The Evidence-Based Investor

Tag Archive: Magellan fund

1. Don’t miss out on your only free lunch

   April 12, 2023 6:30 am Comments Off on Don’t miss out on your only free lunch

    

    

   Welcome to a new series of articles by COSMO DeSTEFANO. Based in Boston, Massachusetts, Cosmo is a retired CPA and tax partner who worked for more than three decades for PwC, one of the largest professional services firms in the world. He has consulted with clients big and small, public and private, across a wide variety of industries, helping them solve complex business and financial issues. He is the author of an excellent new book called Wealth Your Way: A Simple Path to Financial Freedom. In this first article in the series, Cosmo explains why diversification really is the only free lunch in investing.

    

   Of all the truisms about investing that Warren Buffett has come out with over the years, perhaps the most important one for investors to understand is this: “Risk comes from not knowing what you’re doing.”

   Most investors, including many professionals, are simply unable or unwilling to acknowledge how little they actually know, or the risk that they’re taking as a consequence. Smart investors, by contrast, know their limitations and, instead of trying to predict the future, simply buy and hold a broadly diversified investment portfolio.

   Peter Lynch is regarded as one of the greatest stock pickers of all time. Over his 13-year tenure, he turned Fidelity’s Magellan fund into the world’s largest mutual fund and a financial juggernaut.  From 1977 to 1990, he averaged 29.7% annually, beating the S&P 500 in 11 out of 13 years, while never having a down year.   

   But Lynch didn’t build Magellan into a behemoth by broadly diversifying across the entire market.  On the contrary, he made calculated, concentrated investments in his skilfully researched portfolio. So also did Warren Buffett in growing Berkshire Hathaway; and Bill Ackman who maintains highly concentrated bets in his Pershing Square fund. So why diversify?

   With respect to your investment strategy, are you as good at picking individual companies as the likes of Peter Lynch, Warren Buffett, Bill Ackman, George Soros, John Templeton, or other investing greats? If you are that good, you can stop reading. If you’re not, you may want to continue on.

    

   Be good, get good, or give up

   When it comes to investing for retirement, giving up is not an option, so either you are already good, or working to get good.

   The Merriam-Webster dictionary defines “ignorance” as a lack of knowledge, education, or awareness. When it comes to financial planning, self-awareness is crucial. As average investors, we generally do not have the in-depth knowledge, experience, intestinal fortitude or time needed to properly research concentrated stock investments.

   We need to understand the outer edge of this border where our knowledge ends and our ignorance begins. This is where diversification comes in handy.  For the average investor, unlike the notables mentioned above, diversification is part of getting good.

    

   Protection against ignorance

   Diversification is not how you make money in the stock market; it’s an insurance policy against incurring crippling losses. If you are familiar with the game of tennis: diversification is more akin to avoiding an unforced error than hitting a winning shot.

   Risk is a direct descendent of fear. The brain’s fight or flight response to big change is based on fear — the brain perceives risk and tries to get away and avoid that risk. Knowing what you are doing, helps eliminate the fear and reduce the risk. As it turns out, Lynch and the others didn’t want or need the insurance because they had strong convictions in their company research and selection process, and the guts to stick it out. Can you say the same?

    

   Concentrate on not losing

   A concentrated portfolio (in winners!) is the best chance for outperforming the market but the cost of being wrong can be catastrophic. Diversification is the embodiment of the adage: the best offence is a good defence. According to Buffett, investing Rule Number One: Never lose money. Rule Number Two: Never forget Rule Number One.

   Whether you are in the accumulation stage or withdrawal stage, diversification provides safety and protection from the permanent loss of a significant chunk of your portfolio. It helps you to preserve your wealth, which in turn allows your wealth the opportunity to grow. It positions you to achieve your long-term goals.

    

   A cost worth paying

   The relative safety that diversification provides, however, comes at a cost. The cost is giving up a shot at excess (market-beating) returns. But as I’ll discuss in a later article, this is a worthwhile trade-off since we don’t care about beating the market or keeping up with the Joneses. We do care about reaching our personal financial goals and, frankly, being able to sleep at night.

   An S&P 500 Index fund provides substantial diversification, but don’t lose sight of how it interacts with your personal timeline and goals. While the S&P 500 index is a large group of 500 companies and has performed remarkably well over the long-term, it represents only about 12% of all the listed companies in the US, and an even smaller subset (1.2%) of the 41,000 listed companies around the world. In the long-term, it might represent enough diversification for you, but if you have a shorter timeline, maybe not.

