The Ego, The Market, and The Mania

Fact #1: from 1984 through 1995 the average stock mutual fund posted a yearly return of 12.3% while the average bond mutual fund returned 9.7% a year.

Fact #2: from 1984 through 1995 the average investor in a stock mutual fund earned 6.3% while the average investor in a bond mutual fund who earned 8%.[i]

If you are like me, you ask the questions, “What is wrong with this picture? How can this be?”

Well, what it shows is actually quite interesting. Rather than creating an appropriate asset allocation and “buying and holding” a diversified portfolio of mutual funds, it appears that most investors over that time period moved in and out of various mutual funds, probably in an effort to maximize their returns.

This is happening more often now as our society becomes entrenched in the “up to the minute” news phenomenon.

Consider a study done by former Harvard psychologist Paul Andreassen which compared the mock investment performance of four groups of investors:

Using actual prices and news reports, two of the groups made investment decisions about a relatively “stable” stock – its share price didn’t move all that much over the course of the experiment. In this study, one group was subjected to regular streaming news reports about the company; the other group received no news at all. In a subsequent study, the other two groups received a similar test, except that in this instance, the stock in question was a highly volatile company that was subject to wider price swings than the shares of the other company. In both instances, investors who received no news performed considerably better than those who received constant information; those who were kept “in the dark” actually earned more than twice as much money as those whose trades were influenced by the media.

How would you react under similar circumstances?

Imagine for a moment that you owned Hewlett-Packard stock eighteen months ago and read the cover story in Fortune entitled “Why Carly’s Big Bet is Failing” which provided an in-depth discussion of the demise of HP after the Compaq Computer merger.[ii] Written by veteran Fortune writer Carol Loomis, the article exam the promised benefits of the controversial merger with Compaq computer completed in May 2002 and found that the results had fallen far short of the mark. Loomis wrote, “This was a big bet that didn’t pay off, that didn’t come close to obtaining what (CEO Carlton) Fiorina and HP’s board said was in store.” She further argued that personal computers for HP were a “Big Lousy Business,” and observed that the real money and technology was earned by firms dominating their markets like Intel and Microsoft and apart from the printer business. Loomis observed, “HP doesn’t dominate anything.”

At the time the article appeared, Hewlett’s opposition appeared to be vindicated: HP shares had underperformed the S&P 500® as well as industry rivals Dell, IBM, and Lexmark, since the merger was first announced in September 2001.

After reading the above, would you have considered selling HP?

Contrast this to Fortune’s next major cover, a salute to Dell Incorporated, which appeared only one month later entitled “The Education of Michael Dell.”[iii] This glowing review of Dell went on to rank the company #1 in the magazine’s Most Admired Company survey. Fortune writes, “Be it desktops, notebooks, and servers, or in profits, growth, and margins, Dell is the leader. And it isn’t slowing down either.” Apparently, the combination of HP and Compaq appeared to pose little threat to Dell’s direct-sales model. As one observer said, it was “just a bigger butt to kick.”

Sounds like Dell is the stock to beat, right?

Well, subsequent earnings announcements and stock returns certainly illustrate how difficult it can be to earn the highest stock returns by backing the “winning” horse:

On August 16 Hewlett-Packard Reported fiscal third quarter revenue of $21.9 billion and net income of 1.38 billion-exceeding estimates from Wall Street analysts for the fifth consecutive quarter. Operating profits for Hewlett’s personal computer business were up 69%.

Dell reported fiscal second quarter net income of 502 million a 51% drop compared to a year ago. And the shares have fallen 26% for the year to date through August 18.[iv]

		August 31, 2001	August 18, 2006
Hewlett-Packard	HPQ	$23.21	$35.52	+53.04%
Dell	DELL	$21.38	$22.16	+ 3.65%
IBM	IBM	$99.95	$79.90	- 20.06%
Lexmark	LXK	$52.17	$53.32	+ 2.02

The evidence suggests that exhaustive analysis of a company’s prospects offers no sure path to excess returns.