Where Fools Rush In

By Michael Mauboussin

The investment world is filled with numbers, but these are perhaps the most troubling: according to Vanguard founder Jack Bogle, in the 20 years ending in 2005, the S&P 500 index rose 11.9% annually and the average mutual fund 9.7%, but the average investor realized only a 6.9% return. The difference between the index and the average mutual fund is readily explained by fund costs, including management fees.

Why does the average investor perform so much worse than the average fund? The answer is timing--bad timing. People have a knack for stampeding into a sector as its performance peaks, only to suffer the impending decline while missing the rally. So the average investor's money, often earmarked for important future needs like education and retirement, grows at a slower rate than it would with a simple buy-and-hold strategy.

Take energy funds. Investors poured more than $23 billion into them in the 12 months ending in July 2006, just in time to lose $4.5 billion as those funds swooned in the following months. Not surprisingly, those funds posted average annual gains in excess of 30% from 2003 through 2005, outperforming all other categories. As they say, past performance is no guarantee of future performance.

This proclivity for poor timing is not described in any textbook but is a phenomenon well known to psychologists. Two concepts explain the behavior. The first is recency bias, a tendency to place a disproportionately large emphasis on recent price performance without sufficiently weighing other relevant facts, including long-term performance and valuation.

The second concept is attention. Most people pay little mind to the details of why the stock market rose or fell. But the media capture our attention by highlighting strong sectors--real estate and energy are recent illustrations. More often than not, once a sizzling sector comes to the attention of an individual investor, the opportunity is gone.

If you think the investment industry is there to protect you, think again. Many firms see a hot sector as an opportunity to gather assets. Before the tech-stock peak in 2000, the industry marketed nearly 500 technology, telecom and Internet funds. It's the same story now, only the actors have changed. In October 2004, 180 hedge funds were dedicated to energy and commodity investments. Today there are 525.

There's nothing new about bad timing and Wall Street's willingness to accommodate it. In fact, poor timing may be one of the most systematic and predictable errors investors make. Famed portfolio manager Bill Miller has dubbed it the "five-year psychological cycle." Investors want to own today what they should have owned five years ago. Currently, investors are pining for energy and commodities, but they should have owned them in the early 2000s, when they were cheap and unloved. Instead, investors coveted the high-flying tech and telecom stocks, which would have been smart purchases in the mid-1990s--except that investors were busy chasing bank stocks, which would have been shrewd purchases in 1990. You get the idea.

The five-year psychological cycle suggests a contrarian strategy: take a hard look at buying what has performed poorly in recent years. The answer today looks to be, as a group, large-capitalization U.S. stocks. The top 10 U.S. firms by market cap as of March 2000 have seen their stocks decline 27% on average through September 2006, while their combined net income has nearly doubled. The market has wrung out most of the 1990s excesses.

Moving money from sector to sector to capture performance is like frequently changing lanes on a crowded highway: you rarely get where you're going faster, and you risk a wreck. Recognize that strong recent performance often signals an investment opportunity that has passed. It's best to heed Alexander Pope's admonishment: "Fools rush in where angels fear to tread."

Mauboussin, chief investment strategist at Legg Mason Capital Management, wrote More Than You Know: Finding Financial Wisdom in Unconventional Places