THE MEAN CAN BE VICIOUS

FUND RETURNS, REVISION VERSUS REVERSION OR THE VICIOUS TRUTH ABOUT THE MEAN

Did you ever wonder why that hot fund you bought is suddenly a dog? The fact that it has happened so frequently makes you start to think the market is personally trying to make you the world’s worst investor. You can relax, there is a good chance it’s not you that is the problem.

When you look at Mutual Fund advertising you can begin to understand the primary reason why investors almost inevitably buy the wrong funds at the wrong time. The reason of course, is that you do not really buy mutual funds; somebody sells them to you. Whether you read about the fund in the paper, saw the marketing at your bank, or had it recommended by your advisor, there is a good chance the seed was planted through a sophisticated marketing program.

That most marketing programs promote yesterday’s success is not important to the marketing machine; they need “outstanding returns” to put in big bold letters above the tiny warning about past returns not guaranteeing future returns. In fact, the warning should state that past returns are likely to foretell a weaker return in the future. Mutual fund companies know it, the advertising companies know it, and your sales person knows it! It’s really basic mathematics!

In statistics it is referred to as “reversion to mean”. That basic statistical rule suggests that over time the returns on markets, securities and funds will move toward the average. If a fund had a great 2007 then there is a great chance it will have a sub par 2008. If the fund had a great 2006 and 2007 then there is still a great chance it will have a sub par 2008. Knowing this basic rule, it would seem that promoting a poorly performing fund is just as likely, if not more likely, to produce superior results in 2008.

If you need proof Just look at the world’s indexes by country. Hong Kong was the top country in 1991,92 and 93 and just as you and I figured it out it went to last place in 1994. In 1994 Japan was number one and in 95,96 and 97 it was in last place. In 1999 it was back to first place. The U.S. was last in 1993 and second best in 1995,97 and 98 but careful because as you jumped in 98 the U.S. was headed for last in 2003,04 and 05. If you followed the industry marketing you jump in at the end of the bull and you sell out in frustration at the bottom of the bear market. The fund companies and advisors however take their cut in good and bad markets so they were not hurt nearly as bad as you.

What does the smart money do? The smart money is often called contrarian because it refuses to chase last year’s winners. The smart money also avoids the bubble stocks because they invest on sound fundamentals, not on marketing noise. Retail customers however invest by listening to the marketing campaigns. If everybody is getting into energy then I better call my advisor and get some energy stock. If everybody is buying REITS I better get some too. If everybody is buying Nortel I better get some too. To make the urge to chase hot securities seem legitimate you have the marketing supported by buy side analysis and seemingly independent sourses like Business News Network and the national papers with buy side articles telling you the top securities every week, month and quarter. How can all these folks be wrong?

Reversion to mean is vicious because it is relentless. What goes up does indeed come down and most often it does so shortly after you bought it. The smart money leads on the way up and the suckers follow as the security turns negative. Unfortunately in the security markets, retail investors are often played as the suckers.

How do you beat this cruel reality of the markets. You have two choices. You can find a great contrarian manager and hope their returns do not revert to the mean, or you can buy the indexes and accept the mean returns as a fair return on your equities. The indexes of course are not exciting, but they are cheap to own . Best of all in a well diversified portfolio you can accept the markets random emotional turmoil without wondering if you are the smart money or the sucker.

A lot of good will happen if you stop chasing last year’s winner and just accept that reversion to mean will balance your returns over time. You can play the market but you cannot beat the market by looking in your rear view mirror.
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