to be conventional so they can avoid criticism. The investment manager who is unconventional and right often is considered merely rash. When he turns out to be wrong, as he probably will be over some short period of time, his peers will show him no mercy, and he is likely to lose his job and his clients. The penalties for unconventional failure are far larger than the rewards for unconventional success, so most investment managers choose to be conventional. The psychology of investment management has not changed since Lord Keynes wrote in 1936 that "worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."
Investment managers generally diversify their clients' portfolios of stocks for two reasons. First, prudence suggests that risk can be lowered by spreading it around. Second, few investment managers have any real confidence in their own judgment so they hedge their bets. Consistent underperformance in a long bear market has reduced the level of confidence among investment managers from deeply perceived omniscience to barely felt competence.
The impulse toward extensive diversification often results in a collection of stocks with no central strategy. One successful investor described this as "the Noah's Ark plan.You put two of everything into the portfolio (of stocks) until you get a zoo."
Investing other people's money is a serious business but most investment managers take themselves seriously, too. As a result, most financial gatherings are somber affairs. The folklore of business has no room for a jolly banker, and few people feel comfortable entrusting their money to a man with a sense of humor. As one disgruntled trustee said of his investment managers, "Of course they have no sense of humor. Losing other people's money is a very serious business."
While professional investment managers as a whole fail the test of competence, they pass the test of honesty with flying colors. The standards are high, and the vast majority of investment managers adhere to them scrupulously. The client who suffers poor performance at least can take some comfort from the thought that it did not arise from malevolent intent. The vast majority of investment managers are honest and try hard to do a good job even if their performance leaves something to be desired.