Thursday, December 8, 2011

That's Fine, But Did I Make Any Money?

In late 1999, when I first joined Boston Private Bank, I had the chance to make a number of new business presentations with one of our top salespeople named Trip Hargrave.

Trip was successful for a number of reasons, but one of his best traits was his ability to help prospects come to decisions.

For example, often a prospect would make the first decision - yes, they wanted to open an investment account - but froze when it came to asset allocation.

The correct balance between stocks, bonds, and any other asset class is a very difficult decision, but Trip made it simple.

Here's the only question he would ask:

"Historically, stocks have returned 12% per annum, and bonds 6%. Which return would you prefer?"

Um, let's see: do I want 12% or 6%?

Easy, right?

But, as it turns out, that was the wrong decision, at least for the first decade of this century.

Starting at the end of 1999, the investing in the stock market - as measured by the S&P 500 - was a money-losing proposition. Meanwhile, bond investors nearly doubled their money, assuming interest payments were reinvested.

This is not to pick on Trip - who remains a friend of mine, even though he no longer works here at Boston Private - but rather to highlight the problem of using past performance results to make investment decisions.

Fortune magazine had a good article discussing this issue. Fortune focused on Legg Mason's legendary stock investor Bill Miller, who for 15 years straight outperformed the S&P 500 but then stumbled in the last few years.

Fortune asked a simple question: Yes, Bill Miller's performance numbers were great, but investors in his fund on average make any money?

Here's what they wrote:

{Mutual fund consultant} Morningstar crunched Miller's numbers for me, showing that his average investor had a considerably lower return than the fund posted during his long hot streak.

The fund made 16.44% a year in gains and reinvested dividends during that period, but the average investor made only 11.34%. Miller's average investor actually underperformed the S&P (which returned 11.51% annually during his streak), even though his fund way outperformed the index...

"It's human nature for investors to act this way," says Don Phillips, Morningstar's president of fund research. "When stocks are popular and the market is rising, everyone wants to invest." Then, when the market hits a bad patch, many fund investors sell near the bottom, giving them the worst of both worlds: buying high and selling low.

Today people are generally wary of the stock market, which is not suprising given the anemic returns of the last few years.

And yet, looking forward, are you more likely to produce better returns by investing in stocks or bonds?

Or, as my friend Trip might say, bonds are now trading at yields not seen in 60 years, and stocks largely yield more than corporate bonds and valuations are not unreasonable.

Which area do you think makes the most sense?