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July 23, 2009

Buy High, Sell Low

Last summer in a previous newsletter, writing about the similarities

between investing and flying kites, I said that, when we lose control
of a kite and see it plummet downward, we instinctively recoil and
pull on the string hoping that we will regain control of the kite, when
in fact all we do is make matters worse; and, that the correct
maneuver is to trust the kite, as it were, give it more string and wait
for it to right itself. In kite flying, “doing nothing” is sometimes the right thing to do.

A group of research psychologists in Israel, studying the behavior of professional soccer

goalies in penalty shot situations, identified a similar bias toward action even though
“doing nothing” ― in that case, standing still ― was also the right strategy. They found
that diving to their right or left, trying to guess which way the opposing player would kick
the ball, had a one-in-seven chance of succeeding whereas standing still would succeed
one third of the time. However, despite their skill, experience and huge financial
incentive to succeed, professional goalkeepers held the centre only 6.3% of the time,
which the researchers attributed to an action bias that makes “goalkeepers feel worse
about a goal being scored when it follows from inaction (staying in the center) than from
action (jumping)”. What is the relevance of these finding for investors, and of my
comments about flying kites?

Last month, John Boggle, founder of Vanguard Funds, the second largest mutual fund
company in the world, and a leading proponent of indexation over actively managed
funds, released new research showing that individual investors in exchange traded funds
(ETFs) are significantly under performing the very same ETFs in which they invest.
The degree of investor-lag ranged
from -0.4% per year for large-cap MAJOR MARKETS
value funds to -17.9% per year for Annualized Five-Year Performance
financials ETFs. Fund Returns vs. Investor Returns
Fund Investor Investor # of # of Funds w/

Return Return Lag Funds Investor Lag

In other words, the average Large Cap Blend -1.40% -5.70% -4.30% 14 14

annual return for the 79 ETFs in Large Cap Growth -1.70% -7.70% -6.00% 6 6

the sample, over the study’s five Large Cap Value -1.80% -2.20% -0.40% 9 9

year period, exceeded the actual Mid Cap Blend 0.40% -3.00% -3.40% 5 5

Small Cap Blend -0.50% -6.90% -6.40% 3 3

returns that the investors earned
European-Pacific 3.10% 0.50% -2.60% 6 6
as a group. Moreover, what is Emerging Markets 15.60% 3.80% -11.80% 3 3

most important from our

perspective is that we can trace this underperformance to changes in the cash flows in
and out of these funds as they were going up and down in value. In a nutshell, these
investors tended to buy high and sell low.

July 23, 2009

As John Boggle put it, “So we have evidence, strong evidence, that exchange traded
funds ― because of the timing that goes on ― are not acting in the best interest of
investors, or investors are not acting in their own best interest, might be a fairer
way to put it (my emphasis)”.

While Vanguard’s study is the first one that focuses on the inability of ETF investors to
time the market, we have long been aware that poor investor behaviour is the rule rather
than the exception in the world of mutual funds. But what is striking is the degree of
under performance, which may be
the result of the incredibly high
Five Highest Turnover ETFs Five Lowest Turnover ETFs
turnover (trading) in the 79 ETFs in
Annual Share Annual Share
this study: more than 10,000% for Fund

the SPDR broad US ETF, for 1. iShares Real Estate 21,977% 34. iShares Europe 350 241%

example. 2. SPDRs 10,105% 35. Vanguard Pacific 235%

3. Financial SPDR 9693% 36. Vanguard Health Care 204%

4. PowerShares QQQ 8774% 37. BLRDs Asia 50 200%

It would be difficult to convert the
5. iShares Russell 2000 7763% 38. Vanguard European 188%
investor-lag percentages in the
above tables to actual dollar amounts. The actual losses for an individual investor would
depend on the specific allocation to equities but, they can be quite significant. For
example, assuming an average market return of 8.5% per year and a 15 year investment
horizon, for an investor with a $250,000 equity portfolio, who consistently underperforms
the ETFs in his portfolio a mere 2% per year, his loss would exceed $200,000.

Warren Buffet remarked that a pre-condition of a successful investment experience is a

coherent framework for making investment decisions and the discipline not to let our
emotions interfere with that framework. What are the factors that were at play in the
market-timing efforts of ETF investors? Likely, a combination of the “action bias”
exhibited by the soccer goalies in the aforementioned study with the emotional response
exhibit by the kite flyer when he sees his kite plummet to the ground and a host of other
behavioural and cognitive biases that came together to corrupt what could - should -
have been a more profitable investment experience.

In contrast, the investment strategy that we try to follow is based on a series of simple

• The essence of investing Is not the management of returns but the management
of risk
• Markets are efficient; it is very difficult to identify mispricing opportunities and
harder to exploit them profitably. Market timing doesn’t work
• Diversification is key
• Portfolio structure determines performance
• Costs matter

July 23, 2009

Boggle, in a Q&A after the release of the Vanguard study had a few comments to make
about the role of financial advisors in helping individual investors that I would like to
share with you. I hope you will find them useful

“Well, I happen to believe the financial adviser serves a very useful purpose for many,
certainly not all, but for many, and perhaps even most, investors. We put the stock
market and the bond market and financial planning in this aura of great mystery. And if
you have been around long enough… you realize that there is not that much mystery
about it. The idea is to capture the returns of the bond market and the stock market,
essentially. And that is all there is to it: to capitalize on the miracle of compounding
returns and avoid the penalty of the tyranny of compounding costs…. If investors
understand that much and are broadly diversified, they can really operate on their own.
Now, not everybody can do that….

So I think the investment adviser can play a very useful role, particularly in fund
selection and in asset allocation and, in general, trying to help investors avoid the
penalties of the behavioral kind of investing; of doing dumb things at dumb times. We
may even need a financial adviser to, at times of crisis, have the courage to say to his
clients or her clients, “Don’t do something. Just stand there. Stay the course.” It is
generally better than moving your money around at times of crisis.

…I don’t think we should rely on financial advisers to pick the best funds for us. They
can pick intelligent funds. They can pick broadly diversified funds. They can pick
funds with low turnover and funds with low cost. But picking funds that win is pretty
much hazardous duty that nobody, now matter what their knowledge is, has really the
ability to do. We rely too much on fast returns. I think the idea is to have the adviser
help you capture as much of the market returns as you can … “

These are the year-to-date returns of my model portfolios to July 22nd.

Model Portfolio FP Index Excess Return
(July 22, 2009)
Capital Preservation 5.19% n/a
Income 5.12% 2.83% + 2.29%
Balanced 10.14% 2.99% + 7.15%
Growth 7.95% 5.25% + 2.70%
Aggressive Growth 9.34% n/a

Victor Medina-Leal F.
Toronto – July 2009