Friday, January 1, 2016

The Market Poses Problems to the Rational Thinker...

Time. Time is  perceived in two ways . . . as a cycle or as a line.  Cycle time is the time image that best describes nature. Seasons, days, seeds, and birth-death cycles are all part of the rhythmic pulse of nature. Linear time is an abstraction. It is the invention of humans who arbitrarily divide cycles into units. Unfortunately, once the division is made, the units are often perceived as being more significant than the cycles. They are, after all, more logical . . . that is, they are more addable, subtractable, and certainly more abstract. Cycles, on the other hand, vary. None of the cycles of nature occur consistently in terms of linear time. Days, tides, seasons, and gestation periods are all different in terms of linear time. As a result they pose problems to those who measure them in linear time---the rational thinkers. They pose no problems to those who accept cycle time, for these humans are closer to nature and to the metaphoric mind.

The above, from the second edition of Bob Sample's The Metaphoric Mind, elegantly explains what plagues so many individual investors: Linear thinking --- assessing their results on a per unit of time basis, typically a calendar year. All the while the market moves in cyclical fashion, meandering through the seasons without regard for man's calendar.

When comparing past cycles, we see each move through the normal phases---each a bit nuanced---but none occurring consistently in terms of linear time.

That linear thinking---the obliviousness to the market's cyclical nature---is the culprit behind the phenomenon Wesley Grey recently wrote about in the Wall Street Journal.

Here, again, is a snippet:
Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance. “No problem,” you might think—buy and hold and ignore the short-term noise.

Easier said than done.

Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009. The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period.

What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.”

The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially.

In other words, fund managers can deliver a great long-term strategy, but investors can still lose.

1 comment:

  1. Eloquently stated and well noted as usual Marty.