    

   The “Lost Decade”

   As an example, let’s think about a retiree at the beginning of 2000 with their $1m portfolio invested 100% in the S&P 500. For the next decade, 2000-2009, the S&P 500 returned zero (actually, slightly less than zero; an annual average of negative 0.95%).  An unlucky and unpleasant position for our recent retiree. After the first ten years of retirement, our retiree’s portfolio value (before taking any withdrawals) would have declined by almost $100,000.

   This so-called “Lost Decade,” however, turned out to be a good decade for investors who diversified their holdings globally beyond US large cap stocks and included other parts of the market — for example, companies with small market capitalisations, or value stocks.   

   A more diversified portfolio (for example, US stocks, foreign stocks, emerging market stocks, bonds, and real estate) averaged 6.7% — all during a timeframe that included the dot-com bubble, 9/11, the Iraq War, and the 08-09 financial crisis.

   [NOTE: The following decade, 2010-2019, the S&P 500 return stormed back and averaged 13.5% per year for a cumulative two-decade average of 6%. And for those curious, the average annual return for the S&P 500 since adopting 500 stocks into the index in 1957 through 2021 is 10.67%. The long-term has been spectacular for the S&P 500 index, but the short-term is often a bumpy ride.]

   Here is a mathematical fact: a concentrated bet in the RIGHT individual stocks will produce a better return than the S&P 500 or almost any other index. But what is the probability that you can pick the right stocks and stick with them for decades? And what are the consequences of you being wrong?

    

   Winners and losers

   If you had picked one of the best performing stocks at the beginning of the Lost Decade, Green Mountain Coffee, a $10,000 investment would have grown to a tasty $889,000 over the next ten years (assuming you didn’t sell and take your profits somewhere along the way of that meteoric rise).   

   Alternatively, if you had instead chosen to put your entire portfolio into JDS Uniphase (a high-flyer coming out of the 1990s), you would have lost 99% and be looking at less than $100 remaining in your account. So, do you have the chutzpah to pick one or two individual stocks for the next decade and invest your entire portfolio in them?

   And don’t be dissuaded from diversification by the following observation. By being properly diversified, you will never have the best performing portfolio. There will always be other portfolios that perform better than yours. Being diversified means that some of your investments perform worse than others (since not all your money was in Green Mountain). On the bright side, it also means that you will never have all your money invested in the worst performing investments. Avoiding catastrophic losses is more important than capitalising on big-win opportunities.

    

   Time is your friend

   Professional money managers may overweight their favourites to capitalise on what (they think) they know, but even they still diversify to some extent to protect against what they don’t know. In fact, contrary to the common perception, active fund managers with diversified portfolios tend to outperform those with heavily concentrated ones.

   No matter how bumpy the ride is in the short-term, the long term is your friend. Here are the WORST long-term compound annual growth rates (using rolling 20-year periods) for a sample of popular U.S. asset classes from 1980 through 2021 (i.e., the 1980 annual result would be for the 20-years ending with 1980):

   • Large-cap blend stocks 5.9%

   • Large-cap value stocks 6.4%

   • Small-cap blend stocks 9.0 %

   • Small-cap value stocks 8.9%.

   You can invest in low-cost ETFs for any or all these asset classes. Looking for one stop shopping? A total stock market fund, such as Vanguard’s Total Stock Market Index ETF (ticker: VTI) might be a good place to start your search.

   To ensure your diversification is effective, make sure your exposure to the various sectors and asset classes you end up choosing is consistent with your timeline and overall financial plan.

    

   Don’t miss your one free lunch

   As Harry Markowitz said, diversification really is the only free lunch in investing — and it’s a healthy lunch too.

   Failing to diversify as an investor is like going grocery shopping and simply filling your cart with 17 different brands of potato chips. That might work in the short-term, but for your long-term health, you also want to find room in the cart for staples like grains, fruits, vegetables, and of course, filet mignon!

    

   The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.   

    

   NEXT TIME: What do market cycles teach us?

    

   PREVIOUSLY ON TEBI

   If you found this article interesting, we think you’ll enjoy these too:

   The Big Shortcoming: a dismal decade for active large-growth

   Why financial planning is worth paying for

   What does it really mean to be wealthy?

    

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   We are currently seeking partnerships in North America and Australasia with firms that share our evidence-based and client-focused philosophy. If you’re interested in finding out more, do get in touch.

    

   © The Evidence-Based Investor MMXXIII

    

2. The only way to be a buy-and-hold investor

   November 27, 2020 5:24 pm Comments Off on The only way to be a buy-and-hold investor

    

   This tale is part of LARRY SWEDROE’s Investor Tales series. Unless otherwise specified, the tales are hypothetical scenarios, designed to educate the reader on investment principles.

