The Behavior Gap

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Magellan in the 80s

Massachusetts native Peter Lynch is widely recognized as one of the greatest investors ever. He ran Fidelity’s Magellan Fund from 1977 to 1990 and generated a whopping 29% average annualized return along the way.

This historic stretch would lead most to believe that shareholders made a fortune. Quite the opposite. Lynch calculated that the average annualized return to investors was only 7%, considerably underperforming the S&P 500.

How is it that the typical investor in a fund run by one of the most successful fund managers ended up trailing the overall market? The reason is one that has confounded investors for centuries: timing.

In July 1981, on the heels of Lynch's stellar first four years managing Magellan as an incubator fund for the Johnson family, Fidelity opened it to the public. He continued outperforming in the following three years.

Mesmerized investors flocked to Magellan, and assets began to pour in. In 1986 alone, Magellan took in $2.3 billion in new assets, which was more than half of the fund's AUM at the start of the year. But the prime opportunity already passed.

And on the flip side, many early investors jumped ship at the first setback, in search of the next hottest fund on Wall Street. Had early investors stayed the course they would have continued at least beating the S&P 500 for the remainder of Lynch’s tenure.

Thus we have the behavior gap:

Today, the U.S. stock market is down roughly 15% from all-time highs. The Fed is tightening monetary policy in response to inflation, thus reducing optimism about corporate earnings.

Many companies are down anywhere from 40-90%. Some of them are high-quality businesses that may offer massive buying opportunities. Some may never reach new highs. GE has been waiting since 2000, and AT&T since 1999.

Nobody knows without the benefit of hindsight.

It’s human nature to feel the temptation to try to time the market. And it’s notoriously difficult. The bottom is rarely the bottom, and the top is rarely the top. Buying in at the top is often just unfortunate timing.

But what motivates people to sell at the bottom? Most of the time, it's an emotional reaction to a perceived problem. An avalanche of bad news drops with the market and leads to panic. We forget that TV is entertainment designed for hot takes and CNBC will never show a chyron saying “stay the course”.

And as social creatures, our unique ability to cooperate in groups gives us a survival advantage. So ignoring the noise means resisting our basic instincts. You see red in your portfolio and want to solve the problem. Alas, we humans are not rational and as a result, neither is the stock market.

Banks employ the sharpest financial minds in the world to predict market movements. They have access to droves of financial information that individual investors do not. And still their ability to predict market tops and bottoms is subpar, to say the least.

Apply any algorithm or logic you want, but the human element will always add unpredictability.

Good, not perfect

The thing is, you don’t need to time the bottom to achieve decent returns, as long as you have a far enough horizon.

Inflation is still elevated, the global economy looks weak, and the Fed is raising rates. But it won't take a psychic to produce good returns over the next decade. If you have a far enough horizon, the kind of discount you get in today’s market is already good enough to deploy cash.

With enough time, market corrections become less material. Here’s a look at the 20 worst quarterly returns since 1926 and the ensuing future returns.

I have a pretty good idea of what color those 6/30/2022 question marks will be. Sure there are no guarantees and the market could be worth nothing in 2032. But if that happens, investing will be the least of our worries. We’re buying the market knowing that timing is not perfect, but eventually, the fundamentals matter more than timing. There’s no need to predict the unpredictable.

Time is the main advantage individual investors have. The performance of professional managers is evaluated relative to other active managers and benchmarks. Investors demand quarterly feedback, so prestige and pay depend on how well managers meet expectations. But as an individual investor, to the extent that your time horizon is at least five years, there is no reason to care about price fluctuations over the next day, month, or year.

One of the ways to reduce the risk of further downside is to dollar-cost average. This is just a fancy term for repeatedly buying the same equity positions at a fixed interval. It removes emotional decision-making from the equation and smooths out your cost basis.

Your investment performance will be largely attributed to how you handle times like these. Experienced investors expect bear markets and invest through bear markets.

Prices could drop further but the U.S. stock market is undefeated at coming out of bear markets, and new highs will be reached someday. As for when, unless you’ve cracked the code that none of the Ph.D’s on Wall Street have, most investors are better off staying the course.

As Munger Says, the most difficult thing a person can do is sit alone and do nothing. At the end of the day, is it really about squeezing every basis point out of your portfolio?

Next time you feel inclined to panic, think about this retiree in Boca Raton:

-Sam

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