The Next Big Investing Mistake

Five years ago (July 2001) the S&P 500 sat just above 1200, down from it's peak just above 1500, over the next 15 months the index plunged to just over 800, shedding a third of its value and destroying billions of dollars of invested wealth, taking the index down to just over 50% of its peak.

As the index went through this sickening plunge a select few money managers preserved client wealth, or at least lost a lot less than the index. These managers have reaped the benefit over the past few years as their 2001-2002 record fed into their three year and five year performance numbers, the result is that these (primarily value) managers have attracted a lot of investor money to their funds over the past five years.

It's a little counter intuitive, but protecting investor assets during a downturn is more valuable than beating an index return during good times.

As Warren Buffett says: rule number on of investing is don't lose money, rule number two is don't forget rule number one.

Think about it this way, if an investor has $1000 and earns a 50% return followed by a 50% loss, they don't get back to even, they end up with a loss, the fund goes up to $1,500 and then falls to $750. The order of the gain and loss doesn't matter, you can go down to $500 and then up to $750, but the simple fact is that a 50% loss has a bigger impact than a 50% gain.

So how does this lead to the Next Big Mistake?

Over the next year the investment managers who protected their clients during the 2001-2002 crash will lose those performance numbers as the beginning for the five year period slips into the later part of 2002. The result is that as investors screen funds using three and five year numbers, they end up looking at less capable investment managers who destroyed client wealth during the most recent crash.

Growth managers who lost tons of money for clients will be happy to see the five year numbers change (and five year Morningstar screens) and see investors forget they used such reliable valuation metrics as price per page views to buy stocks like Pets.com and Webvan.

It is already beginning to happen, and the short memory isn't limited to individual investors. Institutional investors who select mutual funds for clients are already heavily discounting manager performance during 2001-2002. These professionals are beginning to treat good performance during the downturn as some sort of aberration, rather than a real indication of investment talent.

The real mistake is that they implicitly assume that there will not be another big correction in the future, that the market will keep going up, so it is okay to focus on performance numbers generated during good times.

In short, get ready to hear how well "Growth" has done over the past five years as the "Growth" disaster of 2001-2002 fades from memory.

Timothy Burger
timothyb(at)timothyburger.com