    

   In early 2000, Cathy called Brenda to invite her to an investment seminar sponsored by her CPA. She told Brenda the seminar was part of a series. She had enjoyed the prior sessions and thought Brenda would too. Brenda was sceptical; her experience was that investment seminars were really sales presentations. Cathy assured her this seminar would be purely educational. With that assurance, Brenda agreed to join her.

   The speaker began by stressing the importance of developing an investment plan before any investment decisions are made. She emphasised this point by explaining that without a plan it would be impossible to properly evaluate how any decision would impact the overall risk, and the likelihood of success, of an investment strategy.

   She then explained how important it is to understand there is no one “right” plan. Each plan should be based on an investor’s unique ability, willingness and need to take risk. The plan should take into account such factors as the stability of the investor’s earned income, their investment horizon and their current level of wealth relative to their need for investment income. She also stressed the importance of diversification and the need to avoid the “too many eggs in one basket” syndrome.

   She then explained that the only effective way to build a truly globally diversified portfolio is through mutual funds or exchange traded funds. She emphasised that having a well-developed plan was only the necessary condition for investment success. She presented the evidence on the failure of market-timing efforts to deliver on the promise of superior returns and the inability to avoid bear markets. Thus, the sufficient condition for investment success is to be a disciplined, patient, long-term, buy-and-hold investor.

   After the seminar, Cathy introduced Brenda to her CPA, Erica. They both thanked Erica for an entertaining and educational program. Cathy noted that she was particularly impressed by the slides on the failure of efforts to successfully time the market—too much of the returns occurred over brief and obviously random periods.

   Brenda said she’d been told early in her career that the winning strategy was to be a buy-and-hold investor, and she was particularly proud she’d been investing with Fidelity Magellan Fund for more than 20 years and had never sold any shares. The conversation proceeded as follows.

   Erica: I’m glad both of you enjoyed the seminar. There’s one point I believe is worth going over. Unfortunately, many investors make a mistake when implementing a buy-and-hold strategy. There’s really only one way to ensure that your investment plan, or asset allocation, remains what you want it to be. That way is to invest in only passively managed funds such as index funds and other funds that invest systematically in a transparent and replicable manner.

   Investors who use actively managed funds to implement their asset allocation often have their strategy undermined by market-timing efforts and the resulting style drift that accompany active management. So, Brenda, while you were being a disciplined, patient, passive investor, holding your Fidelity fund for more than 20 years, the fund manager was active, undoing your buy-and-hold strategy. Let me explain.

   The charters of most actively managed mutual funds give their portfolio managers the freedom to shift allocations between asset classes at their discretion. Investors in such funds not only lose control of their asset allocation decisions but also end up taking unintended risks by unknowingly investing in markets, or types of instruments, they wanted to avoid. For example, a large-cap fund might invest in small-cap stocks. Or a domestic fund might decide to buy international stocks. Ironically, perhaps the best example of this problem (but one that is in no way unique) is the fund you own, the Fidelity Magellan Fund. Do you recall what happened to the fund in 1996?

   Brenda: I do remember it wasn’t exactly a great year. In fact, I think the manager was fired due to poor performance.

   Erica: Your memory is good. Let me explain what happened and why it’s so crucial to learn from that experience. Over the years many investors have placed the equity portion of their portfolio in Fidelity Magellan. Unfortunately, in February 1996, Magellan’s asset allocation was only 70 percent in equities, 20 percent in bonds and 10 percent in short-term marketable securities (data from Portfolio Visualizer).

   Magellan’s investment manager at the time, the highly regarded Jeffrey Vinik, was obviously making a big bet — with your money — that long-term bonds and short-term marketable securities would outperform stocks.

   To illustrate why that’s a problem, I’m going to create an example demonstrating how Vinik’s decision impacted your investment strategy. Let’s assume that at that time your portfolio had a total value of $100,000 and your plan was to have an 80 percent equity/20 percent fixed-income allocation. You would have had $80,000 invested in Fidelity Magellan. However, as this table I’m creating shows, due to Vinik’s strategy, you actually would have had only $56,000 ($80,000 x 70 percent) invested in equities.

   Unbeknownst to you, your allocation was subjected to what is called “style drift” — your 56 percent exposure to the equity markets was less than the desired 80 percent. By placing funds with an active manager, you allowed someone else to modify your strategy.

