Why rational investing requires a long-term view

Why rational investing requires a long-term view

Let’s do something in honour of Rational Decision Day[1] today, and try to advance the cause of sound investment decision making.

Consider the following scenario: A fund manager launches a fund with capital from family and friends.  In the first 6 months, the manager delivers a pleasing 15 per cent return, but then gives up two-thirds of that gain in the following 6 months, to end the first year up 5 per cent.  In the first half of the second year, the headwinds continue and another 5 per cent is lost, before things turn around in the second half when another 15 per cent return is delivered. To keep it simple, let’s assume the market was flat for these two years, so all of the gains and losses reflected outperformance or underperformance.

Here it is in graphical form.

Now, what do we make of the skill this fund manager has demonstrated?

The first point to make is that with 2 years of track record we really can’t tell much.  Our manager has delivered an excellent rate of outperformance over the two years, but clearly there is significant volatility and so luck plays a big role in shaping the numbers.  If we had checked in on our manager mid-way through the second year, for example, we would have observed zero outperformance.

I harp on about this issue every chance I get, so for many readers this will be old news.  But wait! There’s more.

Now imagine you were watching from the sidelines for the first 6 months, and decided to invest with this manager at the end of the first half, having seen the good early results.  Your experience of the manager would be a painful series of losses over the following 12 months, at which point many investors would throw in the towel and withdraw their money.

Those that held onto their towel would have recovered to end square in the next 6 months, but we now have three different groups of investors we could consider:  Those that were there from the beginning, those that came late and left disappointed, and those that came late and held on.

If we were to ask these three groups of investors to each rate the skill of the manager, I can guarantee we would get three very different sets of answers, ranging from excellent to miserable, reflecting the particular investment experience of each investor group.

We can see that it is not rational to have three conflicting assessments of the skill of the one manager but, human nature being what it is, this is absolutely what happens.

Compounding this is the fact that a lot of investors unwittingly allocate themselves to the “miserable” group.  It is very tempting to allocate capital to a manager on the strength of a strong year, and then withdraw that capital following a period of weakness.  This mindset results in investors systematically buying high and selling low, and achieving far weaker returns than they could with a more patient mindset.

To summarise, it’s important to take a long term perspective on investment performance to minimise the effect of short term “noise”, and it’s helpful if you can detach yourself so that your own short term gains and losses don’t get in the way of sound assessment and decision making.

With that in mind, it’s time to get back to the business of finding the opportunities that will drive those long term gains for investors.

Which I’ll do right after I check to see whether The Montgomery Fund is outperforming or underperforming today.

[1] Not a real thing

MORE BY TimINVEST WITH MONTGOMERY

Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.