How can everyone be below average?

By DAVID MOON, Moon Capital Management
June 17, 2007

A friend cornered me in my office building last week. 'David, I know that small stocks are more risky, but I've been reading Morningstar and TheStreet.com. They tell me that small stocks do well when the economy starts to do better, but they do a lot worse when the overall economy starts doing poorly. Do you think I ought to be selling my small cap funds right now and buying large cap stocks?'

If it weren't for the fact that we were having this conversation in the men's room, I would have tried to shake some sense into him.

Studies repeatedly demonstrate a few predictable statistics about investing. The stock market returns about 10 percent a year. The average stock mutual fund returns about 9 percent a year. The average mutual fund investor earns about 3 percent a year.

The difference between the average return on stocks and mutual funds is easy to understand; it is the expense ratio of the average fund. But it may be a bit more difficult to understand how investors can buy assets that return an average of 9 percent a year, yet only earn 3 percent annually.

What happens to the other 6 percentage points of return?

Some of it goes to taxes. But a bunch of it vanishes when investors switch back and forth between small cap stock funds and large cap funds or energy stocks or funds that invest in mid-cap southeastern US ethical growth stocks.

As investors chase the hot sector of the day, many of them invariably buy high and sell low. Their emotions guarantee it.

Each January, every national magazine and newspaper publishes a list of the best performing mutual funds from the previous year. About the same time, 401(k) plan participants receive their year-end statements. These two incidents prompt a great number of people to review their investment choices ' and a vast number of them will move some of their money into the best performing funds from the previous year.

Look at the money flow in and out of funds for the first quarter of each year. The funds receiving the most money are the ones with the best short-term performance. That is, investors buy high.

If investors get disappointed at the end of the current year, they dump the most recently purchased funds ' the ones they bought only after the big increase. Then they buy the new winners. That is, they sell low.

Buy high. Sell low. It's an old investment joke, but for many investors, it isn't a joke; it's a description of their portfolio management process.

There were several fallacies in the logic of my aforementioned bathroom buddy. For example, when it comes to risk, size doesn't matter. The market capitalization or revenues of a company do not determine its riskiness.

The most dangerous assumptions in his logic, however, is that he could make broad predictions about the economy, and then switch among stock segments, generating above market returns. It is, instead, a predictable way to guarantee leaving those six percentage points on the table.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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