   It’s essential to note that, for me, the key issue wasn’t the outcome of Vinik’s decision. Instead, it was your having lost control of the asset allocation process, which means you lost control of the risk and expected return of the portfolio. You may not remember, but the market subsequently soared to new highs. To make matters worse, the bonds Magellan had bought fell in value. And as you correctly recalled, the fund manager moved on, as they say, “to pursue other career alternatives”.

   This was such a compelling story that it led Peter Bernstein, in his wonderful book Against the Gods: The Remarkable Story of Risk, to analyse the composition of the Fidelity Magellan Fund. For the period February 1985 to June 1995, he noted that its composition “varied over time to such a degree that it would have been virtually impossible for investors to determine the asset classes in which they were investing, or the risks to which they were being exposed.”

   The Fidelity Magellan example is by no means a unique one. There is really only one way for you to avoid this type of risk and the damage it can cause. You must use only passively managed funds. However, even this is only a necessary condition for successful buy-and-hold investing. The sufficient condition is to rebalance the portfolio on a regular basis. Since asset classes change in price by varying percentages, it’s necessary to rebalance the portfolio on a regular basis to restore it to its desired asset allocation. Otherwise, the market will cause the same type of style drift that active managers cause.

   Brenda: That was a helpful explanation. Thanks again for inviting me. I have a lot to think about.

    

   The moral of the tale

   There is only one effective way to implement a passive, buy-and-hold investment strategy — both the investor and the vehicles in which they invest must be passive. And even that is not sufficient. The investor must periodically rebalance the portfolio to avoid allowing the markets to cause it to style drift (alter their asset allocation).   

    

   Important Disclosure: The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.  While reasonable care has been taken to ensure that the information contained herein is factually correct, there are no representations or guarantees as its accuracy or completeness. No strategy assures success or protects against loss. The story about Cathy, Brenda and Erica is hypothetical and should not be interpreted as representative of any individuals actual experience.

    

   LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.

   Want to read more of Larry’s insights? Here are his most recent articles published on TEBI:

   For every buyer there must be a seller

   Cost a huge factor in endowment performance

   Even a crystal ball won’t help

   A higher intelligence

   Unique insight or common knowledge?

   What investors can learn from Moneyball

    

   PREVIOUSLY ON TEBI

   Here are some other recent posts you may have missed:

   The only way to be a buy-and-hold investor

   Why active will continue to underperform

   Why cap-weighting dominates

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   The patience of a saint

   For every buyer there must be a seller

    

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   © The Evidence-Based Investor MMXX

    

    

    

3. The beating-the-market myth

   September 11, 2019 12:36 pm Comments Off on The beating-the-market myth

    

   Much of the mainstream media commentary around investing carries with it the assumption that beating the market should be everyone’s goal. But what does that mean? And does it make any sense?

   Essentially, the idea that ordinary investors can consistently do better than the market, after allowing for risks and fees, is a fanciful one. The truth is even the pros struggle to outperform the market year-in and year-out.

   Of course, you will hear of outliers like Warren Buffett of Berkshire Hathaway or Peter Lynch of the Magellan Fund who seem to hold out hope that delivering market-beating returns for years is within everyone’s grasp.

   But the record shows that most managers struggle to beat benchmarks over long time periods and that the winners don’t tend to repeat. And even allowing for manager skill, that still leaves investors with the challenge of finding the skilled ones ahead of the event.

    

   Distinguishing luck from skill

   Another issue for those of us trying to pick the best managers is separating out luck from skill. A famous academic paper in recent years looked at the performance of US mutual funds over 23 years and found few funds product benchmark-adjusted returns sufficient to cover their costs.

   This isn’t to say there aren’t skilled managers. But think about this: If those managers do have sufficient skill to beat the market year after year, why would they not capture all those rents themselves? Why would they share it with the wider public?

   In any case, what is advertised as skill is frequently just what is there for the taking. In recent years, what managers advertise as “alpha”, the skill that enables them to beat the market, has increasingly been exposed as beta – the return you can earn without trying to outguess the market.

    

   The behaviour gap

   But while the various camps in the asset management industry slug it out over how much value they add, the challenge for most investors is just getting the market rate of return. Studies like the annual DALBAR analysis of investor behaviour regularly find a significant gap between what the market offers and what average investors receive.

   People underperform the market mainly because of their own behaviour. They are more sensitive to losses than gains, they chase past winners, they fail to sufficiently diversify, and they try, in vain, to time the market. They also ignore boring, but important, factors like costs and taxes.

   A lot of this bad behaviour results from people thinking that their goal should be to “beat” the market when their real goal is to earn the market return and do it consistently and at low cost so that they maximise their chance of securing the long-term returns they need to retire on.

