Tuesday, October 27, 2009

Professionals May Be Anything But...

Most people have the idea that professional investors, such as fund managers, really know what they are doing. Frankly, the truth is nowhere as pretty. And it is Peter Lynch, who blew the whistle, so to speak, in his book, "One Up on Wall Street".

Think about it... Professional investors are a tight-knit lot, read the same news, talk to the same people, no wonder they have the same mindset... pretty homogenous lot.

Also, the investor community in general are risk-averse. They want returns, but not the risk. Thus, if a fund manager picked a seemingly "safe" investment, and it lost money, the shareholders will not fault you for picking it. However, if the fund manager picked a risky startup as investment, and it lost money, the fund manager gets blamed. Thus leading to another famous Wall Street Myth: "You can't get fired for recommending IBM (even if it loses money)". Or put it another way: if you pick IBM and it lost money, people blame IBM. if you pick some noname dotcom and it lost money, people blame YOU.

Furthermore, people love to compare notes. If A invests in fund X and B invests in fund Y, then A and B talk and A found out fund X has underperformed fund Y by about 10% (even though X is doing 20% and Y is doing 30%, both are darn good yields), A will likely do either of two things: 1) yell at the fund X manager for NOT investing wise enough, and how he could have done better with fund Y. (very powerful if A is a large investor in fund X) or 2) simply pull his money out of fund X and put it into fund Y.

The net effect is fund managers are given an "approved list" to invest from, supposedly safe investments, usually big caps, and as a result, they will give similar yields... LOW yields.

Also, a lot of fund are restricted to a certain company size: small cap, mid-cap, large cap. All based on market capitalization. The best time to invest in a company is when it is still a small cap, but 1) it is risky, as all startup or new companies are, 2) some funds simply cannot invest in them, due to their charter and their approved list of stocks, and 3) because the government says that you can't.

SEC rules that a fund cannot allocate more than 5% of its assets in a single company, and it cannot own more than 10% of a company's oustanding shares. In other words, a fund is forced to diversify, and cannot capitalize fully on a company's rising fortunes. Instead of finding 1 or 2 high growth companies, it now must find at least 20 (5% x 20 = 100%), assuming 5% of its funds will buy 10% of the stocks. Often, it's too much, so they need to find yet MORE companies to invest in, so is it really diversifying the risk, or is it diluting the gain potential?

And what's worse, most analysts are groupies: nobody wants to stick their neck out and be first to recommend something. Peter Lynch gave several examples, like "The Limited" women's apparel company. When it first launched, NOBODY CARED. Maybe one obscure analyst rated it good, even though it opened dozens of stores in a few years, and people who shop there loved it. Major investment firms ignored it for almost a decade, then suddenly it is the darling of the market and the price got so inflated it was way overvalued, then came the inevitable crash. Plenty of other companies were that way.

Thus, you should not totally trust the professionals in the market. Again, "trust, but verify". Don't assume that because they work at a big and famous investment company, they would know what they're doing.

[NOTE: there are ways around the SEC rules... Such as a hedge fund, which is open only to investors with more than 1 million dollars to invest (presumably, if they have that much money they know what they're doing). We small investors can't hope to get in like that. ]

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