   It doesn’t sound sexy, does it? But when investing starts to sound sexy is when the alarm bells should go off.

    

   Short-term market movements are unpredictable

   The fact is market returns are unpredictable. And that, in part, is because news is unpredictable. Economies are fluid; growth accelerates or slows; companies rise and fall; once dominant industries succumb to technological evolution; and consumer preferences are always changing.

   Markets price all this news instantaneously, reflecting collective expectations for future returns. Trying to outguess the market means second-guessing those prices, which is a haphazard occupation at best.

   You may, of course, be right, but you’re just as likely to be wrong. And remember, to outperform consistently you need to keep on making correct calls time and again, and hope that any gains you make at least offset the costs involved in active trading.

    

   Follow Warren Buffett’s advice

   Even Warren Buffett, the doyen of stock pickers, has argued that most people would be better off in a low-cost index fund. And he famously won a $1 million bet that these boring “passive” funds would do better than most expensive and elaborate hedge funds over a decade.

   So, while the idea of beating the market is an attractive one, the reality is that most people are more likely to get “beaten up” by the market. And they do so primarily because of a refusal to just accept that prices, however imperfect, reflect the best available estimate of future returns.

    

   Investing Fundamentals is a series in which we look at the basic principles underpinning successful investing. Here are some other recent articles in the series you may have missed:

   Be prepared for any weather

   Stock price movements: How predictable are they?

   How much risk should you take?

    

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4. Active vs passive investors: who behave better?

   November 6, 2018 9:08 am Comments Off on Active vs passive investors: who behave better?

   I was given the opportunity at the recent Humans Under Management conference in London to tackle one of the more insidious and resilient myths about index investing — namely that passive investors are particularly prone to bad behaviour.

   I’ve included my presentation at the end of this article. You should find it reasonably self-explanatory, but here’s a brief summary is what I said.

   The theory that those who invest in index funds and passively managed ETFs are especially vulnerable in the event of a downturn is closely connected to another myth — the idea that actively managed funds provide (to use the phrase favoured by fund house marketers) an element of “downside protection” in falling markets.

   Downside protection is a myth

   Numerous studies have been conducted which show that active funds are no more likely to beat their benchmark in bear markets than they are in bull markets. In my presentation, I highlighted research by Lipper, Goldman Sachs, Vanguard and S&P Dow Jones Indices — all of which concludes that that active funds perform no better in down markets than index funds, and in many cases considerably worse.

   How have active investors behaved in the past?

   Active management is often sold to investors and advisers as if it somehow makes it easier to stay the course. It’s instinctively reassuring to many investors to know that, to quote a recent investment manager in the Financial Times, that “there’s someone driving the bus”. But it’s a false comfort.

   As Joe Wiggins, himself an active manager, recently explained on his blog, the behavioural challenge facing active investors is particularly daunting. “The more genuinely active a strategy is,” says Wiggins, “the greater the likelihood that it will experience spells of pronounced and often prolonged underperformance, which will be unpalatable for many investors.”

   Fidelity Investments conducted a study on its Magellan fund from 1977 to 1990, when Peter Lynch was in charge. His average annual return during that period was 29%, which makes him one of the most successful active managers of the modern era. You would have thought that investors in the fund enjoyed substantial returns, and yet, shockingly, Fidelity found that the average Magellan investor lost money during Lynch’s remarkable winning run. In other words, whenever the fund suffered a setback, money would flow out, and when it got back on track, money would flow back in, by which time investors would have missed the recovery.

   How have passive investors behaved in the past?

   What about passive investors, then? How do they behave when markets fall? The historical evidence is actually pretty encouraging. Bloomberg’s Eric Balchunas, for example, has shown how, in 2008, the year of the credit crunch, actively managed funds in the US saw outflows of $259 billion, while index funds and ETFs saw inflows of $205 billion. In other words, active investors were net sellers, while passive investors were net buyers.

   It was similar story in the downturn between May and October 2011, when the S&P 500 Index fell 20%, and again between May 2015 and February 2016, when it fell 14%. Active investors fled; passive investors continued to buy.

   Conclusion

   Of course, passive investors are only human, and there are many who do misbehave. There are also large numbers of investors who invest actively using passively managed products. But, generally speaking, investors in index funds and ETFs have historically shown themselves to be relatively disciplined.

   There is no room for complacency. It’s up to financial advisers and other financial educators to keep encouraging good behaviour. But the idea that passive investors will, en masse, head for the hills in a blind panic when the next crash comes is completely fanciful.

    

   How do passive investors behave? from Robin Powell